2018issue C0740-41
A protective put as a prepaid loss budget
Fix put premium as a share of account equity before the hedge is placed. After a stated market shock, and after time-decay, leftover drawdown is residual-exposure the hedge was never sized to erase.
- A hedge-budget is the share of account equity set aside for put premium before the hedge is placed.
- Premium-at-risk can expire as a full cash loss if the hedge vehicle stays above the relevant levels through expiration.
- Residual-exposure is the part of a modeled portfolio loss that remains after the hedge's illustrated gain is subtracted.
- Time-decay can change hedge value on the same price path, so an earlier decline can leave more option value than the same decline at expiration.
Set the budget before the hedge
A protective put is a long put held against existing equity so a defined market decline can be partly offset by option gains. The archive treated the cash paid for those puts as a hedge-budget: the share of account equity an operator is willing to spend on premium before the hedge is placed.
In the illustrated $100,000 account, the example hedge bought five quarterly puts at $6.17 each, for a total outlay of $3,085. That $3,085 outlay was described as 3.1% of the $100,000 account, near a 3% hedge-budget target.
Premium can be lost in full
Premium-at-risk is the full cash outlay paid for the puts, which can expire worthless if the hedge vehicle stays above the relevant levels through expiration. If the hedge vehicle finished at $255 or higher at the September expiration, the full $3,085 premium was shown as lost.
The write-up stated that wanting more hedge protection raises the cost to enter the hedge.
What remains after a stated shock
In the illustrated $100,000 account, a 20% drop in the hedge vehicle to $213 was treated as implying an approximate $20,000 portfolio loss. In the 20% decline-before-expiration case, the puts were shown gaining about $17,000 to $18,000 against the $20,000 equity drop.
An editorial reading is that the unclosed gap between that modeled $20,000 drop and the illustrated put gain is residual-exposure. Residual-exposure is the portion of a modeled portfolio loss that remains after the hedge's illustrated gain is subtracted. The hedge-budget was fixed first. The leftover loss is what that budget was never sized to erase.
Time-decay changes the same path
The illustrated risk curves were used to show that an earlier decline can leave more option value than the same path at expiration because time premium decays. Time-decay is the reduction in option time premium as expiration approaches, which changes hedge value even if the underlying path is unchanged.
An editorial reading is that residual-exposure should be read after both the stated market shock and time-decay, not from the shock alone.
All readings on this track · 15 readings
- 1988Two-sided cheap premium, volatility, and protective puts
- 2000Compare a Protective put and a Stop-loss order before entry
- 2007Sizing options by assignment, spread legs, and portfolio margin
- 2007Fund a put-hedged long by remaining package loss
- 2008Protective put sizing under broker insolvency
- 2008Seasonal regimes, index put overlays, and call-spread mechanics
- 2008Stops, protective puts, and financed spread risk
- 2008Three loss bounds: debit spreads, stops, and protective puts
- 2014Seasonal put spreads for index-linked portfolios
- 2017Option construction after a post-listing drawdown
- 2017A stop-loss is an execution request, not a loss ceiling
- 2018Objective-first construction of hedges and income
- 2018A protective put as a prepaid loss budget
- 2020When a futures gap-open voids stop-loss protection
- 2020Protective put loss budget by strike and tenor