Is Buying Puts in a Rising Market a Good Idea?

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Since the start of the year, the S&P 500 has been on quite an impressive run. The S&P 500 is comprised of 500 of America’s largest publicly traded companies, and each company is weighted my its market capitalization. In other words, the S&P 500 is the best barometer for the overall “stock market.” Since the stock market is up over 6.433% YTD and has only closed in the red twice, a lot of traders are wondering if buying puts in a rising market is a sound investing strategy.

Key Points

  • Volatility is as cheap as it has ever been in history
  • We cannot forget about gambler’s fallacy
  • Buying puts would pay off if volatility increases of the stock market declines, or both
  • Buying puts is a risky investment strategy
  • The risk/reward for buying puts is almost always favorable

Buying Puts when Stocks go Up

Although this may seem basic, the number one thing to remember about buying puts is that it is primarily a bearish strategy with a time component. The time component factor is critically important. We say “primarily” because puts can and do increase in value when volatility increases, but the main way that puts become more profitable is when the underlying asset declines in price.

Therefore, buying puts in a rising market is not only a bet that markets will stop rising, but it is also a bet that markets will stop rising by a specific date in the future. This is a paramount concept to grasp.

Looking at Other Bearish Investment Strategies

Buying puts is not the only bearish investment strategy. The outright shorting of stocks is a very popular method to bet that prices will decline. The important thing to note about shorting stocks is that, assuming you have the margin to maintain the position, there is no set “expiration” date for the trade.

On the other hand, buying puts literally involves a predetermined date where the underlying asset must be at a specific price for the puts to be profitable. This means, when you buy puts, you are literally betting you will not only correctly prognosticate on the direction of the market, but you will get the timing correct, too. Quite the bet!

Gambler’s Fallacy

It behooves put buyers to be aware of gambler’s fallacy. Simply put, gambler’s fallacy is the idea that when heads comes up in a coin toss numerous times in a row, the next toss MUST result in tails. This is NOT true. And to think this is true is to fall victim to an age-old fallacy that has allowed casinos to legally take millions (perhaps even billions) from roulette players since the invention of the game.

Past occurrences of a situation with a 50/50 probability never affect the future outcome of that same 50/50 probability situation. Just because stocks closed in the green 30 days in the row, it does not mean that they will close in the red the following day. Although it is not probable to have stocks close in the green 30 days in a row, just like it is not probably to get heads on ten consecutive coin flips, it does not mean the next outcome is guaranteed to be the opposite.

This is something to know before getting bearish and buying puts in a rising market. Ask yourself what’s going to change. Will there be a polarizing geopolitical event that shatters the world economy as we know it? Will inflation rise and the Fed will have no choice but to rapidly hike interest rates? Will Citadel’s software fail and cause a massive flash crash? The short answer is, we don’t know for certain, but these are the types of events that would shake the complacency out of long investors in a rising market and make put options explode in value.

Volatility is Cheap

One thing that works in the favor of put buyers in today’s market is volatility. Historically speaking, the VIX Index is trading about 4 points lower than where it used to hover at the beginning of 2014-2017.  The fact that volatility is relatively inexpensive is not a good enough reason alone to buy puts, but it does mean a couple of things.

  1. Puts literally cost less money to buy
  2. The market is not pricing in wild and chaotic price swings
  3. Many market participants are therefore unhedged and can be caught off guard

5yr VIX chart

Because there has not been a significant sell-off for quite some time, traders have become very complacent in the markets. There is unequivocally an attitude of “this rally will last forever” which is both not true and very dangerous. Eventually, the rally will come to an end, although there’s no telling when that will be, and when it does come to an end, there will not be enough room for everyone to exit.

Because S&P 500 volatility is inexpensive, this suggests market participants are not hedging their long stock positions. When people don’t hedge their positions, as Mark Cuban notes, this creates a chaotic exit scenario. When stocks tank, people naturally panic and scramble to get their hands on puts, but at this point, it’s often too late as puts have already appreciated in value due to volatility expansion.

Final Thoughts

Before you think about buying puts in a rising market like we have today, make sure you’re aware of gambler’s fallacy, the price of volatility, and the possibility of an unnerving fundamental event.

More over, before betting against the market you have to ask yourself, why is the market rising in the first place? We have asked ourselves this question over and over, and the conclusion we came up with is this: you first need to determine what specific factors are causing the market to rise, and then you need to determine the probability (roughly speaking) that those factors will go away. If you can determine that, you may have an edge over the rest of the market on a longer-term timeline.

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