I believe that buying SPY puts is a bad idea for most investors. I will run through some scenarios that show it to be a weak strategy. SPY in order to hedge a portfolio. I agree with everything in the article - and I am a fan of the author in general - with the exception of the conclusion that SPY puts are a good hedge for many investors.
In addition, I wrote an article a few days ago titled "How To Prepare For The Upcoming Correction" that outlined some alternate ideas for investing in an overvalued market. Puts might be a good idea in certain unusual situations, but in general I don't think they are the best way to go.
Parsimony's article went through some calculations such as how many puts would be needed to hedge a portfolio, but the author did not actually calculate the cost of the "insurance" that the portfolio holder would incur.
I will calculate that here. The first item that I have a problem with is the assumption of a 0. I will use a Beta of 1. Now to annualize the cost. The option expires in 85 days - I will assume that is one quarter which actually makes the put strategy look slightly better than it is. Thus, the options will need to be rolled four times. Therefore, the cost of this particular form of portfolio insurance is about 6.
That would be 2. Using current prices, a 2. It is certainly possible to model in some volatility and some final worth to the put options, but the assumptions would really start to pile up, so I will keep it simple.
I will also model that each quarter the cost of the options are the same since the VIX is quite low at this time, chances are good that the cost would actually increase. Would the investor sell the option at just the right time? There is no bell that rings at the bottom! I am also going to assume that the drop occurs in the first quarter and I won't annualize the strategy.
In many ways, my model actually gives some benefit of the doubt to the put insurance strategy. Some benefits I wrote about above like using the current cost of a put 85 days out from expiration to approximate a 91 day quarter , but perhaps the largest favorable assumption is that the put options would not get any more expensive in the future.
The strategy is already far too expensive for my taste. That is the scenario if an investor bought the puts immediately and the market tanked by September What if the market goes sideways for a few quarters, then tanks? What if the market goes down a few percent per quarter? What if the investor does not sell the puts back at the right time?
Of course, the largest risk of all is if there is no correction, or that the correction is very long in coming. In that case, the put buyer has paid a bundle for insurance that was wasted.
The only reason I can envision someone buying SPY puts as a hedge would be as a very short-term strategy. I have yet to meet the person who can routinely predict corrections accurately enough to make such a strategy work. I personally would not buy SPY puts. I have outlined some other strategies that I think make more sense. The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it other than from Seeking Alpha. The author has no business relationship with any company whose stock is mentioned in this article.
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