January 2020 (i)

SPECIAL SECTION: TACTICS

Luckbox is devoting this month’s tactics section to a three-part series on protective puts, courtesy of the Learn Center @tastytrade

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

Losses 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,”below.)

Michael Rechenthin, Ph.D., aka “Dr. Data,” is the head of data science at tastytrade. @mrechenthin

Paying protection money: As fear of a loss increases, the cost of an “insurance policy” against risk goes up, too.

INTERMEDIATE

The Myth of the Protective Put

Buying an expensive “portfolio insurance policy” hardly ever works

By Michael Gough

Trying to maintain a hedge with long put options is expensive and requires nearly perfect timing.

In Chicago, the weather can seem as volatile as the market. A day that begins with a 5% chance of rain can end with a torrential downpour. In a similar way, buying put options to protect a portfolio against a downturn seems a lot like grabbing the umbrella before heading out the door to work. The cost is low and the benefits can be huge.

Put options can protect a portfolio during a downturn by locking in a selling price before the market crashes. Assume the market is trading at 3,000 and an investor thinks it could fall 10% in the next 45 days. To protect a portfolio, an investor buys the 2,700 put option for $3. Several days later, the market crashes to 2,000. With the 2,700 put option, the investor can immediately sell the portfolio for 2,700, which is a much better price than the current 2,000. Buying the put has protected the investor’s portfolio against the extreme down move.

History shows that maintaining a consistent hedge with long put options just hasn’t been an effective strategy.

But this investment narrative is missing details. Firstly, market participants are already pricing in the possibility of a large down move in the market. This risk is manifested in the price of put options. On average, put options trade almost twice as rich as the same delta call options on SPY, the S&P 500 exchangetraded fund. Trying to maintain a hedge with long put options quickly becomes futile as the high cost diminishes their potential benefit.

Secondly, if the investor buys the put, it requires near-perfect timing for the hedge to be profitable. If, in the previous example, the market didn’t correct—poof, there goes $3 in option premium. Or, even more demoralizing, the market falls to 2,000 on the 46th day. Maintaining the hedge requires consistent put buying, and that cost can quickly add up, especially during a bull market rally like that of 2009 to present.

Maintaining a consistent hedge with long put options has historically been an ineffective strategy. The table, right, presents statistics on the value of buying puts. From 2005 to the present, buying 45-day portfolio insurance with long put options in SPY has resulted in an average trade performance of -$19.00. Given the option’s delta and its probability of expiring in the money by expiration, these options should have been profitable around 5% of the time. In reality, they were profitable only 2% of the time.

During this back-test period, the largest profitable long put option netted a gain of $1,788. Depending upon the timing, that may be enough to convert the cost of buying puts but would probably not cover the losses incurred in a long stock portfolio.

Long put options can provide portfolio peace of mind, but they aren’t an effective tool for maintaining a consistent hedge because of their high cost and reliance on perfect timing. More effective strategies, such as portfolio diversification and delta hedging, can provide similar portfolio protection without the high cost.

Michael Gough enjoys retail trading, and writing code. He works in business and product development at the Small Exchange, building index-based futures and professional partnerships.

ADVANCED

False Prophets Get It Wrong About Profits

New data suggests it pays to concentrate on managing stocks that are gaining value, not the ones in decline By Anton Kulikov

For the last 100 years, Wall Street has been dispensing this advice to investors: “Cut your losses and let your winners run.” The adage formed the basis of trading discipline. The problem is that it’s not necessarily true.

To build wealth, in fact, the opposite may be a better strategic choice. The data backs that up—thanks to research tools that weren’t available even 10 years ago. So, don’t fault the old-timers for getting it wrong. It’s just that today, investors should base decisions on the latest information.

After all, it feels awful when a loss wipes out weeks, months or even years of gains. But the reason that happens has less to do with a lack of discipline and more to do with strategy. Luckily, in today’s world of largely democratized financial technology, individual investors can take advantage of strategies that enhance portfolio performance.

Pundits often dwell on ways to stop losses, but it’s more advantageous to enhance performance by managing existing winners. Why? Because the probabilities and historical backtests suggest that managing winners will more effectively boost overall portfolio returns and prevent profitable positions from slipping away and turning into losses.

The philosophy of managing winners instead of losses stems from the fact that losses, albeit undesirable, cannot be controlled. Managing losers will only lock in the loss and does nothing to prevent future losses. In other words, managing losers is a reactive strategy, and managing winners is a proactive strategy. Investors should remain proactive and thus give themselves the best chance of success while they can still control the outcome of a win.

So, what do the numbers say? The table above shows a historical backtest of a strategy known as a short strangle in the S&P 500 ETF (SPY) going back 14 years. In the left column, the trade was placed 45 days to expiration and then held to expiration. In the middle column, the trade was placed 45 days to expiration and then taken off if and only if the loss reached two times the credit received for the strangle; otherwise, it was held to expiration. In the right column, the trade was placed 45 days to expiration and then taken off if and only if the trade reached a profit of 50% of the credit received; otherwise, it was held to expiration.

It feels awful when a stock market loss wipes out weeks, months or even years of gains.

The rightmost column yielded the best results, not only in terms of daily profits, but also in terms of risk and win percentage.

The reason? Managing winners prevents those winners from turning into losses, while losses that already have happened did not get much worse. That means overall performance was improved, and the numbers demonstrate that.

The moral of the story is that taking a loss is largely unproductive compared to managing existing winners. To enhance a portfolio’s returns, increase the win percentage and reduce the risk, compared to managing losses.

Anton Kulikov is a trader, data scientist and research analyst at tastytrade. @antonkulikov97

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