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ATM or OTM Index Puts for Portfolio Hedging?

| | Posted in: Equity Options

A reader asked: “I have been looking into portfolio hedging using index put options, but I cannot find any analysis on the efficiency of using at-the-money (ATM) versus out-of-the-money (OTM) puts. Do you know of any research focusing on this question?”

The most relevant research at CXOadvisory.com is:

“Actual Index Options Trading Results” …evidence suggests that individual index option traders tend to transfer wealth to institutional traders and market makers, but they can improve their probability of success by: (1) focusing on the short side of index options; (2) trading against trend; and, (3) practicing/learning.

“Is 40% Per Month Shorting Index Puts a Fair Return?” …investors are willing to pay very high premiums, perhaps irrationally high, to insure against large losses in their stock portfolios. Sellers of this insurance can earn high average returns.

“Abnormal Returns from Selling Index Put Options?” …a strategy of systematically selling index put options generates on average large abnormal returns but suffers occasional very large setbacks when the underlying index plunges.

“Good Deals in Broad Market Index Options?” …investors/traders are generally willing to overpay for insurance and leverage via options, but only the market makers can consistently exploit this willingness.

“Can Individual Investors Enhance Returns with Options?” …investing in options as a marginal enhancement to a buy-and-hold approach can improve returns and Sharpe ratios, but only if the options positions are small compared to overall portfolio size.

The sense of this research is that OTM puts are likely less efficient than ATM puts from a return-on-investment perspective, and ATM puts are likely less efficient than in-the-money puts. Results are subject to limitations related to data availability, data quality, assumptions about trading frictions and assumptions about option return distributions.

What is optimum for you depends on your own goals and constraints.

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