Are Puts Efficient at Protecting Downside Risk?

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).