Equity investors concerned about potential drawdowns often turn to put options for protection, but investors who simply reduce their equity exposure to decrease risk will likely achieve better outcomes than those who purchase protection. Intuitively, it seems that portfolios protected with expensive put options should have a well-defined and limited loss profile, but the author shows that put-protected portfolios actually have worse peak-to-trough drawdown characteristics per unit of expected return. The outcome is precisely the opposite of what is intended.

The surprising result that put options often do more harm than good comes about because drawdowns rarely coincide with option expiration cycles. The longer a put option’s maturity, the more likely it is that a stock can rise far above the strike of an out-of-the-money put and then crash. Even though the stock has declined appreciably, the put does not hedge the decline. Such path-dependent outcomes can circumvent a put option’s intended downside protection. In addition to the misalignment between the option protection cycle and the drawdown period, the put option itself has a negative equity beta that varies as a position moves away from the strike price, which introduces a time-varying equity exposure to the overall portfolio and thereby adds risk. Buying protection changes the shape of the return distribution relative to divesting, but the textbook hockey-stick shape that investors envision is not what they receive in real life.

The author compares the drawdown characteristics of simulated put-protected portfolios with those of a “divested” strategy that invests a fixed proportion of assets in equities and the remainder in cash. Protected strategies are often compared with their fully invested unprotected counterparts, but the author sizes the equity-plus-cash portfolio to match the return of the put-protected portfolio. The portfolios are not beta matched; in fact, the protected portfolio has nearly three times the beta of the divested portfolio and is significantly more volatile.

Historical analysis is conducted using Monte Carlo simulated data and the CBOE S&P 500 5% Put Protection Index to evaluate put protection in both idealized and real-world settings in order to explain how the hedging breaks down. As the author continues his analysis, he increasingly incorporates important realities into his simulations. When options are expensive, protecting is a much riskier approach to earning a unit of return than divesting, so later analyses incorporate a volatility risk premium to price crash risk. Next, the author addresses the fact that real-world options have more negative delta in periods of increased volatility relative to the 20% annualized volatility assumed in his earlier simulations.

The protected position is less negatively skewed than the divested position, but it is more fully invested in equities. Its increased volatility is unhelpful because, unlike the divested position, the protected position is subject to larger and path-dependent outcomes. The net result is that the protection strategy’s losses and gains are generally greater in magnitude than those of the divested strategy, despite having the same compounded return. The key takeaway is that put options are effective in reducing drawdowns only in the rare circumstance when options are priced with no volatility risk premium and equity drawdowns precisely coincide with the option holding period.

Because secondary motivation for protection strategies is to achieve greater upside participation, the author also measures trough-to-peak “drawups” and finds that the put protection strategy succeeds in this regard. Despite the strategy’s asymmetric exposure to equity markets, protecting with puts has both more painful peak-to-trough drawdowns and more enjoyable trough-to-peak rallies. The loss in realized returns, however, is disproportionate to the reduction in tail risk when protecting, so the net result is a significantly lower Sharpe ratio than that of divesting.

The simulation approach allows the author to vary the depth and duration of a market decline so that he can point out when the put-protected approach performs best. Ultimately, investors who are evaluating put protection against divestment must choose which drawdown horizon worries them the most: the infrequent sudden extreme market crash or the more common protracted drawdown.