Efficiency of Put Options as a Hedge

May 22, 2018

Put options on broad-based equity indices are systematically overpriced as measured by the expected profit of buying or selling them. Market prices for put options are usually higher than their Fair Values because of the volatility premium demanded by option sellers as compensation for high volatility and the potential for huge drawdowns. For more information, see this research: Are puts really overpriced?

However, since an expected value (all possible outcomes weighted by their probabilities) is always calculated as an arithmetic average, options Fair Values and their respective expected profit/loss do not reflect the compounding effect of returns. At the same time, we know that drawdowns have a negative impact on the total return if we capitalize all gains and losses (volatility “drag”), see more information in this post.

Theoretically, if an option seller bears this “drag”, a buyer, on the other hand, should benefit from removing this excessive volatility from his or her portfolio. In practical terms, with a long put option strategy as a hedge to a long equity portfolio, an investor can use the realized proceeds from put options at the time of a market crash as “dry powder” to buy more underlying assets at lower prices. This is also known as a “rebalancing bonus”, which is the opposite phenomena to the volatility drag.

In this research, we have studied whether put options overpricing is justified by this rebalancing bonus for a hedged portfolio. The results show that it is not. It turns out, there are no parameters (moneyness, DTE) of put options and put spreads that would make them an efficient hedge in the long run without predictions of market turmoils.

The information provided on this Website is for informational purposes only and should not be considered as an investment advice. It is not intended to replace consultation with a qualified financial professional. Investing in options involves risk of potential loss exceeding the whole amount of money invested. No one should make any investment decision without first consulting his or her own financial advisor and conducting his or her own research and due diligence.