Pathetic Protection: The Elusive Benefits of Protective Puts

Abstract

Conventional wisdom is that put options are effective drawdown protection tools. Unfortunately, in the typical use case, put options are quite ineffective at reducing drawdowns versus the simple alternative of statically reducing exposure to the underlying asset. This article investigates drawdown characteristics of protected portfolios via simulation and a study of the CBOE S&P 500 5% Put Protection Index. Unless option purchases and their maturities are timed just right around equity drawdowns, they may offer little downside protection. In fact, they could make things worse by increasing rather than decreasing drawdowns and volatility per unit of expected return.