SPY puts are the cheapest they’ve been in 15 years. As a result, there’s a rare opportunity to make a value investment in de-risking.

Normally when SPY puts get cheap, they’re cheap far out-of-the-money and cheap only at shorter expirations. But today they’re cheap across the board: up to one year out and at less out-of-the-money strikes. This is significant for two reasons. One, you can lock in a cheap hedge for a long time, and, two, you don’t have to bet only on a vol spike. Your hedge will work even if the market grinds down.

Recommendation:

Sept 2024 SPY puts with $390 strike at $10.

November 2023 SPY puts with $315 strike at 21 cents, rolled monthly.

Anatomy of a classic tail hedge

According to Forbes, in early September 2008, Mark Spitznagel bought put options on the S&P 500 with a 850 strike. The S&P was at 1200, so his puts were 30% out-of-the-money (“OTM”). He paid 90 cents for them, and the implied vol on the puts was 42%.

By October 10, 2008, the S&P had fallen to 900. Spitznagel’s puts were still out-of-the-money. Yet fear had taken hold in the market, causing volatility to soar. The implied vol on Spitznagel’s options had skyrocketed from 42% to 102%. The puts, which he’d paid 90 cents for, were now worth $60, a 67x return. Basically the market was saying that the S&P would imminently fall to 790, a 35% cumulative drawdown from where the market was when Spitznagel had originally placed his bet.

This investment is worth understanding because it offers us a way to back into Spitznagel’s strategy without complicated options math. Spitznagel, like many long-vol investors, typically buys 30% OTM puts and is essentially betting that something will happen which causes the market to fear a 35% fall. His payoff is the spread between 30% and 35%. And the less he pays for his puts, the greater his MOIC. This is important because a higher MOIC means you can size your position down, reducing the drag on your portfolio from the cost of the hedge.

The opportunity set today

The S&P 500 ETF (“SPY”) is currently at 448. 30% OTM SPY puts with a November 17, 2023 expiration have a 315 strike and trade at 21 cents. The implied vol on these options is just 37%. It doesn’t sound like much, but this is massively lower than the 42% implied vol Spitznagel paid for his. A 35% fall in the market would bring SPY to 291. The payoff in such an event would be 24, and since the puts cost 21 cents, the MOIC would be 114, almost double the payoff Spitznagel realized. SPY puts are cheap.

Normally you have to commit .5% of your portfolio monthly, 6% annual, to insure against a 30% fall. But if you were able to roll your puts at today’s prices for a year, the annual cost would be just 2.7% of your portfolio, half what it usually would be.

Given the market’s Shiller PE is 30, housing prices are higher than 2006, and corporate profit margins, which are highly mean-reverting, are at record highs, this is an astonishing dynamic. At a time when there's been no rain for several years, Los Angeles county is selling homeowners fire coverage at half off. 

Investing in vol through short-dated options is a classic tail hedge, but it has limitations. One, it’s short-term, so if put option prices rise, the cost of rolling your position will be high. Two, you’re betting only on a vol spike. If the market grinds lower, you’re out of luck. Nonetheless there’s a reason why practitioners like Nassim Taleb and Mark Spitznagel generally confine themselves to far OTM options and bets on explosions in vol. And the reason is that, as Cliff Asness and others have pointed out, hedging with puts that are at-the-money or just 10-15% OTM is a disastrous move. Over the long run, even after profiting from the epic downturns of 2000-2003 and 2008, the strategy underperforms the market. The reason: these puts are almost always over-priced. In fact they’re so consistently overpriced that Spitznagel has said he likes to sell them to fund his 30% OTM puts. So there you go: they're typically a sucker's bet, one the smart money exploits to lower its cost basis.

Today, however, long-term 15% OTM puts are cheap. In fact they’re so cheap they might be an even better investment than short-term 30% OTM puts.

September 2024 SPY puts with a 390 strike trade at $10.10. If fear of a 35% drawdown was priced in, they’d be worth $100, a 10x MOIC. To give a frame of reference and to compare apples with apples, if we annualize the cost of Spitznagel’s position in 2008, the 90 cents he paid becomes something in the ballpark of $9. So when his puts became worth $60, he made 6.7x on their annual cost, a far lower MOIC than the 10x offered on the Sept 2024 puts which are just 15% OTM today.

Once again, this is an astonishing dynamic. At a time when so many capital assets are priced for low to negative returns and the yield curve is inverted, the insurance against any fallout has never been cheaper.

Ultimately I don’t know which is the better hedge: short-dated 30% OTM puts or long-dated 15% OTM puts. But some combination of the two offers a way to de-risk and to cheaply remove the macro risk from a portfolio at a time when macro risks are towering.