Managing risk using Put Options

One of the ways to manage risk of a portfolio it is said is by buying Out of the Money puts so that in the event of a market meltdown, one’s portfolio (assuming total correlation to Nifty) will be protected from the point where Put option gets in the money.

Since options are expensive, there is no point buying a At the Money option but if you were to buy a Out of the Money Option, it comes pretty cheap (more like a Term Insurance Policy). If market drops catastrophically as ZeroHedge predicts day in and day out, the option can save the distress by ensuing that losses aren’t as huge as one would experience if one is unhedged.

But is it a worthwhile strategy is the bigger question and for that we really need to test based on some real data.Testing option based strategies can be a real nightmare given the amount of data we have and unless one has some good programming skills, it can be tough.

But we have CBOE to thank here since it runs a Index called CBOE S&P 500 5% Put Protection Index (PPUT). Following is the description of the said index from the CBOE site

The CBOE S&P 500 5% Put Protection Index is designed to track the performance of a hypothetical strategy that holds a long position indexed to the S&P 500 Index and buys a monthly 5% out-of-the-money S&P 500 Index (SPX) put option as a hedge.

The PPUT Index rolls on a monthly basis, typically every third Friday (OTM)y of the month.

In other words, this Index replicates what you would stand to gain by having a long S&P 500 hedged by puts (at 5%). So first lets see the historical chart for the said index. Remember, the chart is one of Gains / Losses accrued through being long S&P minus the cost of Options bought.

While not shown in the chart above, the draw-down in 2008 / 09 was to the tune of 41% vs 53% suffered by S&P 500. Lets now move on to a chart that compares this with the S&P 500.

In other words, lets compare this performance with that of S&P 500 and see if the cost we are paying has benefits.

What one observes here is that some one who held this index was almost all the time under-performing one who had just bought and held onto the S&P and the only time the twain did meet was in Feb 2009 when for a brief moment of time, he actually held a upper hand.

The under-performance is guaranteed given the fact that the investor of the Put strategy needs to keep buying puts which got way way expensive as markets cratered in 2008 / 09. But is the whole thing worth the trouble?

You may say that he will get a slightly better benefit if he compensated for the cost of puts by selling out of the money (5%) calls. But as we very well know, Put options (due to a variety of reasons) are always more expensive than Call Options. Just to give you a idea, lets take the case of Nifty 50.

Nifty current month futures closed at 7568 and if you had to hedge at 5%, that would mean buying 7200 puts (rounding off from 7189) and selling (to compensate for the Buy Call options of strike 7950 (rounding off from 7946). On Friday, the 7200 Puts closed the day at 35.50 while the 7950 CE closed at 11.40 (nearly 3x the price of Puts).

There is no simple way to avoid market crashes and the only way to ensure one has lesser pain is either by trading some kind of timing system or having a higher cash component / lower leverage. Buying puts while sounds like a nice theory will only end up enriching the seller of the option for most of the time.