The bull market has been going strong since March 2009, defying analysts’ frequent predictions of its demise. Nevertheless, a lot of investors continue to believe that the end of the bull market is imminent, and would like to protect themselves against a future bear market.
I have been asked many times whether there are options strategies to help protect against a bear market. In this post, I’ll look at the most common strategy, which is to buy put options as portfolio “insurance” against a bear market.
Stock Options Basics
The basic building blocks of an options trading strategy are the call option and the put option. A call option is a contract that gives the buyer the right to purchase a stock at a specified price (“strike price”) on or before a specified date (“expiration date”).
A buyer of a call option would want the stock price to go up, while the seller of a call option would want the stock price to go down.
A put option gives the contract buyer the right to sell a stock at the strike price on or before the expiration date. Therefore, a put option buyer would profit if the stock falls, while the put option seller would profit if the stock rises (or at least does not fall below the strike price).
One common option strategy to protect against losses if the stock market were to fall is to buy a put option. Let’s say you own 100 shares of Vanguard Total Stock Market ETF (VTI). You could buy a put option to sell 100 VTI shares at 10% below the current price in the next month for 1% of the current price. If the stock market falls more than 10%, then you would exercise your contract, selling your VTI shares for a 10% loss. If the stock market were to crash 50%, you still only lose 10%, since the gains in your put option value would offset the losses in your VTI shares. If VTI moves sideways or rise, then you will lose the 1% you paid for the put option.
You can see why a put option when you own the underlying stock is essentially an insurance policy against market declines. If the stock market rises, you keep most of your market gains, losing only the put option premium. If the stock market falls, you are limiting your downside risk to the difference between the put option strike price and the current stock price.
Why I Don’t Like Using Put Options As Portfolio Hedges
There are several reasons why I am not a proponent of using put options as a hedge against a bear market.
Option strategies have significant transaction costs
Stock options should theoretically have no inherent value – it is simply a contract between a buyer and a seller. It is a zero-sum game where every dollar made by one side of the transaction is a loss to the other side of the transaction.
However, options can have significant transaction costs (bid-ask spread, commissions) that are higher than those to buy and sell stocks, which would erode your returns.
Put options may be overvalued compared to its expected value
Stock options are valued using the Black-Scholes formula. The only variable that is unknown in that formula is the stock market volatility. This makes stock options an implicit bet on future stock market volatility. When you buy a put option (or a call option), you are indirectly making a bet that future volatility will be higher than what is implied by the current option price.
It turns out that the implied volatility of stock option prices is higher for lower strike prices than at higher strike prices. There are many possible explanations for this, but one possible explanation is that investors are willing to pay a premium for the insurance of protecting against downside risk using put options. This means that put options may be slightly overvalued.
In fact, a popular early retirement blogger employs a put option selling strategy on the theory that put options are overvalued. I disagree with this option strategy, but it makes you wonder whether buying put options are a losing bet.
Put options reduce your expected return, while also decreasing the volatility of your portfolio
Purchasing put options decreases the volatility of your portfolio returns by limiting downside risk. However, in doing so, you also decrease your expected returns.
Most of the time (e.g. when the stock rises or remains unchanged), your return is lower than if you had not bought the put option by the amount of the option premium. When the stock falls significantly, your return is higher when you buy the put option. The volatility in your investment returns is decreased, but on average, your return will be lower than if you had just owned the stock.
There is no free lunch in investing: in order to get higher expected returns, you need to take on more risk and more volatility. Buying put options reduces your volatility, and therefore should decrease your expected returns.
Robert Merton, Myron Scholes (who shared the Nobel Prize in 1997), and Matthew Gladstein wrote a 1982 paper in the Journal of Business entitled The Returns and Risks of Alternative Put-Option Portfolio Investment Strategies. They empirically studied the strategy of purchasing a put option as insurance against a long stock position using data from the 1960s and the 1970s. They come to this conclusion:
“The investor who follows a [put option] strategy can significantly reduce the risk of his stock portfolio. However, the cost of this insurance is reflected by a reduction in expected return.” – Merton, Scholes, Gladstein, The Returns and Risks of Alternative Put-Option Portfolio Investment Strategies, p. 41
But what if I’m willing to buy insurance for the peace of mind?
Like a life insurance contract or a disability insurance contract, it might be beneficial to purchase a contract that will cost you money on average, but because you don’t want to take on certain risks (whether it be the financial cost of death, disability, or investment losses), you are willing to pay the premium.
I tend to disagree with this logic, because I don’t believe that most investors are truly trying to buy portfolio insurance with this put option strategy. Buying put options against a portfolio is a strategy that most investors do not maintain consistently, month after month for years on end. More often, they selectively buy insurance when they think that a bull market has gone on for too long and that a bear market is imminent.
Stock market investors need to accept bear markets as part of the deal to enjoy long-term market returns that far exceed the bond market. If you can’t stomach occasional bear markets, then you need to increase the amount of bonds in your portfolio to reduce the swings in your portfolio.
Conclusion
I understand the appeal of buying put options to protect against stock market drops. However, I recommend against this strategy for most investors. It decreases the volatility of your portfolio, but also decreases its expected return. You can achieve this more efficiently, and with lower transaction costs, by simply choosing a stock/bond allocation that fits your risk tolerance and your ability to ride out the inevitable bear markets that will occur in the future.
What do you think? Have you ever tried to buy put options on your portfolio as insurance?
Interesting concept and sheds light on some terms I heard of but never really explored.
So instead of putting a 1% premium buying an option, why could an investor protect him or herself from a downturn by employing a trailing stop? I believe that is completely free and because it is trailing it keeps rising as your equity rises but initiates when the threshold is met in a decline (could be a dollar or % amount)
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There’s always a percentage for investment, for cash, a bit on income-generating assets, etc. But for the passionate, a small percentage in speculation will exist, Vehicles such as options, futures, penny stocks and/or cryptos are great for this, the leverage they provide ain’t for everyone though.
OK but is this for a month only? What if I want to buy this insurance for the long term, is that such an option?
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