Jun 30, 2010
Q & A
Q&A: Reducing Risk with Options
Can put or call options be used to achieve a more predictable risk-return tradeoff? For example, should I purchase put options to minimize equity portfolio losses?

EFF/KRF: This strategy does reduce your downside exposure to equity, but the insurance is not free. Buying the put leaves you with less to invest in equities. In other words, you have to sacrifice part of your upside return to protect against downside loss.

You can get exactly the same payoff by combining call options and Treasury bills. But the put-call parity relation says that the cost of this portfolio matches the cost of the stock plus a put. In either case, the insurance is not free.

It is important to remember that someone has to bear the downside risk on your equity portfolio. The risk does not go away when you insure your portfolio by buying a put, it is simply transferred to whoever sold you the put. You should buy protection only if you think the insurance is underpriced or you have an unusual utility function. If you are motivated by simple risk aversion, you would probably be better off reducing your overall allocation to equity.

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ABOUT FAMA AND FRENCH
Eugene F. Fama
The Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business
Kenneth R. French
The Carl E. and Catherine M. Heidt Professor of Finance at the Tuck School of Business at Dartmouth College
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