Protective puts and collars

There is a thread on the Vanguard forum (link) asking about protective puts. The rough outline is as follows:

Example of an 100k portfolio:

20k cd ladder (1 to 10 year with 5 year average duration)

79.2k SP500 ETF (example only)

0.8k put (2 to 3 month in duration) which gives me the right to sell my ETF if it drops below 55.4k (70% of 79.2k) before the put expires

The cost of protection with at the money puts is easier to find, it is the VIX. For example if VIX is 14 on SPY puts, the cost of insuring with at the money puts is 14% per year. For out of the money puts, the skew means the implied volatility is higher, typically about 25 if at the money is at 14. I know that I have lost almost all of you by now by keep reading the mud gets clearer.

The other problem with the strategy is that insurance is not at a fixed cost. When the market is in turmoil, the cost of insurance, doubles and doubles again. So what is projected as a 1% annual cost becomes 2% or 4% in volatile markets. Interest rate is another input for option pricing, and high interest rates would mean the same, much higher premiums.

Another point is that 10% monthly declines are rare. Back-to-back 10% declines even more so. Three in a row are even more so. Someone buying puts that far out of the money is only going to get to use their insurance maybe two or three times in a typical decade. Of course, if a person knows when the big banana is coming, they can do better--but we don't know. No one knows. Options try and price things according to the odds.

Right now, there has been some research into collars, selling calls and buying puts, as a profitable strategy. Like most strategies that get published, it has a recency bias (worked recently). Publishing also tends to make a strategy more popular, and less profitable as more people use it.

The bottom line, buying protective puts is a form of insurance, and it costs. In the example given the premium is about 1% a year in calm markets, with the caveat that the premium will expand during volatile markets. The protection is rather modest, with a 20% deductible so to speak, before a claim is paid.

Collars can be useful for people with special circumstances. The more famous examples are executives at high tech companies that have just gone public, but the stock they are given has a lock up period before they can sell. By doing a collar, the person guarantees a floor, and gives up some upside. For average folks, reducing the equity allocation is a simpler plan, with nearly the same benefits. Another possibility is that tax reasons mean a sale next year works out better than a sale right now. Same deal, give up some upside to get a floor, by doing a collar.