Managing Risk With Put Options

In today’s post I will discuss the potential use cases for put options in the context of individual portfolio construction.

For those who are not familiar, put options are financial instruments which give the buyer the right, but not the obligation, to sell a specified amount of an underlying security within a specified time frame at a specific price.

Put options which are far out of the money (meaning well below the current underlying security price) can be viewed as an insurance policy of sorts. Most of the time the premium paid is lost, but in the event of extreme outcomes out of the money put options can offer substantial payoffs.

Historically put options have been primarily used by institutional investors but they represent a valuable tool which have a role to play in individual portfolio construction and risk management.

Tail Risk Mitigation

In my previous post How To Ride Out A Stock Market Storm: Part 1 , I discussed a number of the most significant stock market declines which have occurred historically. The decline which really stands out, but is not often discussed by financial media pundits or financial advisors, is the 86% decline experienced by the S&P 500 from August 1929 to June 1932. One important thing to note about the 1929 crash is that the market was not wildly overvalued heading into the crash as the market was only trading at ~15x earnings. Another thing to note is that the stock market would not reach a new high until 1954.

While I am not suggesting that such a steep and long lasting stock market decline is in the cards anytime soon, it is a low probability event that investors should keep in mind.

To get a sense of the cost/ benefit for tail risk hedging lets consider a simple example. Let’s assume an individual has a 60% equity (S&P 500) / 40% bond (Barclays US Agg) portfolio and is considering a hedge which will protect 100% of the equity position from declining more than 20% over a roughly one year period.

The SPDR S&P 500 ETF (SPY) tends to have the most liquid options market of broad market products, so for purposes of this example, I will assume the individual decides to hedge with SPY puts. Currently, SPY is trading at a price of $501.2 and thus a put option 20% out of the money would have a strike price of ~$400. Given the goal of hedging risk for a one year period, the Jan. 17, 2025 expiration date is reasonable expiration to use.

As of this writing, the Jan. 17, 2025 $400 strike SPY put option would cost $5.4. This represents a cost of ~1% of the current trading level of $501.2 for SPY. Given that the investor is only hedging the 60% equity portion of the portfolio the total cost on a portfolio level for this protection would be 0.6%. While this is meaningful, it is important to consider that the long-run historical return of a 60/40 portfolio has been ~8.5%.

Moving the strike up from the current level to 15% out of the money would cost 0.9% at the portfolio level while using a strike 30% out of the money would cost just 0.3% at the portfolio level.

Much like life insurance, a buyer of deep out of the money portfolio hedges would almost certainly hope to never need the insurance but can sleep easier knowing that insurance is in place.

One thing to note is that the cost of such protection can vary significantly based on market conditions. As risk increases the demand for puts typically increases and thus the cost of the hedges referenced above would be much higher. For this reason, portfolio tail risk hedging must be a dynamic process that takes into account market conditions.

Single Stock Risk Mitigation

Another way investors can use put options to manage risk is to reduce individual stock risk. It is not uncommon for investors to end up with a significant amount of exposure to one stock after a period of outperformance from a specific holding.

A great example of this phenomenon is the Apple position owned by Warren Buffett’s Berkshire Hathaway. Buffett began building a position in the stock in 2016 and increased the position in 2017 and 2018.

Due to significant outperformance relative to the market and Berkshire’s other holdings, Apple now accounts for ~50% of Berkshire’s public equity portfolio.

Individuals who successfully invested in big tech companies often face a similar scenario and may want to reduce risk. As a company with a perpetual life and limited liquidity needs, Berkshire is able to take more risk than individual investors.

While selling an individual holding is always an option, such a transaction is likely to result in a very big tax bill due to the realization of capital gains. This option is particularly unattractive for investors who are late in life and might otherwise benefit from a step up in basis which results in no capital gains tax.

An alternative approach involves the use of put options to reduce exposure. Based on current market prices, one could purchase a roughly 20% out of the money put option on Apple with an expiry in Jan 2025 for a premium of ~1.8%. The cost of insurance for individual stocks is typically higher than the broader market due to the fact that individual stocks tend to be more volatile.

One thing to note is that there can be certain tax implications to consider and individuals should always consult a personal tax advisor to understand treatment. For example, if the underlying stock has been held for less than one year the clock would reset in terms of holding period required for the gains to be considered long-term for tax purposes. If the stock has already been held for more than a year prior to the protective put purchase then the tax characterization of the stock generally does not change. Additionally, a protective put might result in dividends from an investment being treated as regular income as opposed to a qualified dividend income, which receives better tax treatment.

Tax Efficient Risk Reduction

Investors who choose not to rebalance frequently (in order to save on tax and transaction costs) between equities and other asset classes may find that equity exposure as a percentage of the portfolio often increases overtime. The reason for this is that equities tend to deliver stronger investment performance than cash, fixed income, or other asset classes overtime.

The result of this is than in individual late in life might find themselves sitting on more equity exposure than they are comfortable with. Similar to the single stock discussion above, the downside to simply selling equities to rebalance is this transaction may come with a significant tax bill related to realized capital gains.

Alternatively, an investor could use put options on a broad market index ETF such as SPY to reduce risk without triggering a massive tax bill. This strategy becomes more appealing the later in life one as as the potential savings on capital gains tax due to a potential step up in basis.

Takeaways

Put options are a financial instrument which can have an important role to play in individual investor portfolios. Put options often (but not always) serve as cheap insurance for a worst case scenario and can allow investors to manage individual stock or asset class risk in a more tax efficient manor than would otherwise be possible.

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