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. Figure 15 below shows when this cost is suffered by the investor, and when the structure starts to provide protection against declines.
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 via collars or put spread collars is the best way to pay for protection.
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.
- Figure 15. Protection Strategy Comparison:
BEST STRATEGY DETERMINED BY VOLATILITY LEVEL
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).
MATURITY DRIVEN BY DURATION OF LIKELY DECLINE
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.
- Figure 16. Types of DAX Declines (of 10% or more) since 1960:
Median maturity of protection bought is c4 months
The average choice of protection is c6 months, but this is skewed by a few long-dated hedges. The median maturity is c4 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). The typical cost of ATM puts for different maturities is given below.
- Figure 17. Cost of ATM Put on SX5E:
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 (see Figure 17 above).