Protective Puts: How To Protect Your Portfolio

Includes: SPY
by: Find My Hedge

Historical data from the last 13 years have been used to evaluate a protective puts strategy on SPY.

This study shows that using protective puts can be an interesting ally to your portfolio strategy.

Given the right strike price and time to expiration, they are essentially free from a risk/return perspective, while allowing an investor to cap losses to a fraction of the portfolio value.

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Protective puts are a common option strategy that allow you to alleviate the risk of a position in a given security. It can be seen as a form of insurance. Let’s say you own 100 shares of XYZ, each of them valued at $100, and would like to protect your position. A possible strategy could be to buy a protective put of XYZ for $350 at a strike price of $100 for the next two months. At the end of the two months, if the stock price stays above $100, the option expires worthless: as with any insurance, if nothing bad happens, you receive nothing. But if the stock price goes below $100, the option allows you to sell your shares at $100 each, even if the stock has dropped significantly.

It is therefore easy to understand why protective puts are attractive to investors. However, in practice, using them can be a lot more confusing than the simple example described above.

First, there are a multitude of expiration dates to choose from. You can choose to buy this “insurance” for a few days as well as a few years. There are also a multitude of strike prices: you can insure your stock at $100, but you can also choose to insure it only at $90, in which case the cost of the option will be lower.

Finally, the price of the options is regulated by the market. A general truth is, the longer the expiration and/or the higher the strike price, the more expensive the option will be priced. But there are also other factors that enter into the picture, and an important one is the implied volatility of the stock. If traders are unsure of the direction of the stock or expect a large move, this implied volatility will be higher, and options, including protective puts, will be more expensive.

Therefore, determining a long-term portfolio protection strategy using protective puts can be confusing because of this multitude of choices and because the option pricing can substantially vary over time.

By using historical data, we will attempt to clarify the impact of both the strike price and the expiration date of the protective put on the return and risk of the portfolio. We will suppose that the investor holds 100 shares of SPDR S&P 500 Trust ETF (SPY) and wants to protect his/her investment by perpetually renewing protective puts. This backtesting will be done between January 2005 and June 2018; this duration is long enough to formulate a general idea and include the 2008-2009 recession period, allowing us to observe how the strategy holds during bearish markets.


The strategy developed here is simple and easily actionable. We will test our strategy on multiple relative strike prices (strike price divided by share price) - 70%, 80%, 85%, 90%, 95%, 98%, 99%, 100% - and multiple times to expiration - 60 days, 120 days, 180 days, 365 days.

As for describing the strategy, we will suppose that we are testing it with the following parameters:

  • Relative strike price: 95%

  • Time to expiration: 60 days

  • Starting date: 2005-01-11

Day 1 (End Of Day)

Here is concretely what happens on 2005-01-11 with the parameters chosen earlier:

  • We suppose that the investor initially doesn’t hold shares or options of SPY.

  • The investor buys 100 shares of SPY at $118.18 each.

  • He/she buys the protective put with a time to expiration close to 60 days and with a strike price close to 118.18 x 95% = 112.27.

Each following trading day (end of day)

There are two possible outcomes:

  • As long as the time to expiration of the protective put is larger than half of the original time to expiration (60/2 = 30 days), the investor doesn’t update his/her position.

  • When this isn’t the case anymore, the investor sells the current protective put he/she owns, and buys another one, with a time to expiration close to 60 days and a strike price close to (Price of SPY) x 95%.


In this strategy, the investor does not hold the protective put until expiration. Indeed, the price of the protective put tends to plummet near expiration. In order to avoid this large loss, the investor should, therefore, renew his/her position a long time before it expires. This renewal time could be a parameter to optimize as well; I will analyze this parameter in another article if I think that it might have an important impact.

Though this strategy is simple, it doesn’t take into account several pieces of information that might critically impact the return of the strategy: the recent move/trend of SPY, and the evolution of implied volatility. This could be the subject of a future article.


Before discussing results, we have plotted the performance of our strategy using different sets of parameters for illustration purposes.

Relative strike price: 90%, time to expiration: 60 days.

Relative strike price: 70%, time to expiration: 120 days.

Relative strike price: 80%, time to expiration: 365 days.

Relative strike price: 100%, time to expiration: 365 days.

Relative strike price: 90%, time to expiration: 365 days.

Source: Created by Find My Hedge using data from DiscountOptionData.

Using protective puts has a cost...

Returns for each variant of the strategy is shown in Table 1. Over the last 13 years this strategy has been backtested, and there is not a single variant that produces an annualized return superior to holding shares of SPY without options. In other words, using protective puts has a cost, and the protection it offers in tough markets doesn’t offset for the premium paid by the investor, at least in terms of absolute returns.

60 days 120 days 180 days 365 days
100 % 0.4 % 1.0 % 1.4 % 2.7 %
99 % 1.0 % 1.2 % 1.7 % 2.8 %
98 % 1.6 % 1.7 % 1.9 % 2.5 %
95 % 3.3 % 2.7 % 2.8 % 3.2 %
90 % 4.8 % 4.2 % 3.9 % 4.2 %
85 % 5.6 % 5.0 % 4.7 % 4.7 %
80 % 6.0 % 5.5 % 5.1 % 5.1 %
70 % 6.3 % 6.0 % 5.8 % 5.7 %
NO PP 6.4 % 6.4 % 6.4 % 6.4 %

Table 1: Annualized returns of each variant of the strategy depending on relative strike price (each line) and time to expiration (each column). These returns are not adjusted, meaning they don’t take into account dividends received. NO PP: No protective put.

… but they reduce the risk of the portfolio

Not surprisingly, the protective puts also allow one to reduce risk. This is true whether we look at the maximum drawdown of the portfolio (Table 2) or the standard deviation of daily returns (Table 3). For example, if the investor chose to buy protective puts with an expiration of one year and with a relative strike price at 90%, the maximum drawdown would have been 32.1% instead of 56.4% with no protective put. The standard deviation of daily returns would have been 0.72% instead 1.19%, so on a day-to-day basis, the strategy was also less volatile.

60 days 120 days 180 days 365 days
100 % 36.5 % 32.9 % 31.2 % 29.5 %
99 % 38.3 % 33.7 % 32.2 % 29.6 %
98 % 40.1 % 35.7 % 33.3 % 33.7 %
95 % 43.4 % 38.9 % 36.5 % 34.3 %
90 % 47.3 % 42.1 % 41.6 % 32.1 %
85 % 49.4 % 45.9 % 44.9 % 36.6 %
80 % 51.3 % 50.0 % 49.7 % 46.3 %
70 % 54.5 % 53.0 % 53.3 % 45.1 %
NO PP 56.4 % 56.4 % 56.4 % 56.4 %

Table 2: Maximum drawdown: the maximum loss from a peak, depending on relative strike price (each line) and time to expiration (each column). NO PP: No protective put.

60 days 120 days 180 days 365 days
100 % 0.71 % 0.64 % 0.62 % 0.61 %
99 % 0.74 % 0.66 % 0.63 % 0.61 %
98 % 0.78 % 0.7 % 0.67 % 0.65 %
95 % 0.85 % 0.77 % 0.73 % 0.68 %
90 % 0.93 % 0.85 % 0.81 % 0.72 %
85 % 0.98 % 0.91 % 0.86 % 0.79 %
80 % 1.02 % 0.98 % 0.95 % 0.87 %
70 % 1.1 % 1.06 % 1.03 % 0.94 %
NO PP 1.19 % 1.19 % 1.19 % 1.19 %

Table 3: Standard deviation of daily returns, depending on relative strike price (each line) and time to expiration (each column). In other words, how much the portfolio varies from day to day. NO PP: No protective put.

Readers might wonder why the maximum drawdown is always greater than the protection chosen: in other words, in our previous example, why the maximum drawdown is 32.1% when the investor buys protective puts that should protect his/her investments to a maximum 10% loss. This happens for the two following reasons.

First, the maximum loss is 10% plus the cost of the protection (i.e. the protective put). This cost greatly varies depending on the market’s condition:

  • For instance, buying a protective put of SPY on 2018-09-21 (then valued at $291.61) with a strike price of $260 and an expiration date of 2019-09-20 (so a 10% protection for one year) would have cost you roughly $700, or 2.4% of your investment. The maximum loss is therefore 12.4% in this case.

  • Buying a protective put of SPY on 2008-12-19 (then valued at $88.19) with a strike price of $80 and an expiration date at 2009-12-19 (again, a 10% protection for one year) would have cost you roughly $1,030 or 11.7% of your investment (!). Maximum loss would, therefore, be 21.7%. This is a good illustration on how volatility can influence protective put pricing in turbulent times.

Secondly, this maximum loss stays constant as long as the position is not renewed, but the strategy relies on the perpetual renewal of protective puts. Concretely, the price might fall 20% every six months for 18 months. If you renew your position every six months with 10% downside protection, you will lose 10% every six months instead of 20%. As a result, the total loss will be close to 30%.

As both returns and risk are diminished, we have to take a look at the risk/return ratio to better assess the quality of our strategy.

A similar risk/return according to standard metrics

Several metrics exist to assess the risk/return ratio of a portfolio. One of the most used metrics is the Sortino ratio, which divides returns by the downside variation. We have evaluated this metric for each of our strategy variations in Table 4.

60 days 120 days 180 days 365 days
100 % 0.14 0.23 0.31 0.52
99 % 0.23 0.28 0.34 0.54
98 % 0.3 0.33 0.36 0.49
95 % 0.51 0.46 0.47 0.54
90 % 0.65 0.61 0.56 0.67
85 % 0.7 0.66 0.62 0.68
80 % 0.71 0.69 0.64 0.65
70 % 0.72 0.72 0.69 0.67
NO PP 0.68 0.68 0.68 0.68

Table 4: Returns/risk as measured by the Sortino ratio, depending on relative strike price (each line) and time to expiration (each column). NO PP: No protective put.

According to the Sortino ratio, if the investor buys protective puts that are less than 10% out the money (in other words, with a relative strike price more than 90%), the risk/return ratio diminishes. In these cases, the price of the protective puts become too important when weighed against the protection they offer. This is especially true for shorter-term protective puts, whose value tends to diminish faster as time passes.

In other cases, still according to the Sortino ratio, the risk/return ratio of the strategy is similar to that of buying SPY shares without protective puts.

Numbers don’t tell the whole story: the hidden benefits of using protective puts

At this point, readers might question the validity of the strategy. If the risk/return ratio is similar, an investor can simply invest less to reduce his/her risk exposure. However, these numbers should be put in perspective in order to fully understand the pros and cons of this protection strategy.

First, the current bull market has been relatively long (eight years so far) historically. During this period, protective puts have been useless most of the time. Despite this incredible period, the risk/return ratio of the strategy has been similar to that of the underlying security (SPY), which suggests that the strategy might be more profitable in the longer run.

Secondly, there is something that neither the Sortino ratio nor any risk/return metric won’t show: much greater risk control. Indeed, when an investor owns any security, including SPY, the maximum loss is 100%. But let’s say that, at the same time, the same investor buys a protective put with a relative strike price of 90%: the maximum loss is then 10% plus the price of the option. At any point, the investor can sell all of his/her positions with a well-defined maximum risk that only represents a fraction of his/her initial investment. Given the option of two investment strategies with a similar risk/return ratio, I would certainly prefer the one that offers this type of additional guarantee. The figure below shows, in addition to the strategy performance (for a relative strike price of 90% and time to expiration of 365 days), the maximum loss the investor could see over time; the safety net it provides is quite reassuring.

Max loss over the protective puts strategy.

Source: Created by Find My Hedge using data from DiscountOptionData.

Possible strategies

Favor long-term protective puts that are around 10% out the money

Per tables 1-4, investors should attain the best risk/return trade-off by buying protective puts with a relative strike price around 90% and a time to expiration of about a year. Variants with shorter time to expiration do have a slightly better Sortino ratio, but their maximum drawdown is much worse so, overall, it seems better to choose one-year protective puts.

It would have been interesting to see the performance of the portfolio with two-year protective puts (they do exist for SPY) but, due to a lack of available data, it was not possible to add them to the benchmark. It is possible that an investor could achieve even better performance using those.

Improvements using adapted entry & exit

There is also another reason you should prefer long-term protective puts: they give you entry and exit choices.

Until now we have stuck with the very simple strategy outlined above, as this allows us to get a general idea of what works and what doesn’t. However, this strategy doesn’t adapt to the market condition: it simply renews option positions at regular intervals. This simplistic behavior can lead to objectionable trades. For instance, during the volatile markets of 2008-2009, we have seen that the price of protective puts could cost up to 12% of the investment, compared with 2% to 4% in normal markets.

Instead of buying these expensive options, the investor could choose to wait for the implied volatility to go down again. After all, when you buy an option with an expiration of one year, instead of renewing the protective put after six months, you can wait several additional months if prices are too high.

Another strategy, if implied volatility is high and the strike price of the protective put is near the underlying price, could be to close the position entirely and to wait for the implied volatility to go down again. One downside here is that the investor might miss a price rebound. But by doing this, he/she might also be able to allocate capital to strategies more suited to volatile markets.

If the markets have crashed and volatility is still high when the protective put position is near expiration, a confident investor could buy the dip and decide not to renew the protective put temporarily while keeping his/her shares. This is a risky and contrarian strategy, but during the 2008-2009 recession, it would have borne fruit.


Using protective puts can be an interesting ally to your portfolio strategy. While essentially free from the risk/return perspective, they allow investors to cap their losses to a fraction of their portfolio value. Using one-year protective puts that are around 10% out the money seems to yield the most benefits, even discounting the numerous entry/exit choices they offer in case of bearish markets. Investors should consider using them, especially if they invest on margin or are looking for improved downside protection.

Disclosure: I am/we are long SPY. 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.