Pathetic Protection: The Elusive Benefits of Protective Puts

Topics - Volatility Derivatives

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Pathetic Protection: The Elusive Benefits of Protective Puts

The Journal of Alternative Investments 

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 paper investigates drawdown characteristics of simulated put protected portfolios and the CBOE S&P 500 5% Put Protection Index. Unless your option purchases and their maturities are timed just right around equity drawdowns, they may offer little downside protection. In fact, protective puts could make things worse by increasing rather than decreasing drawdowns and volatility per unit of expected return.

What's Inside?

This article investigates the efficacy of buying protective put options in reducing peak-to-trough drawdowns. I compare the put protection strategy against a “divested” strategy that invests a fixed proportion of assets in equities and the remainder in cash. Historical analysis is conducted on the CBOE S&P 500 5% Put Protection Index as well as on simulated data to evaluate put protection in an idealized setting with no volatility risk premium. I find that: 

• Put options are only effective in reducing drawdowns in the unusual circumstance that options are priced with no volatility risk premium and equity drawdowns precisely coincide with the option holding period.

• Put protection can lead to worse drawdown characteristics when options are priced with a volatility risk premium, which is almost always the case with index options.

• Even if options are priced without a volatility risk premium, put protection is only modestly effective in the usual case when equity drawdowns do not align perfectly with option expiration cycles.

• Put options may offer crash protection, but their crash protection is also weakened by path dependence and the volatility risk premium.


Equity investors are appropriately concerned about potential drawdowns and often turn to put options for protection. Because of path dependent outcomes and option expensiveness, put options may do more harm than good. An alternative approach to protection that investors can take is increasing diversification. Reallocating from equities to liquid alternatives may allow investors to reduce volatility while maintaining returns, thereby reducing expected drawdowns.

This document is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.

This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance. Diversification does not eliminate the risk of experiencing investment losses. 

This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. 

The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Diversification does not eliminate the risk of experiencing investment losses.

The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.