Buying Protection: Is it cheap?

By Lawrence G. McMillan

Nearly every day, one hears a trader on TV telling you to “buy protection, because it’s cheap.”  Is it, really?  Yes, $VIX is low, so that means that overall implied volatility of $SPX options is low, and therefore by inference, one might think that $SPX puts are cheap.

It’s more complicated than that.  It depends on two things that these commentators never mention – the skew of the $SPX puts, and the term structure of the $SPX puts (or the $VIX futures, if you prefer).

From the table on the right, above, you can see that there is a significantly steep skew in the $VIX futures.  $VIX is at 12, but the Feb $VIX futures (just two months out) are at 16.73.  If you buy $SPX puts expiring in February, you are paying a 16.73 implied (weighted across all of the strikes).  

But a protective put buyer is not going to buy at-the-money puts.  Rather, he’s probably going to buy something 10% or 15% out of the money.  SPY is currently at 225, so let’s just look at the 200 puts.  Here are the current implieds:

SPY Jan 200 put: 20.5% implied vol
SPY Feb 200 put:19.9% implied vol
SPY Mar 200 put: 20.0% implied vol

So you are really paying roughly a 20% implied volatility to buy a put that is 11% out of the money.  The “average” implied volatility for $SPX/SPY options over the years is actually a bit less than 20%.  The “average” realized volatility for $SPX is closer to 15%.  So, are these puts really cheap?  I don’t think so.

Clearly, these puts don’t cost a lot dollar-wise.  They are offered at 0.19 (Jan), 0.76 (Feb), and 1.50 (March), respectively.  But in terms of implied volatility, they are fairly priced and not really cheap.   

Is there a better alternative?   Yes, I think so.  Consider this: what if you buy those SPY puts with the 200 strike now, and the rally continues on through the end of the year (as the seasonal patterns suggest that it might).  Suppose that $SPX reaches 2300 by that time, and SPY is at 230.  Now those puts are so far out of the money that they probably aren’t going to do you much good unless there is a major crash, not just a mere market correction.  That is one problem with buying $SPX/SPY puts as protection.

 However, the purchase of $VIX calls doesn’t have that problem.  We usually recommend that one buy $VIX calls about 33% out of the money. $VIX Jan futures are trading at 15.53 (see table above), so 33% OOM would be the 21 strike, roughly.  Those calls cost 1.00, but they will be “in play” even if $SPX rallies.  Suppose that  $SPX rises to 2300 and then corrects, $VIX should easily surpass 21 in any sort of correction, so these calls are much more dynamic than $SPX/SPY puts.  

One might also consider the purchase of VXX calls, but the problem there is that with the $VIX futures term structure as steep as it is, VXX will lose ground daily.  So that by the time that $SPX does correct, VXX might be coming off a much lower level.  VXX Jan 36 calls (also 33% out of the money) cost 0.76 – not that much of a savings from the $VIX call price.

In summary, beware of free advice that you get on TV.  While the commentators are well-meaning about advising one to buy protection after a monster stock market rally, their advice to buy $SPX puts is poor.  If you desire protection, you will do much better by buying $VIX calls.

This article was published as part of The Option Strategist Newsletter on 12/9/16. Receive articles like this on a weekly basis by subscribing today.