Hedging with Puts: Do Volatility and Skew Signals Work?

Portfolio hedging remains a complex and challenging task. A straightforward method to hedge an equity portfolio is to buy put options. However, this approach comes at a cost—the option premiums—leading to performance drag. As a result, many research studies are focused on designing effective hedging strategies that offer protection while minimizing costs.

Reference [1] presents the latest research in this area. It examines hedging schemes for equity portfolios using several signals, including MOM (momentum), TREND, HVOL (historical volatility), IVOL (implied volatility), and SKEW. The study also introduces a more refined rehedging strategy for put options:

• If, during the investment period, a put option’s delta falls to −0.9 or lower, the option is sold to lock in profits and avoid losing them in case of a sudden price reversal.
• Put options are bought when implied volatility is below 10%, as they are considered cheap. No position is taken if implied volatility is above 30%, to avoid overpaying for expensive options.

The authors pointed out,

The results from the backtests of the long-put strategy, presented in Table 5, also indicate that the TREND signal is the most effective among those tested for selecting the underlyings on which to take option positions. Specifically, the TREND signal substantially reduces the portfolio’s risk without sacrificing annual return when compared with the BASE signal, the equity-only portfolio, with no option positions. This suggests that the TREND signal offers a compelling balance between downside protection and performance preservation. The SKEW signal contributes positively to the GMV allocation, although it fails to show the same effectiveness under the EW allocation scheme. Consistent with the findings from the covered call strategy, the introduction of additional trading rules, TR1 and TR2, does not consistently improve the performance of the portfolios. Their impact appears to be in the best-case marginal and in most cases negative …

The bootstrapped results from Table 6 diverge from the ones of the backtests. The TREND signal no longer outperforms the BASE portfolio. Instead, the HVOL and IVOL signals emerge as the most effective, outperforming the BASE portfolio in risk-adjusted terms, with and without trading rules. The different findings from bootstraps vs. historical backtests indicate that the added value of these signals is dependent on the market regime.

In short, buying put options using the TREND signal appears to improve portfolio risk-adjusted returns. While SKEW and IVOL add little in backtests, they perform better in bootstrapped results, suggesting that the effectiveness of put protection strategies is regime-dependent.

This study offers a comprehensive evaluation of various hedging rules. There is no conclusive answer yet, implying that designing an efficient hedging strategy is complex and requires ongoing effort. Still, the article is a strong step in the right direction.

Let us know what you think in the comments below or in the discussion forum.

References

[1] Sylvestre Blanc, Emmanuel Fragnière, Francesc Naya, and Nils S. Tuchschmid, Option Strategies and Market Signals: Do They Add Value to Equity Portfolios?, FinTech 2025, 4(2), 25

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