Hedging with Put Options: A Costly Endeavor

After a decade-long economic expansion and bull market in US stocks, investors are understandably nervous about downside risk. Global economic policy uncertainty rose sharply in 2018, fueled by the threat of a trade war among the world’s largest economies. With the stock market crash of 2008-’09 a distant but still painful memory, many investors are asking about efficient ways to protect their hard-won gains of the last decade.

One of the primary tools that investors consider to protect their equity portfolios is the purchase of put options, which provide a dollar-for-dollar increase in value as stocks decline below some predetermined level (the strike price). With the CBOE Volatility Index (VIX), which serves as a proxy for the price of options, trading well below its long term average, the thought of buying some “cheap” portfolio insurance through the purchase of puts is increasingly appealing to taxable investors with appreciated holdings.

Unfortunately, hedging downside risk with options is often a costly proposition. Taxable investors considering options for downside protection should be wary of embedded tax-inefficiencies. The short to medium-term nature of options means that most are taxed at onerous short term capital gains rates, sharply reducing the neutralizing benefits of owning puts when stock prices are falling. This article will discuss the benefits and drawbacks of using options to hedge risk and touch on alternative ways of reducing risk in a portfolio that minimize hedging cost and tax impact.

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