Buying a protective put…this is something that everyone has undoubtedly heard of doing. Buy a put to “protect” your downside.
Look, we are all for protecting our downside. If we are long the market, who wants to get burned to the downside? Nobody!
Financial media makes a big deal about and suggests buying a protective put as a way to reduce your downside. When the market begins to go down, the value of the put will increase, thus, offsetting some of the losses of your long stock.
This works in theory…and we will spend the rest of this article talking about if the numbers behind buying a protective put actually make it worthwhile or not.
Buying a Protective Put
Here is the scenario. We are long 100 shares of stock. Let’s call it for argument sake, we are long 100 shares of the S&P 500 Index ETF $SPY. But we don’t like to lose money and we heard that buying a protective put is a good way to limit our downside or at least make it less than it otherwise would be if we did not put the put. Let’s look at an example from right now and how it actually plays out.
We are long 100 shares of $SPY and we are going to buy the 30 delta put that expired closest to 50 days from now. We are purchasing the 30 delta put as it is understood to be the “proper” strike price when purchasing a protective put.
We already long the stock and we paid $1.84 for this option. Right now, $SPY is trading at $237.49. Here are the logistics on this play.
First, let’s assume we bought the stock right where it is right now. That means we paid $237.49 a share. And remember, we are afraid that we need to be protected to the downside so we went ahead and bought the 30 delta put and paid $1.84. When this put expires in 42 days, we need the put the finish in the money (stock below the strike price) for it to be worth anything or we lose the money we paid. This means, $SPY has to finish below $233 ($4.49 away) for this put to be worth anything. On top of that, since we paid a debit for this put, $SPY has to close below $231.16 before we start making money on the trade. And to make it even better, the value of the option we purchased is losing value every day because all options have theta decay. This is the opposite of what we want as we only make money if the put is more valuable.
When we really break it down to pure math instead of emotion, it should make buying a protective put seem not so great.
Now you might be saying, “well, it has worked for me in the past!” And you might be right. So we did you one better!
We went back to the beginning of 2007 and every first day of the trading month, we bought the 30 delta put to “reduce our risk to the downside”. Here is every single trade (all 120 of them).
Again, the first trading day of every month 120 months in a row starting with January 2013 to December 2016 we purchased the 30 delta protective put to see if it did limit our downside or make any positive impact our bottom line. We wanted to show you every single trade since most people won’t believe the results (feel free to check our math :)). Why won’t they believe the results? Because financial media and Wall Street tell us this is a profitable strategy.
Here are the profits and losses shown by year:
Horrible. You lost a grand total of -$6,805.62…
As we can see, this strategy of protecting our downside only “protected our downside” in 1 our of 10 years. Horrible. That year also happened to be the second worst financial meltdown in history. What a terrible strategy as it took the second worst financial crisis ever to make this strategy profitable and worthwhile.
$SPY was trading for $141.62 on January 2, 2017 when this study began. It is now trading for $237.49. That means that since 2007, $SPY is up 67.7%. Great return!
However, if we factor in the losses from purchasing our protective put, we would start with $141.62, go up to $237.49, and then subtract $68.06 from the top as we lost that much per share from buying the 30 delta put every month. That would mean since 2007, if we purchased a protective put on the first day of every month and held 100 shares of $SPY the entire time, we would be looking at a 19.64% gain.
Yes everyone…that is correct. If we bought 100 shares of $SPY on January 2, 2007 and held until December 31, 2016, we made a 67.7% profit. However, if we were all worried about our downside and decided to buy protection, we would have only made a 19.64% profit. That means that over the last ten years, buying a protective put reduced our profits by 66%. Wow!
Are You Going to Buy a Protective Put Ever Again?
Absolutely not. In bear markets does it work? Yes, in the worst bear markets ever it does work. Does it work in sideways markets? Nope. What about bull markets? Impressively no.
And since we never play for black swan events like the one that took place in 08/09, why should we ever use a strategy that is only profitable in that kind of environment?
Remember, this is completely opposite of what financial media says, they make a big deal about the $VIX and they speak about how people are “buying protection”. The good news is that now that you know mathematically it is a failing strategy you will not be one of those people buying protection.