DERIVATIVES 'R US/V1N11/Protective Puts and Portfolio Insurance
VOLUME 1, NUMBER 11/May 1-8, 1995
This week's issue covers May 1 and May 8. I'll be unavailable next week but will return on May 15.
Probably many of you are familiar with the protective put strategy. With a stock as the underlying asset, you hold the stock and buy a put. If at expiration, the stock falls below the strike, you sell the stock for the strike. If the stock ends up above the strike, you let the put expire worthless and gain from the increase in the price of the stock. I've always felt that the protective put is one of the most instructive strategies of all the option transactions. It brings to light much of the mystery of options.
Options are often described as being a form of insurance. Nowhere is this more obvious than with the protective put. The put serves as an insurance policy on the stock. The seller of the put is the insurer and receives a premium in return for promising to cover any losses below the strike. As you probably know, a homeowner's insurance policy usually contains a deductible. This is an amount of the loss that the insured agrees to cover and in return, the insurer charges a lower premium. In the case of the protective put, one can effectively raised the deductible by choosing a put with a lower strike. This lowers the put/insurance premium and means that the insured will incur a larger loss on the downside.
An interesting thing I find about the protective put is that it is the only option strategy I know of in which you buy a single option and hope it expires out-of-the-money (maybe I just can't think of any others; if you can, let me know). If you want it to expire in-the-money, then you must be some kind of financial arsonist. Your best outcome is for the market to go up and your put to expire worthless. Like homeowner's insurance, you hope you don't have to use it but it's good to know it's there.
I personally have never used a protective put and doubt that I ever will. Let me explain why because, in spite of the beauty of the transaction I would be surprised if it benefits many individual investors. The protective put strategy enables one to achieve a minimum return at a target date. Unless you are investing a sum of money with the sole objective of having a certain amount available on a specific date, what do you gain by locking in that minimum? You might have a stock that went up substantially in a short period of time and you'd like to hold it awhile longer but will kick yourself if it falls back down. Then a put might make sense from the standpoint of your feeling less regret that you didn't sell. That strikes me as a more emotional reason and investing on emotions is not sensible investing. If you're a long run investor, you don't need puts because you don't have intermediate targets. It's possible that LEAPS (long term options) might be useful if you wanted to assure a minimum amount of funds available, say to fund a future college education. Even then, however, I'd skip the insurance and buy a solid, well- diversified portfolio.
So who should buy protective puts? Professional investment managers, such as pension fund managers, who are required to generate a minimum amount of cash at a future date are big users of the strategy. In addition investment managers who are evaluated at specific dates are likely to use puts. Unfortunately, this is not always the way things ought to be (to quote Rush Limbaugh). Suppose a mutual fund manager has earned a very high return for three quarters so that he is among the leaders. He remains bullish for the fourth quarter but knows that if he is wrong, he will fall out of the pack, lose some of his bonus and otherwise miss out on the fame and fortune that accompanies such success. He can virtually assure his success by purchasing puts. In that case, he might do so and it would be for the wrong reason. In other words, locking in past profits is not a good reason for using puts unless the reward system induces one to do so. In this case, however, the reward system is at fault.
Because protective puts are not always available with the expirations and strikes needed by investment managers, they sometimes turn to a dynamically-adjusted version of the protective put. This came to be known in the mid-80s as "portfolio insurance." It works like this. If you actually had a put with the desired expiration and strike, the combination of stock and put would have a specific delta that would, of course, change with time and changes in the stock price. But because of the Black-Scholes model, you always know what the delta of a protective put position should be. Instead of using puts, you simply combine your stock with futures or Treasury bills. Then you compute the delta of the stock-futures combination or the stock-Tbill combination and that will tell you how many futures or Tbills you would need to set your delta to the delta of a protective put. As you move through time, you recompute the stock-put delta and reset your stock-futures or stock-Tbill delta to the stock-put delta by adjusting the allocation between stock and futures or stock and Tbills.
During the famous crash of 87, the portfolio insurers were selling quickly because the market moves were faster than their models had assumed. This is the gamma effect I discussed in a previous issue. Portfolio insurance got a very bad name and practically disappeared. In fact, however, portfolio insurance didn't cause the crash. The large amount of selling by insurers may have exacerbated the fall but the biggest problem with portfolio insurance is that it was based on the idea that the market moves would be so small so that the deltas could be reset reasonably fast. The insurers had missed the gamma effect and it got worse when the market stopped trading and the futures price came detached from the cash price. So portfolio insurance did not replicate a protective put as it had been planned. However, those who had portfolio insurance were certainly better off than those who didn't.
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