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Put options for protection

Mr Money Mustache posted a commentary on recent stock market commentary this week, and among there discussions there was an interesting suggestion from one person who said that he buys put options that protect him from a loss greater than 10%, at a cost of 1-2%/year. I wanted to see if the gains from the insurance could be more than the costs, so I pulled up historical data provided by Libra Investment Management and ran some tests.

Past Performance – Long Term

I started with a simple test that assumed the insurance cost the maximum 2% every year, meaning the total value could not go down more than 12% in a year (the losses on the actual stocks are limited to 10%, plus there is the 2% cost of insurance). With this model you would be put everything in stocks and buy puts at the start of each year.

When I ran this on the nominal TSX returns from 1970 – 2009, the final value with no insurance was 4023% of the starting value. With insurance the final value was 3537% of the starting value. Overall this wasn’t a win but you would be ahead from 1974 – 1979 using insurance.

I then tried it on the nominal S&P 500 returns in CAD (a bit esoteric but it’s the data I have). The final value was 4208% with no protection, or 3570% with protection. Again not a win but you would be ahead from 1974 – 1983 with the insurance.

I repeated the experiment with an insurance cost of 1% each year. In this case the final values were around 5100% for both cases which is better than not having the insurance.

Results

This model doesn’t account for dividends. If you exercised a put and stayed out of the market for the rest of the year you would miss out on dividends. In the TSX cases the puts were exercised 6 times, and in 2 of those times the value of the protection was 0.6% of less which is probably less than the forgone dividends. On the other hand, the losses in down years might be minimized a bit more if you managed to collect dividends before exercising the puts. The S&P 500 triggered the puts in 4 years.

Overall this doesn’t look terribly exciting. If the options are cheap enough you might get some gains. On the other hand, the options might be cheap when you don’t need them and expensive when they will pay off. This is a fairly limited test so there might be other time periods where it performed brilliantly, or conditions only slightly beyond those we’ve experienced that make it look even worse.

In the end you could do worse, for example by buying expensive segregated funds from insurance companies. Those probably just charge a high fee to use a strategy similar to this so you can cut your costs by doing it yourself. If you want to reduce volatility this might be a reasonable way to do it. I prefer to seek additional volatility in hopes of higher long-term returns.

Short Term Advantages

Those who are counting on the portfolio in the short term might have a much stronger need to do this. In fact it might be an interesting alternative to bonds/cash for short-term savings goals since you have higher potential returns with losses limited to 12%, unless there is a string of bad years. Historically the TSX has only experienced 2 consecutive negative years one time since 1970. The S&P500 in CAD has had 2-3 consecutive years of losses on 3 occasions.

In rolling 3-year periods using this strategy on the TSX there were 3 occasions of losses ranging from 18.4% to 3.4%, a further 3 periods with gains ranging from 0.8% to 9.4%, and the other 31 cases had gains over 10% including the big winner with a 133.6% gain from 1978 – 1980. In rolling 5-year periods there were no losses, two periods with gains of 2.1% – 8.5%, and the rest had gains over 10% with a high of 176.8%.

Without a doubt there are risks not expressed in this simulation, but if you’re ok with taking slightly more risks than government bonds this could be an interesting option for medium-term savings. We are starting to put together some cash so that we can buy a vehicle in the future with no loan and possibly move to a more expensive house without increasing the mortgage, or pay down our mortgage further when we renew it at a higher rate.

Since only the mortgage paydown is likely to be in the next 5 years I may have to consider this approach to manage that cash once it grows a bit more. Currently it’s in an ING account where the accumulated interest will be very little. Any gains over 10% for a 3-5 year period would be a bonus. However there would be a tax drag since our TFSA is in use and this would be inappropriate for an RRSP. Since capital gains are taxed at a lower rate than interest and the outcomes seem to be mostly upside, this could still have a good chance of being a positive.

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