Buying Puts: Waste of Your Money or Crucial To Survive? (2/2)

Following our first article on buying long-term puts to hedge a long stock portfolio, the second part of the small study is presented.


We have simulated a long put strategy on the Eurostoxx-50 index for 2014, 2015 and 2016.

Let's take a look at the input:

  • 5-year puts being bought in a 250k portfolio; 10% of the portfolio value. In reality, we can easily finance this insurance with covered call premiums.

  • Strike price is 10% below starting price (at 1/1)

  • Renewing the number of contracts, strike price and expiration period each year. Wait for renewal until the VIX is within the 12-13 (maybe 14) range.

  • No rebalancing

  • No other strategies implemented (no portfolio overwriting)

  • Please note that simulations are not 100% accurate but point to a fairly realistic performance based on long-term implied volatility

Goal of the simulation: looking for a volatility hedge, taking profits on puts when possible and re-investing them portfolio overwriting. By taking profits on your long puts, you automatically re-invest these gains when a correction has occurred.


For defensive investors looking to add to their equity exposure only during meltdowns, this strategy bears fruit as they capture juicy covered call premia on new portfolio overwriting positions. In the meantime, you can keep the covered call premia on the sidelines and utilize them during retirement. I steadfastly believe that this approach is far more attractive than rebalancing a 50-50 portfolio (bonds and equities). In my humble opinion, bonds do not provide a cushion one is looking for during a correction.


2014

2014 saw nice gains for the long put strategy and less drawdown risk.

(Source: Option Generator Research)


Investors who bought long-term out-of-the-money puts had an opportunity to generate returns of more than 60%.

(Source: Option Generator Research)


2015

2015 was off to an excellent start for the stock market, but witnessed August 24th when the VIX spiked to 40%. Again, adding 10% of your portfolio to protective puts would have dampened the losses significantly.

(Source: Option Generator Research)


Investors who bought long-term out-of-the-money puts now had an opportunity to generate returns of more than 100%! A no-brainer to re-invest the profits in cash-rich, fast-growing long-term leaders.

(Source: Option Generator Research)


2016

The Brexit referendum, the US elections... enough elements that impacted the 2016 outcome. Once again, strong results for the long puts with opportunities to take profits in June and November.

(Source: Option Generator Research)



(Source: Option Generator Research)


Conclusion

Hedging your portfolio by utilizing long puts on the Eurostoxx-50 turns out to be a successful strategy in conjunction with traditional buy and hold investing, not to mention the covered call premiums we can collect on our long-term leaders.


I wouldn't do this on the S&P-500 given its strong outperformance relative to foreign indices, which would destroy the value of the long puts. Also, there are no 5-year options available on the SPY tracker.


When it comes to individual equities, I would not implement this protective strategy as the Eurostoxx-50 proves to be a good underlying: low implied volatility that can suddenly spike, few positive outlier moves and sufficient liquidity.


Finance your permanent insurance with portfolio overwriting income and you'll be able to absorb future VIX shocks. This is especially true for those who have garnered sizable long-term capital gains and want to reduce drawdown risks. Right now, the VIX is elevated and a lot of VIX speculators turned heavily long, indicating further cooling in the VIX to the sub-20's is likely.

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