1) Does hedging market risk with options work on stocks?
We have several ways to direct and control the risk of loss and drawdown. We can:
Sell to reduce exposure in uptrends
Apply trend following to sell after a trend reverses
Hedge dynamically when risk is high
Hedge always
We have several ways to direct and control the risk of loss and drawdown. We can:
Sell to reduce exposure in uptrends
Apply trend following to sell after a trend reverses
Hedge dynamically when risk is high
Hedge always
2) The Cboe S&P 500 5% Put Protection Index is designed to track the performance of a hypothetical strategy that holds a long position indexed to the S&P 500® Index and buys a monthly 5% out-of-the-money S&P 500 Index (SPX) put option as a hedge, and rolls on a monthly basis.
3) So, the index is an example of "always hedged", so let's see how it's going since it started in 2015. Over the past 5 years, it had some lag due to the cost of 5% OTM put options for protection. Here, I left out 2020 to show how it looked.
4) It lagged by about 6% from 2015 through 2019, which isn't a lot IMO for the protection. Keep in mind, though, the driver of the lag is options premium, which is driven by implied volatility. IV was much lower from 2015-19, so the cost to hedge was generally lower, too.
5) We can get an idea of the IV by looking at the trend in $VIX. So, 2015-19 the VIX averaged only 15 with a low of 9 late 2017.
6) To understand how low mean of 15 is, the long term average is around 19ish and before 2015 (and the Fed put) it was 20. Also, the low of 9 in 2017 has only been observed 3 times in 30 years, so it's been a once in a decade.
7) Now do 2020! Over the past year, the 5% Put Protection Index cost drag was relatively low, since implied volatility was low before the Feb crash. Then, it provided the much-needed market risk hedge as the SPX quickly dropped -34% from its high.
8) As expected, the 5% Put Protection Index was imperfect, as it still had a -20% drawdown, which was brief, and about half the $SPY.
9) As I've been a money manager over two decades now trading and hedging, I expect we'll see other periods when the cost to hedge is much higher, resulting in more drag/lag, and this index doesn't include expenses and such. Still, it suggests if we want protection, we can buy it.
