Puts and Calls - The Pitfalls of Hedging
My family and I were eating dinner the other night, and our 5-year-old spoke up…
Connor: Dad, I found a bone in my fish. I’m going to add it to my collection.
Me: What collection?
Connor: The one in my room.
Me: What is it a collection of?
Connor: So far just this.
Life with young kids can be unpredictable, thought-provoking, and a little bit scary. It comes with volatility, judgement calls and emotional reactions. Sometimes you just have to take a step back and laugh. Kind of sounds like investing, right? Similar to my son, I've seen a lot of investors who find a cool idea and want to add it to their "collection."
No doubt, recent volatility has led many to see out hedging opportunities and there is no shortage of options. While some make a lot of sense, and others have pitfalls. There is no way to manage risk without giving up something in return. There’s no free lunch on Wall Street, as they say.
Options strategies such as protective puts and covered calls are simple enough to implement and at the very least they might make you feel better. But at what cost? This is probably as good a time as any to dig into Puts and Calls 101.
A put is an option that gives the owner the option to sell a stock or ETF at a given price at a future date. A “protective put” position is a combination of a stock or ETF and a put option on that position, creating a “floor” on the underlying position. If you’re holding a position that you don’t want to or can’t sell but aren’t willing to assume its risk, a protective put can be a useful strategy.
The drawback of a protective put is simple. You must pay a premium. Here’s an example. As of the time this was written, iShares S&P 500 Index (IVV) is trading at $254. A 6-month put at $240, which would provide a 5.5% floor, is priced at $9. 1 So while you are locking in a floor of $240, you’re also locking in a cost of $9/share, even if the option expires without being exercised.
In this scenario, for the put to provide value IVV will have to drop to $231 in the next 6 months to overcome the premium you paid. If it drops to $230 then you’ll have saved yourself a whopping $1/share of downside. If IVV tanks then it will have been a really nice move, but you can see why this strategy isn’t more widely utilized.
A call is an option that gives the owner the option to buy a stock or ETF at a given price at a future date. A “covered call” position is when the owner of a stock or ETF sells a call option on the underlying position at a higher price. “Writing” or selling a call generates income, but the investor has to be comfortable with the idea of selling the position at the call price as the counterparty will call the position if it is favorable for them to do so.
A covered call strategy can be a very useful tool to generate additional income on a position you don’t mind selling at a particular price. It can also be an alternate strategy to a limit order. If you’re ok selling a stock at a certain price, why not pick up a few bucks along the way? Like buying puts, it comes with drawbacks.
The drawbacks of a covered call strategy aren’t as straightforward. First off, it is important to understand that while you are collecting a premium, this strategy technically does not give you any downside protection. You own the stock and nearly all of its downside risk. The part you don’t own is the upside potential. You’re trading in a few percentage points of yield in exchange for the upside. Here’s an example.
Again, IVV is trading at $254. A call that expires in 6 months at $265 is priced at $7.60/share.1 Selling this call would give you a 3% boost in income on the position, which is taxable at ordinary income, in exchange for a ceiling on your investment at 4.3% above the existing price.
You might be thinking, earning the return of the S&P 500 with semi-annual caps of 4.3% plus 3% income a couple times per year doesn’t sound so bad. But there are several issues.
Here’s number one. The market is more volatile than most people realize – especially on the upside. Even if your retirement plan says you only need to earn 7% per year to stay on track, you probably need some upside volatility (i.e. really big positive years) along the way to make up for lagging years.
Another issue, as I’ve already stated, you’re still subject to nearly all the downside. If we experience a really ugly 6 months, the call provides no relief. For example, using simple compounding, let’s say the S&P 500 is down 10% in the first 6 months of a year, then up 20% in the last 6 months for a total return of +10% for the year.
In this case, your return for the first 6 months would be -10% + 3% premium = -7%. If you write a similar covered call for the second half of the year, your return for the second half of the year would be 4.3% cap + 3% premium = 7.3%. While the market made 10% for the year, you made 0.3%. Oh, and that’s before taxes on the income, and any transaction fees you incur. So you’re likely netting a red number.
In case you’re wondering, the S&P 500 has earned an average calendar-year return of 9.6% with an average intra-year decline of 13.9% since 19802 - so this example is a relevant one.
In the same year it would be fair to expect a 60/40 portfolio to get you 6% or 7%. You might as well have invested in plain old bonds and maybe earned 2-3% with much less volatility. Which reminds me – I’d be remiss if I didn’t mention my favorite way to hedge equity risk. It’s called buying bonds.
While the unpredictability of investing may make you feel uneasy, understand that most of us NEED the positive side of unpredictability to address our goals. As my son will hopefully learn, if you make a habit of collecting items that seem cool for a minute, you'll probably end up with a smelly pile of trash that ultimately gets thrown away when you aren't paying attention.
1Quotes as of 1/5/2019 (June put) https://finance.yahoo.com/quote/IVV/options?date=1561075200
2JPMorgan Guide to the Markets, December 31, 2019, Slide #14