Parsimony Investment Research recently wrote an article on SA that advocated buying puts on the S&P 500 (NYSEARCA:SPY) in order to hedge a portfolio. I agree with everything in the article - and I am a fan of the author in general - with the exception of the conclusion that SPY puts are a good hedge for many investors.
In addition, I wrote an article a few days ago titled "How To Prepare For The Upcoming Correction" that outlined some alternate ideas for investing in an overvalued market. Puts might be a good idea in certain unusual situations, but in general I don't think they are the best way to go.
Parsimony's article went through some calculations such as how many puts would be needed to hedge a portfolio, but the author did not actually calculate the cost of the "insurance" that the portfolio holder would incur. I will calculate that here.
The $100,000 Question
Assuming a $100,000 long stock portfolio, Parsimony calculated the following (I have updated the numbers for close July 7):
Underlying Value of 1 SPY Option Contract:
$197.51 x 100 = $19,751
Contracts Needed to Fully Hedge Portfolio:
$100,000 / $19,751 = 5.06 Contracts
5.14 x 0.75 = 3.80 Contracts
The first item that I have a problem with is the assumption of a 0.75 Beta portfolio. I will use a Beta of 1.0 since that is a fairer assumption of the average reader's portfolio. Parsimony recommends puts at a strike price of $200 and an expiration of September or October so I will go ahead and use the September 200 in the following calculations. The closing price of SPY as of July 7 is $197.51.
If SPY is Unchanged
What is the cost of the insurance during a sideways market?
The initial cost on the September 30 expiration is $568 per contract (the ask is currently $5.68). The total cost for the portfolio would be $568 x 5.06 = $2,874.
Now to annualize the cost. The option expires in 85 days - I will assume that is one quarter (which actually makes the put strategy look slightly better than it is). Thus, the options will need to be rolled four times. $2,874 x 4 = $11,496.
I am going to assume the S&P 500 does not change during this period. Each contract would be worth $249 (($200 - $197.51) x 100) at expiration. The total insurance "refund", so to speak, would be $249 x 5.06 = $1,260. Multiplying by four in order to annualize it = $5,040.
To get the net annual cost subtract $11,496 - $5,040 = $6,456. Therefore, the cost of this particular form of portfolio insurance is about 6.5% if the options expire when SPY is unchanged. After 12 months, the $100,000 portfolio would be worth $93,544.
If SPY climbs 11%
What is the cost of the insurance during a rising market?
Let's say for the next 12 months the S&P 500 increases 11%. That would be 2.5% each quarter and I will assume that the put options purchased expire worthless. Using current prices, a 2.5% rise would put the SPY at $202.45 and well into worthless territory. It is certainly possible to model in some volatility and some final worth to the put options, but the assumptions would really start to pile up, so I will keep it simple. I will also model that each quarter the cost of the options are the same (since the VIX is quite low at this time, chances are good that the cost would actually increase).
Because the cost of the options is so high - see above that the total yearly cost would be $11,496 - the portfolio actually drops in value. Each quarter, $2,874 is removed from the portfolio to pay for the options and then the portfolio value is multiplied by 1.025. At the end of 12 months, I calculate the value of the portfolio to be $98,149.
If SPY falls 10%
What is the benefit of the insurance during a falling market?
Next, I will look at the typical correction scenario of a 10% drop. I will assume that SPY is down exactly 10% on the day the options expire, which is, of course giving the investor the benefit of the doubt. The market could easily drop 10% or more but then rise back up to a drop of, say, 5% when the options expire. Would the investor sell the option at just the right time? Unlikely. There is no bell that rings at the bottom!
I am also going to assume that the drop occurs in the first quarter and I won't annualize the strategy. Obviously, if the market slowly drops 10% over the course of a year, the return will be even worse than what I am calculating, since more puts would have been bought.
Therefore, the assumption is that on September 30, SPY is at $177.76 and each put is worth $2,224. Multiplied by 5.06 contracts = $11,253. The cost was $2,874 so the gain on the options would be $8,379. Accounting for the loss on the long stock portfolio gives a final portfolio value of $98,666.
A Losing Strategy
To sum up:
- SPY moves sideways for 12 months: 6.5% loss
- SPY climbs 11% annually in a smooth fashion: 1.9% loss
- SPY falls 10% from now to Sept 30: 1.4% loss
In many ways, my model actually gives some benefit of the doubt to the put insurance strategy. Some benefits I wrote about above (like using the current cost of a put 85 days out from expiration to approximate a 91 day quarter), but perhaps the largest favorable assumption is that the put options would not get any more expensive in the future.
The CBOE Volatility Index (VIX) is near historic lows and SPY put options are very likely to get more expensive going forward. The strategy is already far too expensive for my taste. If/when the VIX moves higher, it will truly make this method of portfolio insurance prohibitively expensive to use for any extended period.
If timed extremely well, and assuming today's relatively low option cost, buying SPY puts could make what would have been a 10% loss into a 1.4% loss. That is the scenario if an investor bought the puts immediately and the market tanked by September 30. That is the best case scenario in a 10% correction.
Even if the put buyer is correct about the market going into a correction within 12 months, he/she is unlikely to do as well as the 1.4% loss that I have modeled. What if the market goes sideways for a few quarters, then tanks? What if the market goes down a few percent per quarter? What if the investor does not sell the puts back at the right time?
Of course, the largest risk of all is if there is no correction, or that the correction is very long in coming. In that case, the put buyer has paid a bundle for insurance that was wasted. The longer an investor uses the put hedge strategy, the more likely his/her returns are to suffer. The only reason I can envision someone buying SPY puts as a hedge would be as a very short-term strategy. I have yet to meet the person who can routinely predict corrections accurately enough to make such a strategy work.
There are many strategies for the worried investor to choose from in times when he/she feels the need to be defensive. I personally would not buy SPY puts. I have outlined some other strategies that I think make more sense.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.