Howdy, Stranger!

It looks like you're new here. If you want to get involved, click one of these buttons!

Here's a statement of the obvious: The opinions expressed here are those of the participants, not those of the Mutual Fund Observer. We cannot vouch for the accuracy or appropriateness of any of it, though we do encourage civility and good humor.

    Support MFO

  • Donate through PayPal

Using Equity Put Options to Protect downside risk for a S&P 500 Index Fund

beebee
edited April 2017 in The Bullpen
This is a research paper that I came across and seemed worth sharing on the topic of downside protection of equity positions using equity options.

For example, when an investor takes cash (low risk) and invest in the S&P 500 Index fund they have made a decision to take on "equity premium risk" (in hopes that the Index will rise) above the return of cash. This decision has no downside protection should this equity premium turn negative (market drops). An equity option is an insurance policy (in this case, S&P 500 index put options) that this research paper explains as follows:

The Strategy:
The work is motivated by providing evidence that U.S. stock crashes typically coincide with large consumption drops and showing that the equity risk premium exhibits ample negative skewness, even after being standardized by a measure of stochastic volatility. The equity risk premium is computed as the difference between the total returns on the S&P 500 index and one-month Treasury bills. I form the hedged risk premium as a combination of the equity risk premium and S&P 500 index put options such that at the initiation of the trade the risk exposure of the equity and hedged risk premiums is comparable – the option overlay is hedged, and when the put option expires in the money, the hedged risk premium is
protected from all stock crash risk. In other words, the hedged investment strategy protects the investor from potential stock crashes below a certain strike price.
Full Research Paper:
Isolating the Disaster Risk Premium with Equity Options
Sign In or Register to comment.