Paying for S&P 500 Crash Protection Using Cash From DividendsBy
Here’s a look at stock market insurance that considers using the dividends you get on equities to pay for protection against catastrophe.
As observed in a tweet by the financial blogger known as Jesse Livermore, payout yields on the S&P 500 Index right now are fairly close to the price of options that hedge against big losses in the index. Going by Bloomberg data, protection against a 10 percent plunge over the next 12 months costs about 2.9 percent of a portfolio’s value, compared with the S&P 500’s dividend yield of 1.8 percent.
Given that dividend rates have held fairly steady, the nearness of the two values is mostly a function of rock-bottom equity volatility, the main determinant of how much options cost.
“The implied volatility of 17.6 percent on the put and the premium of 2.9 percent are below normal,” said Ilya Feygin, senior strategist at WallachBeth Capital.
So, time to design your own self-funding S&P 500 protection trade?
Not so fast, says Pravit Chintawongvanich of Macro Risk Advisors. For one, you still must cover the difference between the dividend payout and the options cost. And two, a put priced 10 percent below the market does little to protect you if the market falls less than that.
Another objection pertains to the notion that dividends represent extra money investors receive on top of their price return. In fact, if the S&P 500 paid no dividends, you could fund an identical trade simply by selling 1.8 percent of your S&P 500 stocks every year, forfeiting the price appreciation on those shares (which you do anyway when stocks go ex-dividend). Would the option trade look so tidy then?
“Dividends are a substantial portion of S&P return,” Chintawongvanich said. “It is incorrect to think you are not giving anything up by forsaking the dividend.”
— With assistance by Gregory Calderone