The above graph shows the 2022 performance of the PPUT index against the S&P 500 index through November 30th. PPUT has offered little to no protection in 2022’s bear market.
Why is this?
It is important to understand how the PPUT index is constructed and the shortcomings of short-term options in an extended bear market. Cboe’s definition of PPUT is:
The Cboe S&P 500 5% Put Protection Index (PPUT) tracks the value of a hypothetical portfolio of securities (PPUT portfolio) designed to protect an investor from negative S&P 500 returns. The PPUT portfolio is composed of S&P 500® stocks and of a long position in a one-month 5% out-of-the-money put option on the S&P 500 (SPX put).
Key to this definition is “a one-month 5% out-of-the-money put option.” Hedging with one-month, 5% out-of-the-money options might appear to be a cost-effective strategy because:
- Options with shorter-term expirations are cheaper than options with longer-term expirations
- Out-of-the-money (“OTM”) options are cheaper than at-the-money (“ATM”) options
Both characteristics have drawbacks, brutally exposed in the kind of bear market seen in 2022.
As stated previously, every option eventually expires. A hedging strategy that uses short-term options needs to constantly purchase new put options to replace those that have expired. During bear markets, the price of put options, especially short-term put options, tends to skyrocket as the demand for downside protection surges. In a long, grinding bear market, this can prove costly as a short-term hedging strategy is forced to repeatedly purchase new put options at elevated prices.
The “5% OTM” feature of the put options used in PPUT were designed to reduce the up-front hedging costs. However, the drawback to such an approach is that the investor is responsible for the first “tranche” of losses. For the first 5% drawdown, the investor has full market exposure. It is only if the S&P 500 losses exceed 5% – within the one-month expiration cycle– that further losses are mitigated. If the option is not “in-the-money” at the time of expiration, it is worthless. At expiration the “reset” button is hit, and a new 5% “deductible” must be taken for the coming month.
These costs add up.