Protection Strategies using Options
Derivatives-based Portfolio Solutions


For both economic and regulatory reasons, one of the most popular uses of options is to provide protection against a long position in the underlying. The cost of buying protection through a put is lowest in calm, low-volatility markets, but in more turbulent markets the cost can be too high. In order to reduce the cost of buying protection in volatile markets (which is often when protection is in most demand), many investors sell an OTM put and/or an OTM call to lower the cost of the long put protection bought.

Buying a put against a long position gives complete and total protection for underlying moves below the strike (as the investor can simply put the long position back for the strike price following severe declines). The disadvantage of a put is the relatively high cost, as an investor is typically unwilling to pay more than 1%-2% for protection (as the cost of protection usually has to be made up through alpha to avoid underperforming if markets do not decline). The cost of the long put protection can be cheapened by selling an OTM put (turning the long put into a long put spread), by selling an OTM call (turning put protection into a collar), or both (resulting in a put spread vs call, or put spread collar). The strikes of the OTM puts and calls sold can be chosen to be in line with technical supports or resistance levels.
  1. Puts give complete protection without capping performance. As puts give such good protection, their cost is usually prohibitive unless the strike is low. For this reason, put protection is normally bought for strikes around 90%. Given that this protection will not kick in until there is a decline of 10% or more, puts offer the most cost-effective protection only during a severe crash (or if very short-term protection is required).
  2. Put spreads only give partial protection but are cost effective. While puts give complete protection, often only partial protection is necessary, in which case selling an OTM put against the long put (a put spread) can be an attractive protection strategy. The value of the put sold can be used to either cheapen the protection or lift the strike of the long put.
  3. Collars can be zero cost as they give up some upside. While investors appreciate the need for protection, the cost needs to be funded through reduced performance (or less alpha) or by giving up some upside. Selling an OTM call to fund a put (a collar) results in a cap on performance. However, if the strike of the call is set at a reasonable level, the capped return could still be attractive. The strike of the OTM call is often chosen to give the collar a zero cost. Collars can be a visually attractive low (or zero) cost method of protection as returns can be floored at the largest tolerable loss and capped at the target return. A collar is unique among protection strategies in not having significant volatility exposure, as its profile is similar to a short position in the underlying. Collars are, however, exposed to skew.
  4. Put spread collars are best when volatility is high, as two OTM options are sold. Selling both an OTM put and OTM call against a long put (a put spread collar) is typically attractive when volatility is high, as this lifts the value of the two OTM options sold more than the long put bought. If equity markets are range bound, a put spread collar can also be an attractive form of protection.

Portfolio protection is usually done via indices for lower costs and macro exposure
While an equity investor will typically purchase individual stocks, if protection is bought then this is usually done at the index level. This is because the risk the investor wishes to hedge against is the general equity or macroeconomic risk. If a stock is seen as having excessive downside risk, it is usually sold rather than a put bought against it. An additional reason why index protection is more common than single stock protection is the fact that bid-offer spreads for single stocks are wider than for an index.

Partial protection can give a more attractive risk-reward profile than full protection
For six-month maturity options, the cost of a 90% put is typically in line with a 95%-85% put spread (except during periods of high volatility, when the cost of a put is usually more expensive), therefore put spreads often have an attractive risk-reward profile for protection purposes. Additionally, if an investor is concerned with outperforming peers, then an approx. 10% outperformance given by a 95%-85% put spread should be sufficient to attract investors as there is little incremental competitive advantage in a greater outperformance.

Implied volatility is far more important than skew for put-spread pricing
A rule of thumb is that the value of the OTM put sold should be approximately one-third the value of the long put (if it were significantly less, the cost saving in moving from a put to a put spread would not compensate for giving up complete protection). While selling an OTM put against a near-ATM put does benefit from selling skew (as the implied volatility of the OTM put sold is higher than the volatility of the near ATM long put bought), the effect of skew on put spread pricing is not usually significant (
the level of implied volatility clearly outweighs the impact of the skew).

Collars are more sensitive to skew than implied volatility
Selling a call against a long put suffers from buying skew. The effect of the skew is greater for a collar than for a put spread, as the skew affects both legs of the structure in the same manner, whereas the effect of the skew on the long put in partly counterbalanced by its effect on the short put of a put spread. If there was no skew (i.e. the skew was flat) the cost of the collar structure would typically be reduced by 1% of spot. The level of volatility for near-zero cost collars is not normally significant, as the long volatility of the put cancels the short volatility of the call.

Capping performance should only be used when a long-lasting rally is unlikely
A collar or put spread collar caps the performance of the portfolio at the strike of the OTM call sold. They should 
therefore only be used when the likelihood of a strong, long-lasting rally (or significant bounce) is perceived to be relatively small.

Bullish investors could sell two puts against long put (= pseudo-protection 1×2 put spread)
If an investor is bullish on the equity market, then a protection strategy that caps performance is unsuitable. Additionally, as the likelihood of substantial declines is seen to be small, the cost of protection via a put or put spread is too high. In this scenario, a zero cost 1×2 put spread could be used as a pseudo-protection strategy. The long put is normally ATM, which means the portfolio is 100% protected against falls up to the lower strike. We do not consider it to offer true protection, as during severe declines a 1×2 put spread will suffer a loss when the underlying portfolio is also heavily loss making. The payout of 1×2 put spreads for maturities of around three months or more is initially similar to a short put, so we consider it to be a bullish strategy. However, for the SX5E a roughly six-month zero-cost 1×2 put spread, whose upper strike is 95%, has historically had a breakeven below 80% and declines of more than 20% in six months are very rare. As 1×2 put spreads do not provide protection when you need it most, they could be seen as a separate long position rather than a protection strategy

If an investor seeks protection, the most important decision that has to be made is how to pay for it. The cost of protection can be paid for in one of three ways: 
  • Premium. The simplest method of paying for protection is through premium. In this case, a put or put spread should be bought.
  • Loss of upside. If the likelihood of extremely high returns is small, or if a premium cannot be paid, then giving up upside is the best method of paying for protection. Collars and put spread collars are therefore the most appropriate method of protection if a premium cannot be paid.
  • Potential losses on extreme downside. If an investor is willing to tolerate additional losses during extreme declines, then a 1×2 put spread can offer a zero cost way of buying protection against limited declines in the market.

The level of volatility can determine the most suitable protection strategy an investor needs to decide how bullish and bearish they are on the equity and volatility markets. If volatility is low, then puts should be affordable enough to buy without offsetting the cost by selling an OTM option. For low to moderate levels of volatility, a put spread is likely to give the best protection that can be easily afforded. As a collar is similar to a short position with limited volatility exposure, it is most appropriate for a bearish investor during average periods of volatility (or if an investor does not have a strong view on volatility). Put spreads collars (or 1×2 put spreads) are most appropriate during high levels of volatility (as two options are sold for every option bought).

The choice of protection strategy is typically driven by an investor’s view on equity and volatility markets. Similarly the choice of strikes is usually restricted by the premium an investor can afford. Maturity is potentially the area where there is most choice, and the final decision will be driven by an investor’s belief in the severity and duration of any decline. If he wants protection against a sudden crash, a short-dated put is the most appropriate strategy. However, for a long drawn out bear market, a longer maturity is most appropriate.

Median maturity of protection bought is approx. 4 months but can be more than one year
The average choice of protection is approx. 6 months, but this is skewed by a few long-dated hedges. The median maturity is approx. 4 months. Protection can be bought for maturities of one week to over a year. Even if an investor has decided how long he needs protection, he can implement it via one far-dated option or multiple near-dated options. For example, one-year protection could be via a one-year put or via the purchase of a three-month put every three months (four puts over the course of a year).

Short-dated puts offer greatest protection but highest cost
If equity markets fall 20% in the first three months of the year and recover to the earlier level by the end of the year, then a rolling three-month put strategy will have a positive payout in the first quarter but a one-year put will be worth nothing at expiry. While rolling near-dated puts will give greater protection than a long-dated put, the cost is higher.

Typically, a protection strategy involving multiple options has the same maturity for all of the options. However, some investors choose a nearer maturity for the options they are short, as more premium can be earned selling a near-dated option multiple times (as near-dated options have higher theta). These strategies are most successful when term structure is inverted, as the volatility for the near-dated option sold is higher. Having a nearer maturity for the long put option and longer maturity for the short options makes less sense, as this increases the cost (assuming the nearer-dated put is rolled at expiry).

Calendar collar effectively overlays call overwriting on a long put position
If the maturity of the short call of a collar is closer than the maturity of the long put, then this is effectively the combination of a long put and call overwriting. For example, the cost of a three-month put can be recovered by selling one-month calls. This strategy outperforms in a downturn and also has a lower volatility.

Calendar put spread collar effectively sells short-dated volatility against long put
For a calendar put spread collar, if the maturity of the short put is identical to the long put, then the results are similar to a calendar collar above. If the maturity of the short put is the same as the maturity of the short near-dated put, then, effectively, this position funds the long put by selling short-dated volatility. This type of calendar put spread collar is similar to a long fardated put and short near-dated straddle (as the payoff of a short strangle and straddle are similar, we shall assume the strikes of the short call and short put are identical). For an investor who is able to trade OTC, a similar strategy involves long put and short near-dated variance swaps.

  1. Calls give complete upside exposure and floored downside. Calls are the ideal instrument for bullish investors as they offer full upside exposure and the maximum loss is only the premium paid. Unless the call is short dated or is purchased in a period of low volatility, the cost is likely to be high.
  2. Call spreads give partial upside but are cheaper. If an underlying is seen as unlikely to rise significantly, or if a call is too expensive, then selling an OTM call against the long call (to create a call spread) could be the best bullish strategy. The strike of the call sold could be chosen to be in line with a target price or technical resistance level. While the upside is limited to the difference between the two strikes, the cost of the strategy is normally one-third cheaper than the cost of the call.
  3. Risk reversals (short put, long call of different strikes) benefit from selling skew. If a long call position is funded by selling a put (to create a risk reversal), the volatility of the put sold is normally higher than the volatility of the call bought. The higher the skew is, the larger this difference and the more attractive this strategy is. Similarly, if interest rates are low, then the lower the forward (which lifts the value of the put and decreases the value of the call) and the more attractive the strategy is. The profile of this risk reversal is similar to being long the underlying.
  4. Call spread vs put is most attractive when volatility is high. A long call can be funded by selling an OTM call and OTM put. This strategy is best when implied volatility is high, as two options are sold.

While a simple view on both volatility and equity market direction can be implemented via a long or short position in a call or put, a far wider set of payoffs is possible if two or three different options are used. We investigate strategies using option structures (or option combos) that can be used to meet different investor needs.

Using option structures to implement a bearish strategy has already been discussed above. In the same way a long put protection can be cheapened by selling an OTM put against the put protection (to create a put spread giving only partial protection), a call can be cheapened by selling an OTM call (to create a call spread offering only partial upside). Similarly, the upside exposure of the call (or call spread) can be funded by put underwriting (just as put or put spread protection can be funded by call overwriting). The four option structures for bullish strategies are given below.

With a 1×2 call or put spread, two OTM options of the same strike are sold against one (usually near ATM) long option of a different strike. A ladder has exactly the same structure, except the two short OTM options have a different strike.

Using option structures allows a straddle (long call and put of same strike) or strangle (long call and put of different strikes) to be traded. These structures are long volatility, but do not have any exposure to the direction of the equity market. Butterflies combine a short straddle with a long strangle, which floors the losses.

We note the theoretical profile of a short calendar trade is similar to trading a butterfly. If an underlying does not have liquid OTM options, then a calendar can be used as a butterfly substitute (although this approach does involve term structure risk, which a butterfly does not have). A long calendar (short near-dated, long far-dated) is therefore short gamma (as the short near-dated option has more gamma than the far-dated option).
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