The markets are expensive at the moment and it might be time for investors to refresh themselves on the risk management benefits of options. Put options can be used as “insurance” to hedge a position in what is commonly known as a Protective Put option strategy.
With a Protective Put option strategy, the investor stays long the underlying asset and can continue to participate in its fair value gains and dividends, but is limited to the downside by the put option which gives them the right to sell at the strike price.
The strategy has quickly become my favorite to implement in times of excessively high valuations in the market.
This article will lay out the logic, steps, and important pricing factors behind a Protective Put strategy. Currently in June 2021 as I write this article, put options can be bought on the S&P 500 for a 7.5% premium. Given the high level of the markets, this might look like a good opportunity to lock in some gains.
Protection to the Downside
Options are all too often only thought about in terms of leverage, returns, and incremental income. But the beauty of options lays in their risk management characteristics. As a long-term value investor, I naturally have a long position through all of my portfolio holdings. To offset this long position, I can purchase put options on individual stocks in my portfolio or broad market indices which gives me the right to sell the underlying stock or index at the strike price of the put option.
The cost of the premium paid for the put option can be thought of as your “insurance premium” to be amortized over the option’s maturity horizon. While paying for insurance does not make sense at every point in time, the high market valuations and low volatility make the strategy appealing in the current conditions.
Since investors remain long the underlying portfolio, they still participate in the capital appreciation and dividends of underlying stock or index. For the buyer of a put option, the capital at risk is limited to the premium paid to acquire the put option as well as the long position, which remains exposed to the difference between the strike price on the option purchased and the current trading price of the underlying security.
The strike price multiplied by the number of options purchased yield the total notional dollar amount being protected. As put options move further out of the money and away from being at-the-money (where their strike price is equal to the current market price), their delta decreases. This means that the price of the options is less sensitive (less correlated) to changes in the price of the underlying security and more put options might need to be purchased to keep the hedge ratio the same.
Author’s Application: I use put options on the broad S&P 500 index (XSP.in) to lower the risk of my portfolio which is composed of individual stocks (75%) and index holdings (25%). This practice is known as a “cross hedge” where my individual stocks are being hedged with a separate distinct security, the index, which has a high correlation with the long exposure I am trying to hedge. To keep track of my portfolio allocation, I allocate my index-based long/shorts by the sector weighting of the S&P 500 index so that I can see my overall net risk exposure by market sector (ie. long financials, short technology).
The premium paid for the option (say 8% on an annual basis as an example) could be covered if the underlying assets being hedged continues to appreciate and pay out dividends. If total returns are 8%, than the investor has successfully broke even on the arrangement with the Protective Put option. Any returns above this 8% level of the premium paid will be fully attributable to the investor who remains long the underlying stock or index.
Author’s Application: Along with the purchase of put options, I generally raise the dividend income of my portfolio by switching my core index holdings from simple index ETF products to more exotic covered call ETF products on the same index. The practice of being long a put option and partially financing it by selling a call option is referred to as a “collar”. The weighted average dividend yield of my portfolio approaches 5% so I can be confident part of the 8% premium paid for the put option will be earned back by remaining long.
As maturities come closer and the market creeps up, investors always have the option of rolling over your option rather than letting it expire worthless. While it may be down considerably since purchasing it, getting 10% of your original option premium back might still be worthwhile. And remember, under a Protective Put option, you remained long your underlying portfolio and have been participating in the upside!
Saving on Tax and Transaction Costs
The Protective Put strategy also has significant tax and transaction cost savings compared to selling the assets outright. To liquidate one’s portfolio in part or entirely could possibly incur significant capital gains taxes as stocks are sold which have gone up in value. If there are multiple smaller positions, these capital gains taxes and even transactions costs can slowly add up. Using a Protective Put strategy to lower your risk exposure will continue to delay capital gains on the underlying asset with fewer transactions needing to take place.
Pricing Factors to Consider
I prefer to think of the insurance “premium” I am paying for the put option as an annualized rate so that it is more comparable to how I frame expected return, which is also on an annualized basis. As always with options, there are a bunch of factors at play when it comes to pricing with time and volatility being big factors. Some of the factors I consider before purchasing a put option are described below.
Time: The longer one goes out in maturity, while keeping the strike price constant, the amount of time each incremental premium dollar buys increases. This is because stocks and markets naturally make profits and go up in value (for profitable companies at least!). This natural increase in the underlying security/index makes the fixed strike price in the put option less valuable over time as the chance of it being exercised decreases.
For example, let’s look at put options on the popular S&P 500 e-mini index (which is 1/10th the price of the regular index) over staggered maturity dates. At-the-money put options with a $420 strike price and expiry dates in September 30, December 31, and March 31 trade with prices of $14.32, $21.36, and $27.19 respectively (on the date of June 7th, 2021, when I gathered this data). If we divide the premium for each option by the number of days until its maturity, we will see that the premium per day decreases from $0.12 to $0.10 and then $0.09 per day, respectively, as we move the maturity of the option further out.
Volatility: The volatility of the underlying asset can greatly affect the price of the put option. Higher volatility makes it more likely that the put option will reach the strike price at some point over the options time horizon.
For example, let’s look at the pricing of two at-the-money put options with the same maturity date; JP Morgan and Tesla. Looking at their September put options we see premiums as a percent of the underlying at-the-money exercise price being 4.8% for JP Morgan and 24.8% for Tesla. This considerable difference can be partially attributed to the much higher volatility of Tesla with a 2.0x beta in the underlying stock compared to only 1.2x for JP Morgan. For reference, the September at-the-money put option for the S&P 500 discussed earlier would cost 3.4% of the underlying strike price it is protecting.
Markets are Expensive and Volatility is Low – Great Time to Buy Puts!
In the current climate of stretched valuations where the cyclically adjusted Shiller P/E ratio is a whopping 37.3x, protective put options start to look like a good idea. The current level of 37.3x (based on 10 year earnings over the past 10 years) are a staggering amount above their historical mean and median of 16.8x and 15.8x respectively.
Volatility on the VIX is near 1 year lows currently, helping make the economics of the protective put option strategy all that more enticing. In another article, I calculated mediocre annual returns around 4.6% according to the Grinold-Kroner model over a 5 year period. With all the risk in the markets currently, it looks like a great time to take some risk off the table.