Buying Put Options To Hedge Is A Losing Strategy

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Includes: PG
by: Aristofanis Papadatos

Summary

As the ongoing bull market is in its eighth year, many "experts" advise investors to hedge their stock portfolios by purchasing put options of their stocks.

However, this is a losing strategy in the long term.

The article quantifies the effect of buying put options in the case of Procter & Gamble.

As the ongoing bull market of S&P (NYSEARCA:SPY) is in its eighth year, it has become the second-longest in history. Thus it has made most investors quite nervous that the top may be just around the corner. Moreover, it has led many "experts" to advise individuals to hedge their stock portfolio by purchasing put options of their stocks. This is as dangerous as a piece of advice can be. In this article, I will illustrate that purchasing put options to hedge a stock portfolio is a losing strategy, with the potential to devastate the returns of a portfolio.

First of all, I am sure that some investors like the idea of hedging their portfolio with put options. After all, if the market rises, they will profit; if it falls, they will minimize their losses thanks to the put options. Therefore, it seems like there is nothing to dislike about this strategy. Unfortunately, there is no such thing as a free meal, particularly in investing. Just like in the insurance of your car and your home, the premium you pay on a regular basis tends to offset the compensation you receive much less frequently. This is exactly the case with buying put options. Most of the time they expire worthless and thus the premium paid upfront is lost. These losses aggregate quite fast and thus greatly impair the long-term returns of a portfolio.

Investors should realize that the market spends most of its time in an uptrend or range-bound mode while it spends much less time in a downtrend. Therefore, put options that are at the money or out of the money usually expire worthless. Moreover, if one attempts to purchase them during the initial phase of a downturn in order to prevent further losses, one will have to pay a markedly high premium as the latter grows remarkably with volatility. Consequently, the only way investors can buy cheap insurance is to buy the put options during a calm period for the market. However, as evidenced in the ongoing bull, the market can remain calm much longer than you can afford paying for put options.

I will illustrate the devastating long-term effect of purchasing put options as a hedge with the example of Procter & Gamble (NYSE:PG). I have used its historical stock prices of the last 10 years and have assumed that a portfolio is hedged in January every year with the purchase of put options that expire in next January. Of course, one could purchase puts that expired sooner and roll them over every few months but that would result in higher total premiums (this is just a matter of math) and higher fees, as there would be more transactions and the options of the other months are less liquid for some stocks. I have assumed that the put options are slightly out of the money in order to mitigate the losses of the strategy. If I had used in-the-money options, the losses would have significantly increased. In the calculation of the options with the Black & Scholes formula, I used the VIX value at the end of January of the relevant year. The results are shown below:

Stock price ($)

Price of yearly put ($)

Profit per put bought ($)

Jan-2007

66.09

3.03

Jan-2008

67.15

5.5

-3.03

Jan-2009

57.73

7.54

1.77

Jan-2010

60.82

5.08

-7.54

Jan-2011

65.91

4.24

-5.08

Jan-2012

66.23

4.11

-4.24

Jan-2013

69.94

2.53

-4.11

Jan-2014

79.88

4.25

-2.53

Jan-2015

91.25

7.03

-4.25

Jan-2016

74.98

4.77

7.99

Jan-2017

???

Sum

-21.02

Click to enlarge

As shown in the table, the portfolio that was hedged every January via the purchase of put options lost a total of $21.02 in the nine-year period 2007-2016. Moreover, as the current stock price of Procter & Gamble is $88.57, which is much higher than the strike price of $72.5, it is very likely that the put options purchased in January 2016 will expire worthless once again. Therefore, in exactly three months from now, the portfolio will almost certainly have lost $25.79 (21.02+4.77) throughout the 10-year period 2007-2017.

It should be noted that many shareholders of this stalwart hold the stock for its exceptional dividend growth record. As the stock paid total dividends of $21.4 throughout the above mentioned 10-year period, the total losses from the purchased put options would more than offset the total dividends received in the last 10 years. This is certainly a devastating result for the dividend-oriented investors, who should take this seriously into account before rushing to purchase "insurance" for their portfolio.

It is also prominent from the above table that the put options proved profitable in only two out of the last 10 years. More notably, they did not prove profitable even during the two-year worst financial crisis of the last 80 years (2008-2009), when S&P lost 55% and Procter & Gamble lost 40% from top to bottom. Therefore, it becomes apparent that the benefit of this hedging strategy is somewhat random even in a major downturn. If investors tried to implement the strategy via monthly put options instead of yearly ones, they would eliminate this randomness of the strategy but their fees and commissions would multiply while the total premiums would greatly rise. Moreover, the premiums paid for the put options would skyrocket during the core of the downturn whereas they were much lower in the above scenario, as they were bought before the escalation of the crisis.

As the market spends much more time in bull or flat markets than in bear markets, it is only natural that buying put options to hedge a portfolio is a losing strategy. If a portfolio consists of good stocks with promising growth prospects, limited amount of debt and sound valuation, then it only has to lose from such a strategy. I recognize that fierce market downturns can be remarkably painful to most investors, who thus seek a way to mitigate that pain. However, those who cannot tolerate that pain, which shows up for about 1.5 year every seven years on average, should wonder whether they should be invested in the stock market in the first place. One way to secure a good night sleep is to be invested in S&P instead of individual stocks in order to be more diversified. This is actually the advice of Warren Buffett to all those investors who do not possess exceptional stock-picking skills. Nevertheless, even S&P lost 55% during the Great Recession and hence investors should have the appropriate mindset even if they are invested in S&P.

To sum up, buying put options to hedge a stock portfolio greatly reduces its returns in the long run. Every single day or week that passes without anything extraordinary, the remaining value of the put options declines. As illustrated in the case of Procter & Gamble, the total losses may more than offset the total dividends received. This should certainly deter the dividend-oriented investors. Therefore, investors should do their best to select stocks with promising growth prospects and attractive valuation and keep their confidence in their stocks even during a fierce bear market, as long as the long-term prospects of their stocks do not change materially. This is the only strategy in order to succeed as an investor in the long term. Of course, the results of the above strategy will vary depending on the stock you choose. However, if you have chosen the right stocks for your portfolio, buying puts will always be a losing strategy in the long term.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.