How do I structure and evaluate OTM put protection on an equity portfolio?

Question

AcadiFi · Accepted Answer

OTM put protection sizing requires choosing strike, tenor, notional ratio, and roll frequency. Example: Kestrel Capital has $200M equity portfolio 95% correlated to SPX at 5,400. They want to buy 3-month SPX puts.

**Strike selection**:
- 5% OTM (K=5,130): high delta (-0.20), expensive (~2% of notional per 3 months = 8% annualized).
- 10% OTM (K=4,860): mid delta (-0.08), cheaper (~0.8% per 3 months = ~3.2% annualized).
- 20% OTM (K=4,320): low delta (-0.02), cheap (~0.2% per 3 months = 0.8% annualized). Only pays in severe crashes.

**Notional ratio**: match portfolio beta. If portfolio beta = 0.95, hedge ratio = 0.95 x $200M / (SPX level x multiplier). With SPX at 5,400 and $100 multiplier, number of contracts = 0.95 x 200M / (5,400 x 100) = 352 contracts.

**Cost analysis** for 10% OTM strike at 3 months:
- Premium ~0.8% of notional = $1.52M per 3-month period.
- Annualized carry = $6.08M = 3.04% drag on $200M portfolio.
- Payoff if SPX drops 25%: SPX = 4,050. Puts pay (4,860 - 4,050) x 352 x 100 = $28.5M. Portfolio loss = 25% x 0.95 x $200M = $47.5M. Net loss with hedge = $47.5M - $28.5M + $1.52M premium = $20.5M (vs $47.5M unhedged).

**Roll mechanics**: rolling quarterly mean locking in time decay. If SPX drifts sideways, you pay ~$6M/year. But if you roll at the wrong time (just before a crash), basis risk kicks in.

**Funding the hedge**: 'collar' structure by selling OTM call to finance put premium. Kestrel could sell SPX 10% OTM call (strike 5,940) for $0.6M, partially offsetting the $1.52M put premium. Trade-off: gives up upside above 5,940.

Key metrics:
- Hedge cost as % AUM.
- Expected drawdown reduction in 20% market decline scenario.
- Maximum upside given up (if using collars).
- Basis risk: correlation between portfolio and SPX.

How do I structure and evaluate OTM put protection on an equity portfolio?

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