tactics
SPECIAL SECTION Luckbox is devoting this month’s tactics section to a three-part series on protective puts, courtesy of the Learn Center @tastytrade
essential trading strategies
BASIC
A Better Way to Put It Protective puts are popular, but traders have more cost-efficient ways of hedging their positions By Michael Rechenthin
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osses hurt. Experiments indicate that avoiding a $5 loss carries twice as much psychological power as experiencing a $5 gain. Traders who overstress about loss avoidance actually create the loss they so much want to avoid. A simple online search for “protecting a portfolio from loss” yields an overwhelmingly large number of recommendations to “buy puts.” A put protects the position against a loss in the account. It’s like an insurance policy to protect against loss. But the strategy doesn’t work long-term. The more fear, the higher the cost of the “insurance.” With a moderate VIX (volatility index) fear level of 20, investors pay roughly 6.6% annually for a 5% drop insurance. Considering the average return in the S&P 500 is 6% during the past 20 years, that means the investor is paying more for insurance than the market returns on a given year. Thus, an investor trying to minimize a drop in the account locks in a loss by buying the put. And by creating an initial cost through the price of the put, the break-even becomes even higher for the account holder. Instead of creating a higher threshold for profitability, an investor can lower the breakeven point by selling calls against the position held. By managing positions and managing the gains around those positions, an investor can make break-even lower still. (For more on this technique, see “Advanced Tactics,” p. 61.)
Paying protection money
Michael Rechenthin, Ph.D., aka “Dr. Data,” is the head of data science at tastytrade. @mrechenthin
2700
As fear of a loss increases, the cost of an “insurance policy” against risk goes up, too. Fear in the market
30 days of protection for $1,000 worth of stock against a 5% drop
Percentage of the portfolio sacrificed for the 5% drop peace-of-mind
Low (15 VIX)
$2.29
2.8%
Moderate (20 VIX)
$5.52
6.6%
High (25 VIX)
$9.52
11.4%
Crossing the threshold Buying put protection creates an immediate loss and raises the break-even threshold. Instead, focus on probabilities and strategies that lower the break-even point.
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April 2019
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january 2020 | luckbox
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