Wouldn't we all like to get something for nothing? Have our cake and eat it too? Especially when it comes to buying “insurance” in the stock market? As someone who specializes in the esoteric field of “tail risk hedging,” investors always ask me if there is a cheaper way to buy protection against market dips and busts, because the idea of paying premiums year after year , which bites into profits, is not always acceptable.
To get right to the point, let's assume that the S&P 500 is the stock market we are interested in covering. As of this writing, the S&P 500 is at 4515 (Source: Bloomberg). If we price a one-year put option reached at this level (known as an “at-the-money spot” exercise), the hedge price is approximately 4.75%. If we buy this put option and wait a year and nothing happens, we will obviously lose 4.75% in premium. A call option with the same strike costs about 8.25%. So in this simple example, an investor who owns the S&P 500 Index or similar stocks (for example, by holding an ETF like SPY or IVV) can sell the call option to earn 8.25% and spend some of that money to buy the put option for 4.75. % and a positive net “income” of 3.5%. If the market ends above 4515 in a year, the investor gives up all the advantages of his stock portfolio, since the call option will end in the money. If the market stays where it is, the investor will keep 3.5%. If the market falls, the investor is fully protected against any market decline. Thus, in this example the investor wins in two out of three situations and in one situation he loses nothing. Basically, by giving up potential upside, the investor can buy protection on the downside while earning a little on the upside.
There is no magic here. The reason the call option costs so much more than the put option today is simply because the forward price of the S&P 500, which is the main driver of the option price, is “implied” to be at 4679. , which is approximately 3.5%. higher than the current price. And the reason for this is that the relevant deposit rate of 5.25% for the year is much higher than the 1.6% “dividend” yield of the S&P 500 (the situation is even better for dividend markets lower like the Nasdaq 100).
Now some investors might be reluctant to sacrifice all the upside to buy downside protection. So let's change this to an investor who wants to maintain a 10% lead. This investor sells a 10% out-of-the-money call option and uses the proceeds to buy a 10% out-of-the-money put option on the downside. Selling the call (around 4965) will generate, at current price levels, a premium of around 2.85%. And buying the put option (around 4060) will cost about 2.6%. Therefore, the investor will earn 0.25%, and will also have tilted the portfolio in such a way that if the market recovers he will participate up to 10%, but more importantly, if the market collapses, then any loss above At a 10% settlement it will be invented one by one. Again, there is nothing free here, it is simply a sacrifice of some of the upside potential to protect on the downside. The attractive thing is that today, with stock markets at near-record highs, the yield curve inverted, and so many other risks on the horizon, it is possible to create an asymmetric risk-reward relationship without many out-of-pocket costs. .
In the table below we show the relationship between the price of 10% of the put money and 10% of the call money. When the ratio is less than 1, the put option costs less than the call option, which is where we are today (Source: LongTail Alpha, Optionmetrics). The last time this happened was around the 2008 financial crisis, and the time before that was right around the 2000 tech crash/Nasdaq bubble burst.
Ratio of 10% of the money at 1 year Put option at 10% of the money Call option
long tail alpha
Other investors may want to keep all the upside and not sell any call options. These investors will pay 2.6% for the 10% out-of-the-money put option. If they wait and the market rises above its current level, they will lose all the premium. But if the market falls more than 10% from its current level, they will be protected. Because the implied forward price of the S&P 500 is much higher than in recent history, this is a relatively very cheap level. For reference, an additional out-of-the-money put, such as a 20% out-of-the-money put, costs only 1.35%.
As we said before, there is no magic here. The reason we can achieve this result is, as always,… lack of communication. In this case, the communication mismatch is between the level of short-term interest rates and the level of dividend yields. Over time, since the stock market tends to be riskier than short-term interest rates, one should expect dividend yields to be higher than short-term interest rates. But today we're in a world where a good fraction of the S&P 500 is made up of large-cap growth stocks that don't pay dividends, and are unlikely ever to. Therefore, buying these stocks is accepting the story of further gains in their prices. If one believes that the seven great stocks (Apple, Microsoft, Nvidia, Amazon, Meta, Tesla and Alphabet) will continue to rise, then they have to continue rising at a faster rate than what is included in the forward price of these stocks. . And as we discussed earlier, the forward price is basically the spot price inflated by the difference between the interest rate and the dividend yield.
This is a bit like fighting gravity. We know that when carry is negative, the financial system does not work very well. Today, the negative carry of owning large-cap growth stocks is very large. If one thinks of holding cost as paying a premium for owning growth, then the correct way to think about growth stocks is that one is paying a premium for owning these stocks. And the premium is around 4% annually. The gravitational force has a tendency to knock down those who fight hard against it.
Putting this all together, we can see that the current stock market has massive negative carry, making shorting (rather than owning) the positive carry trade. Of course, nothing is guaranteed and perhaps the stock market will recover further and overcome the negative carry implied by its prices. But given the incredibly low levels of volatility, a downside hedge can be created while gaining carry.
Asymmetric risk-reward is always welcome in the investment business. Nothing is ever free, but when distortions arise in the markets (in this case between interest rates and dividend yields), it is good to pay attention and see if there is an opportunity to generate some return or create more defense in the portfolio at a low cost. Today turns out to be one of those moments.
