The Hidden Cost of Hedging with Put Spreads
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Bernie Schaeffer Schaeffers Research.com |
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A June 8, 2011, Smart Money article entitled, "How to Shop for Car Insurance," warns "It may be tempting to purchase only the minimum amount of liability (insurance) required by law, but experts warn against this as accidents can cost way more than you could ever expect." This seems like sound, sensible and rather obvious advice to anyone with a feel for the ever-ballooning jury awards in liability cases. But these days, some popular options strategies among large (and allegedly sophisticated) players for protecting (i.e., insuring) portfolios against disastrous losses seem to have ignored some fundamental insurance principles.
We all know the price of so-called "DOOM" options ("deep-out-of-the money" puts designed to protect against a crash) has been expensive ever since the last actual stock market crash in October 1987. The "negative skew" underlying the pricing of such options -- the extent to which out-of-the-money puts are priced with much higher implied volatility than comparable out-of-the-money calls -- has varied over the years, but paying up for such puts has consistently been a painful proposition. So, it's not surprising attempts are made to reduce the cost of portfolio protection. But it's also no surprise you get what you pay for, which turns out to be protection that, while "cheaper" in dollar outlay, can be described as illusory in the event of a true disaster.
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For example, on November 8, 2011, an investor in the SPDR S&P 500 ETF (SPY) bought 50,000 contracts of the December 117-110 put debit spread for 85 cents with SPY trading at about $126 (per Trade Alert). Clearly, the December 110 puts were sold against long positions in the December 117 puts to reduce the cost of the portfolio protection. But what becomes of this debit spread strategy in the event of an off-the-charts market decline comparable to that of October 1987, in which the market shed 22.6% in a single trading day? This would translate into a decline by SPY from $126 to $97.50, but because the December 110 puts were sold to reduce the cost of protection, the post-crash value of this debit spread is limited to $7 (the 117-strike less the 110-strike) regardless of how far the market plunges. So, in effect, the investor is insuring against a modest decline in the market but is "self-insuring" the consequences of a huge market decline, which in my opinion defeats the real purpose of portfolio protection.
The lesson here is simple. If your portfolio can't take a modest decline, you should reduce its size. But if you desire crash protection, then pony up the cost of buying puts at a strike that fits your loss tolerance and over a timeframe long enough to avoid the cost of a repeated roll of your expiring position.
-Bernie Schaeffer
Bernie Schaeffer will be available to take your questions until Sunday, February 5. Please use the form below to submit your questions.
Bernie Schaeffer:
• Developed Expectational Analysis®, a proprietary, three-tiered method of options analysis combining technical and fundamental studies with the analysis of investor sentiment.
Publisher
• In 1981, Bernie launched the newsletter, Bernie Schaeffer’s Option Advisor. Serving as senior editor since inception, Bernie has led the Option Advisor to become the nation’s leading options newsletter. Features: market commentary, specific trade recommendations, and trading strategy.
• Launched SchaeffersResearch.com, in 1997. A four-time winner of Forbes “Best of the Web” award, the website has also received positive mention in Barron’s, AAII and The Wall Street Journal Guide to Online Investing - “An independent options site that is one of the best for providing primers for both novice and advanced investors.” Features tools, quotes, data, commentary, and education.
• 10 Days to Successful Options TradingSM – This multi-media home study program teaches options basics. Learn fundamental strategies with hands-on application exercises and examples.
Author
• The Option Advisor: Wealth-Building Techniques Using Equity and Index Options (1997)
• New Thinking in Technical Analysis: Trading Models from the Masters – The industry has viewed Bernie’s Expectational Analysis® methodology as a groundbreaking approach to trading. Proof of this came with the publication of this new book by Bloomberg Press. One of twelve authors, Bernie was honored to be chosen from hundreds of market analysts to explain his methodology.
• Writes a monthly options column for Bloomberg Personal Finance magazine.
• Multexinvestor.com regularly calls on Bernie to contribute to their “Analyst Corner.”
Awards and Recognition
• Three time winner of The Wall Street Journal stock picking contest.
• Ranks fifth among market timers tracked by Timer Digest for the past decade.
• Dick Davis Hall of Fame inductee for his bearish posture ahead of the 1987 crash.
• He is known for successfully maintaining a bullish market posture throughout the 1990s.
• The Market Technician’s Association (MTA) awarded Bernie “Best of the Best” in 1997 in the field of Sentiment/Psychological Analysis.
• Bernie is regularly featured on investment chats on Yahoo! Finance.
• Bernie’s views on the stock market and the economy are regularly quoted in The Wall Street Journal, The New York Times, BusinessWeek, Investor’s Business Daily, and USA Today.
• Both Barron’s and The New York Times have featured Bernie in “Question & Answer” interviews.
• Recognized as a CNBC “Market Maven.”
• Appears regularly on national financial broadcasts such as CNBC, CNN, Bloomberg Television, the Nightly Business Report, Wall Street Week with Fortune and Fox News. Also serves as a guest host on CNNfn.
• Frequently invited to speak at national investment conferences and seminars.
• Regularly sits on Options Industry Council panels around the country.
• One of 50 market strategists appearing in BusinessWeek’s 2001 market forecast.
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