Risk / Return for an OTM Protective Put

A reader of The Intelligent Option Investor, Mr. Arun Garg, who manages an investment fund and also writes anĀ excellent, thought-provoking blog about value investing contacted me about several typos he found in the book. All of the typos were in the chapter on multi-option structures and option overlays–what I call “Mixing Exposure.” (These typos are covered by the Errata that I posted on The Framework Investing website).

One of the things that Mr. Garg called out was my characterization of downside exposure being “Irrelevant” in the strategy summaries for the Protective Put and the Collar. Both of these option structures are used to hedge long positions, so certainly the downside should not be characterized as “irrelevant.” His argument was well thought-out and rational, but mulling it over, I realized that the distinction I had in my mind when writing this section hinged on the difference between Market Risk and Valuation Risk.

Valuation Risk is that an investor will misunderstand the operational dynamics of a firm’s valuation drivers, and in so doing misallocate capital to an investment idea.

If an investor’s estimate of the firm’s fair value is too rosy, he or she will allocate too much capital to the idea and / or use too much leverage in the investment structure. Conversely, if an investor’s estimate of the firm’s fair value is too bleak, he or she will allocate too little capital to the idea and / or use too conservative a structure from a leverage perspective.

Market Risk is that, regardless of the intrinsic value of a company, the company’s stock price moves such that the investor suffers some negative effect from the movement.

One very serious negative effect is if the price of a stock moves against a levered position such that the investor is faced to close the position and realize a loss. A negative effect that often bedevils professional money managers is that one’s clients get worried about a short-term, unrealized loss and force the manager to liquidate their position (converting an unrealized loss into a realized one).

The epiphany for me in thinking about Mr. Garg’s question was that hedging strategies such as protective puts and collars are not designed to control valuation risk, but rather to manage market risk. For that reason, I believe that the characterization of the valuation of the downside in the hedging sections as “irrelevant” is indeed correct.

As much as value investors are loathe to think so, at times, market movement does represent a real risk to their investments and long-term capital position. The long term valuation only matters if you can survive the short term market fluctuations.

In these cases, an investor should consider implementing a hedging strategy, and should try to do so in as cost-effective of a way as possible, as readers of The Intelligent Option Investor will know.