Are put options the new bonds?

Are put options the new bonds?
"Puts are there to protect you when markets go down fast."
OCT 29, 2024
By  Josh Welsh

The saying “There’s no time like the present” couldn’t be any truer, especially in the current economy.

John Archbold, client portfolio manager at Aptus Capital Advisors, an RIA based in Alabama with $7 billion AUM, underscores how evolving market dynamics are reshaping the value and application of traditional portfolio strategies.

For one, he believes the classic 60/40 stock-and-bond portfolio remains prevalent among investors, even as doubts have periodically arisen about its longevity.

“In the last couple years, what you've seen in 2023 and 24 is a lot of discussions really subside. People have really reverted to what they were doing pre-22 which is, again, the traditional stock [and] bond mix. Of course, people have been rewarded for that.”

He suggests, however, that advisors and investors need to think differently, citing the firm’s approach of incorporating options, especially put options, to mitigate volatility while capturing market growth.

Put options, Archbold highlights, allow clients to participate more robustly in favorable market conditions without fully relying on bonds, which have underperformed as interest rate changes diverged from expectations.

After all, in the current economic climate, managing risk is more crucial than attempting to predict market movements.

Drawing an analogy to Formula One racing, he likens put options to a car’s brakes and seat belts: they enable investors to navigate markets with greater confidence and speed, even through volatile turns. By allowing exposure to equities while providing downside protection, puts serve as a buffer against unexpected market shocks.

“Puts are there to protect you when markets go down fast,” he said. The value of put options lies in their ability to appreciate when market volatility spikes, making them a valuable asset during downturns.

“How we construct portfolios, where we have more stocks, less bonds, but have that risk neutral position because we own those hedges, it allows us to drive the car faster and still manage our risk,” he says. “That's really the crux in all this.”

Additionally, unlike bonds, which may lose value in high-stress environments as investors seek cash over securities, put options provide liquidity and an inverse correlation to stocks. This approach, Archbold noted, makes it easier to reinvest in equities at lower prices, potentially enhancing long-term returns.

“Owning more equities and incorporating puts are going to be ways to attack this environment, because in an inflationary regime, you need the stocks to get the growth to outpace inflation,” he added.

He highlights three potential scenarios that could unfold in the coming years, each of which favors a greater allocation to stocks:

  1. Growth cycle: Should the economy experience sustained growth, akin to the late 1990s, portfolios with excess bond exposure could lag, he suggests. In this scenario, equities will outperform bonds, rewarding higher beta exposure. “If we’re in a 1995-style growth cycle, excess bond exposure could get you fired,” Archbold warned.
  2. Inflation: High inflation typically erodes bond performance as interest rates climb. To counter this, Archbold recommends maintaining higher stock exposure to capitalize on growth, with put options in place to protect against unexpected setbacks. “Stocks can appreciate but if we get a spike in inflation and if it does come back, bond’s aren’t going to help you,” he warns.
  3. Recession: In the event of a recession, Archbold believes that put options offer superior downside protection compared to bonds. Bonds, particularly during liquidity crises, may not provide the expected hedge, as seen during periods of extreme market stress like the 2020 COVID-19 crash. Conversely, put options retain liquidity and can be monetized quickly to cushion against rapid drawdowns.

Ultimately, Archbold stresses the importance of balancing growth with protection.

 “We’re not in the prediction business; we’re in the risk management business. Puts are the brakes that let us take advantage of the straightaways.”

Name: John Archbold
Position: Client portfolio manager
Company: Aptus Capital Advisors
Founded: 2013
AUM: $7 billion

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