Longer dated puts are cheaper - but with a catch!

Posted on February 2nd, 2012

Among the long-term positions that we manage, the most popular tactic we use to hedge is the collar. As a refresher, that is when you own a stock/ETF and pair it with a short call and a long put. The put represents your downside protection. The call effectively limits your upside in exchange for some income.

In a lot of ways, we manage our collars as if they were two tactics: a Covered call position along with a married put. Effectively, that is exactly what they are. When I say we ‘manage’ them this way, what I mean is that we typically leg in to each position on its own. We look to buy the put protection separate from selling the calls. In fact, often, we leg in to these positions on separate days.

The reason we treat them separately is the time-value aspect of each option position – or the extrinsic value. Since we invest for the long term, we want our downside protection to be biased towards the long-term. When it is long-term biased, the cost per day is lower. It is like trying to keep our insurance premiums low.

On the other hand, the calls are typically sold always for the NEAR month. This is because we are selling the calls – ie, collecting the premium or time value. Time value erodes fastest in the last 30-45 days. Since we’d like to sell the calls and see them expire worthless, we look to sell for the near month. This approach generates the most premium in the shortest time frame. And every month, we repeat the call selling process.

We are always hoping that the calls that we sell can fully cover the cost of the puts that we buy. But the expirations don’t typically match so the comparison of costs is not always easy. Remember that we buy puts that are 6 months old (or more) and we sell calls that are one month from expiration.

So, to help ourselves with the analysis, we typically divide the put costs by the months until expiration to get a ‘per month cost’. Then, we compare the premium collected in the calls that we sell that are sold for the near month. This way, we are comparing one-month’s call premium to the put premium that has been ‘normalized’ to a per month cost.

Of course, the puts for 1 year from today at strike price X are more expensive than the puts at the same strike price that expire 6 months from today. That should make sense as you have protection for a longer time period so of course it costs more. But on a monthly basis, it will cost less. Sometimes, it will cost materially less.

As of close of business yesterday, the largest S&P500 ETF, symbol SPY, was trading at $132.47. Take a look at the table below to see the total costs and cost per month of the puts on the SPY at the designated strikes and expiration months.
This chart shows what downside protection in the S&P500 costs overall and on a monthly basis. As evidenced in this chart, protection with a longer-dated expiration costs more. Also evidenced here, when you divide that cost by the months until expiration, you can see that the cost per month gets lower as you move out on the time curve.

So, when building a collar, you could go further out on the time curve for expiration and reduce your cost per month – especially if your view for holding the investment is long-term – ie, 2+ years expected hold time. With the reduced cost of the protection side (ie, the put), it should be easier to have the calls you are selling cover the cost of the puts.

However, are these puts really cheaper? Using the math above, they are ‘cheaper’ but they could cost you if used improperly. As an investment advisor, I have to educate my clients on the risks of using puts that are long-dated for more than 6 or 9 months. The risk is related to time.

The majority of the positions that we invest in for our clients have expected hold times of greater than 2 years; and many are even longer than that. However, almost every collar that we structure for clients are around 6 months in length for the puts – with a handful at 9 months and an occasional 12 month window. But we prefer the 6-month put – usually with a rolling ladder.

Why do we use 6-month puts when the client’s expected hold time is 2+ years? Because of time! Puts with a nearer expiration are going to move more in ‘lock-step’ with the market than puts that are 1 year away or more. This should make intuitive sense. Protection is always valuable in any put – but if the put is going to expire soon, the put is going to reflect a value much closer to its intrinsic value than one that still has a lot of time left in it.

When there is still a lot of time until expiration, the stock or ETF could still move back to out of the money – meaning time is still a big factor in the value of the put. As a result, a sharp move in the market will reflect itself more in a shorter dated put than it will in a longer dated put. And when you are an investment advisor that hedges, you need to be able to build portfolios that are more easily liquidated to reflect the real protection you built for the client using the hedge.

No client wants to hear: well we protected you for 10% down but didn’t really realize very much of the protection value yet because expiration is still a year away. The client could possibly need the money now.

As a Buy And Hedge investor, unless you really are committed to holding a position for 1 year or more, avoid going out too far with your puts. You don’t want to find yourself liquidating your portfolio for an unforeseen reason and find you weren’t as hedged as you hoped! Cheaper isn’t always better.

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