Deep out of the Money Put Options as Portfolio Insurance
Macro forecasts are difficult to make. Instead of timing the "riskon, riskoff" trade, investors can try to hedge their portfolios with put options on richly valued securities. This strategy assumes that valuations eventually regress to typical multiples; that euphoria and bubbles do not last forever. Oddly, many REITs (real estate investment trusts) seem overvalued, and are worth considering as put candidates.
The following criteria were used to screen highvaluation REIT put candidates:
 The pricetoearnings ratio is higher than 20 (trailing twelve months).
 The pricetosales ratio is higher than 3 (trailing twelve months).
 The pricetobook ratio is higher than 2.
 There must be an active options market.
Generating a List of Deep out of the Money REIT Put Candidates
Here is a list of REITs that met the criteria:
Ticker 
Company 
REIT Specialization 
P/E 
P/S 
P/B 
Avalonbay Communities 
Residential 
71.9 
14.2 
3.2 

Boston Properties 
Office 
56.7 
9.0 
3.3 

Equity Residential 
Residential 
211.4 
9.5 
3.3 

Simon Property Group 
Retail 
30.8 
10.7 
7.8 

Vornado Realty 
Diversified 
36.0 
5.6 
2.4 
Clearly all of these REITs are pricey from a static valuation perspective. We can evaluate them further by using growth estimates and trends to calculate total return for rosy "best case" and a dismal "worst case" scenarios*:
Worst Case 
Best Case 

Ticker 
Growth 
Terminal P/E 
Annualized Return 
Growth 
Terminal P/E 
Annualized Return 
AVB 
0.3% 
72.6 
48.4% 
12.8% 
50.1 
27.4% 
BXP 
23.9% 
128.9 
57.4% 
7.6% 
45.6 
26.3% 
EQR 
7.6% 
169.9 
61.1% 
33.4% 
89.1 
41.0% 
SPG 
9.9% 
23.2 
24.4% 
11.4% 
22.2 
5.2% 
VNO 
4.4% 
41.1 
37.6% 
4.9% 
31.1 
16.9% 
Inspecting the 3year total returns under the best case scenario reveals that many of these firms have very rich valuations. In particular, AVB, BXP, EQR, SPG, and VNO would yield annualized losses in excess of 5% to investors who bought at today's high prices. These are good firms with great growth prospects expected by analysts, but their current prices are just too high.
It is prudent to note that there is no way to tell the future, and that many of these REITs have traded at high multiples for many years and will continue to do so in the future.** This is a list of put candidates based on rich valuations, and by no means is a divination or a guarantee about future events.
* Total returns were calculated over a threeyear holding period for each of these REITs. (I use a 3year holding period since aboveaverage growth estimates are not reliable further out.) In the rosy "best case" scenario, each stock is assumed to be sold at a generous growth stock pricetoearnings multiple of 17 and the maximum of historical and analyst estimate values for earnings growth are assumed. These assumptions are used to project an annualized total return over the next three years and a terminal pricetoearnings ratios, that is, price paid today divided by earnings at the end of the holding period for each stock.
The dismal "worst case" scenario 3year total returns were calculated using conservative assumptions. A bargain value stock price to earnings multiple of 10 and the lesser of historical and analyst estimates values for earnings growth are assumed.
**There are many clichés, which relate to how investing manias test patience and funding. From "The market can remain irrational longer than you can remain solvent" to "Hope springs eternal" the human capacity to ignore valuation is a tremendous foe. Using put options instead of shorting shares limits losses and heeds the wisdom behind such concerns.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Please read the article disclaimer.