Hedging stock positions can be tricky business. One of the most common schools of thought is to use a simple protective put strategy, whereby a stock investor would simply purchase a long out-of-the-money put option to act as “insurance” in case the stock fell. Sounds logical, but we’re skeptics here at Option Alpha, and so we went on a hunt to see what other research reports and data says about the protective put strategy and its effectiveness at protecting or hedging stock positions.

Four Choices to Hedge Your Position:

What choices does a stock investor have to protect their position from downside risk?

1. Stop-Loss Order

• The most default and automatic choice, used by many day traders.
• However, the market can gap the next day, and your loss can balloon quite quickly.

2. Protective Put Option

• Buying a long out-of-the-money or a long at-the-money put option on the stock that you’re trading
• The protective put acts as insurance so that if the stock starts to go down, the put option kicks in and starts to protect some of the gains below a certain strike price
• You have to determine at what price you feel confident taking enough of the risk and where you want the insurance contract to kick in.

3. Put Spread

• A put spread is a long put option combined with a short put option at a lower strike price.
• The idea is that instead of using all of your capital to buy the long put, you’re going to offset the cost somewhat by selling a put at a lower strike price.
• This results in a net debit, which still costs you money, but the amount of cost out of your account for the insurance is much less.

4. Collar

• A collar is a strategy where you sell a call option, and you use the premium from selling a call option to go out and purchase a put option on the stock.
• Example: If the stock is trading at $100, you might sell the $105 call and buy the $90 strike put.
• The downside to this type of strategy is because a portion of the strategy is a covered call, you reduce a bit of the upside potential in the stock in exchange for protecting some of the downside risks.

Strategies Tested (Portfolio Protection Strategies):

The first study we reviewed was Portfolio Protection Strategies: A study on the protective put and its extension. These are the strategies they tested:

• Long puts, 5% out of the money
• Wide put spreads, 5% and 20% long
• Buying a 5% out of the money put and shorting a 20% out of the money put.
• Buying a 5% out of the money put and shorting a 15% out of the money put.
• Collar strategies at 5% above and below
• Fractional protective puts – buying fractional position sizes.
• Tested over different rolling periods — 1 month, 3 months, 6 months, and 12 months.

Results:

• Although reducing the equity position is more effective, generally, than buying options, the collar strategy (buying the 5% out of the money put and selling the 5% out of the money calls) has one of the most attractive risk-reward profiles and protects the downside.
• The long strategies where you were still net buying options, did not protect the stock position.
• In many cases, simply reducing your equity position was more effective than protecting the whole underlying position.
• This exchange in the risk profile of giving up some of the upside potential in exchange for reducing some of the downside risk is often found in trading strategies that work well.
• At-the-money and near at-the-money options are highly-priced for the implied volatility risk premium, which means that you make more money selling near at-the-money strikes than you do buying.
• In addition to the collar, the long 5% out-of-the-money puts and really wide spreads (5% out-of-the-money on the long options and 20% out-of-the-money on the short options) performed well.
• Generally, buying put protection in different time periods made no significant difference.
• However, protective put strategies ended up working out better with expirations 12 months out and a little bit further down the option pricing chain — with a slightly better Sharpe Ratio.
• Spreads showed better risk-adjusted returns, lower cost, and did better in 1-month and 3-month ranges (5% long, 15% short).
• The collar strategy still performed the best across a wide range of metrics — was low cost and did best with medium dated contracts (three to six months).
• In the 12-month range, the overall returns on collar strategies were capped.

Strategies Tested (AQR’s Pathetic Protection):

The second study we reviewed for this podcast was AQR’s Pathetic Protection: The elusive benefits of protective puts. This is the strategies they tested:

• Tested strategies on the CBOE S&P 500 5% Put Protection Index (PPUT).
• This strategy systematically purchases monthly put options on the S&P 500 that are 5% out of the money.
• The strategy uses short-dated, renewing put options to reduce downside risk.

Results:

• The results of investing in PPUT was so poor that investing 36.5% of your capital in the S&P and holding 63.5% in cash provided the exact same 2.5% compound annualized excess return as PPUT.
• Over a 250-day horizon, the first percentile drawdowns were about 34% for their protected put strategy.
• When they didn’t use the protected put strategy, there was a 13% drawdown for just using a regular diversified index portfolio.
• Sized to earn similar returns, divesting (selling a portion of your position) has significantly better downside risk properties than buying put options in the presence of a volatility risk premium.

Conclusion:

• The vast majority of protective put strategies, or long put strategies in general, are useless and significantly drag down your portfolio.
• It is very hard to find a protective put strategy that works and works at a level that is sustainable for your portfolio — 50% win rates or higher.
• Additional research you can review:
• Protective Puts: How to Protect Your Portfolio
• SPY Short Put Strategy Performance
• Efficiency of Put Options as a Hedge
• Performance of Option Trading Strategies
• Here is a preview of our upcoming research on long put option strategies where only 7.8% of the strategy settings we tested were profitable:

Option Trader Q&A w/ David

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today’s question comes from David:

I’ve been trading options for about a year now and I have a question regarding strategies when rolling the options forward. At what point before expiration do you start to look to implement that type of strategy?

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.