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.
