Put options are rightly viewed as the most direct way to protect against losses in equities. But new research shows that they are painfully inefficient and, in the words of the author of that study, provide “pathetic” protection.
The goal of all investors is to maximize upside participation while mitigating losses. Given the risk of large crashes in equities, investors want ways to “crisis proof” their portfolios – especially since the typical 60% equity/40% bond portfolio has close to 90% of its overall risk concentrated in equities (because equities are much riskier than safe bonds).
Investor risk aversion has led to the development of liquid insurance markets in the form of equity index options. A put option, when combined with an equity position, is designed to limit losses while maintaining unbounded gains. A call option is designed to achieve the same outcome standalone, effectively bundling a long put option with a long equity position.
The interest in hedging crash risk tends to increase as the length of a bull market increases and valuations reach higher than historical averages – the situation we find ourselves in today with the bull market now in its 11th year and the Shiller CAPE 10 at about 30.
Roni Israelov contributes to the literature with his study “Pathetic Protection: The Elusive Benefits of Protective Puts,” which appeared in the winter 2019 issue of The Journal of Alternative Investments. He examined the drawdown characteristics of systematically protected portfolios using the CBOE S&P 500 5% Put Protection Index as well as Monte Carlo simulations. He begins by noting that “A put option’s protective armor is nearly impenetrable over drawdowns that coincide with its option expiration cycle. Unfortunately, equity drawdowns have lives of their own that may not conveniently coincide with option expiration cycles. In these cases, the put option’s protective armor is easily penetrated.” For example, the market could rise sharply after the option is purchased and then crash as the expiration date approaches (before the crash, the option would be far out of the money and thus offer little protection).
Following is a summary of his findings:
- Unless option purchases and their maturities are timed just right around equity drawdowns, they may offer little downside protection.
- Portfolios protected with put options have worse peak-to-trough drawdown characteristics per unit of expected return than portfolios that have instead simply statically reduced their equity exposure in order to reduce risk. Investors who reduce their positions will likely achieve better outcomes than those who purchase protection, as protecting with put options has led to a significantly lower Sharpe ratio than divesting.
- Studying results over various holding periods, Israelov wrote, “The divested portfolio nearly universally has better drawdown characteristics than does the protected portfolio. For example, the worst 1% peak-to-trough drawdowns over a 20-day period are −9.6% for the protected portfolio versus −6.6% for the divested portfolio. Arguably, investors should be more concerned about longer-term drawdowns. Over 250-day windows, the results are even worse for protection: −32.1% for the protected portfolio and −20.9% for the divested portfolio.”
- The quality of protection that puts provide improves (or more accurately, is less bad) when option maturity is most closely aligned with the length of the peak-to-trough drawdown cycle. For example, monthly options do a less poor job of protecting against drawdowns that last about a month than those that last about a year. Unfortunately, investors cannot know ex‑ante how long future peak-to-trough drawdowns will last.
- Things look brighter in terms of upside participation. The put protected portfolio handily wins the race. The 99th percentile trough-to-peak equity rally over a 20-day period is 11.7% for the protected portfolio versus 5.4% for the divested portfolio. Over 250 days, the protected portfolio’s 99th percentile rally is 36.7% versus 20.3% for the divested portfolio.
Israelov found that while puts provide more upside potential than divesting oneself of equity holdings (because of the greater exposure to beta risk), “The strategy that invests 40% in equity and 60% in cash has delivered similar returns as the protected strategy, but with less than half the volatility and significantly improved peak-to-trough drawdowns.” He cited the following example from a prior study he coauthored: Over the period from March 1996 through June 2014, while the S&P 500 Index realized 5.8% annualized geometric returns in excess of cash, “Investing 36.5% in the S&P 500 Index and holding 63.5% in cash provided the same 2.5% compound annualized excess return as the CBOE S&P 500 5% Put Protection Index.”
These findings led Israelov to conclude: “For those who are concerned about their equity’s downside risk, reducing their equity position is significantly more effective than buying protection. Sized to achieve the same average return, divesting has lower drawdowns, lower volatility, lower equity beta, and a higher Sharpe ratio than does buying put options. The one case where buying put options shines relative to holding a reduced equity position, even if options are priced to include volatility risk premium, is when a very large crash occurs prior to the options’ expiration.” He added that because of its cost (in the form of the volatility risk premium), “Protection put options provide is often, well, pathetic.”
Further evidence
Israelov’s finding are consistent with those of Campbell R. Harvey, Edward Hoyle, Sandy Rattray, Matthew Sargaison, Dan Taylor and Otto Van Hemert, authors of the May 2019 paper “The Best of Strategies for the Worst of Times: Can Portfolios be Crisis Proofed?” The authors analyzed the performance of a number of defensive strategies, both active and passive, between 1985 and 2018, with a particular emphasis on the eight worst drawdowns (the instances where the S&P 500 fell by more than 15%) and three U.S. recessions (8% of the full period). They found that the most reliable defensive tool, continuously holding short-dated S&P 500 put options, is also the costliest strategy (-7.4% return over all periods). While it performs well during crashes (earning a 42.4% return on average), it is very costly during the “normal” times (losing 14.2% on average), which constitute 86% of the sample, and expansionary (non-recession) times, which constitute 93% of the observations. As such, passive option protection seems too expensive to be a viable crisis hedge. The authors noted that options are also expensive to trade, and thus returns would have been even worse after implementation costs.
While these findings might be thought of as discouraging, investors are not limited to using puts to manage risks. There are more efficient ways to reduce the tail risks that concern investors. In fact, that is what my book, coauthored with my colleague Kevin Grogan, Reducing the Risk of Black Swans, 2018 edition, is all about. We show that a more efficient way to reduce the risk of large drawdowns for most investors is simply to reduce the strategic allocation to market beta while adding other unique sources of risk and return (adding exposure to factors such as size, value, momentum, profitability and quality). And equities are not the only asset class with positive expected returns – incorporating additional unique sources of returns (such as the carry trade, reinsurance and the variance risk premium) can improve risk-adjusted portfolio returns, allowing for a better possibility of achieving an investor’s objective while mitigating downside risk.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.
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