Jun 30, 2010
Q&A
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.

 
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 Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College
This information is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily Dimensional Fund Advisors and does not represent a recommendation of any particular security, strategy or investment product. Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.