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Abstract
The flexibility and cash outflow certainties make option contracts one of the most favored instruments for hedging purposes. Among various option-based strategies, protective put and covered call have been very popular. However, not much work has been carried out to check the relative hedging performance of covered call and protective put strategies. Moreover, research has remained largely limited to developed markets. This study compares the hedging performance of covered call and protective put strategies by utilizing total returns index for S&P CNX Nifty as a stock portfolio and hedging the same through options available on S&P CNX Nifty. It was found that both covered call and protective strategies could outperform a simple buy and hold portfolio on risk adjusted basis. Specifically, portfolio with 5% ITM short call and portfolio with 2% ITM long put had superior performance. On comparison, protective put strategy outperforms the covered call strategy both in terms of hedging effectiveness and risk adjusted returns. After adjusting for non-normality also, the portfolio with 2% ITM put option offered the best statistics.
Keywords: Portfolio hedging, protective put, covered call
INTRODUCTION
The Black Monday of 1987; the stock market downturn of 2002 across the US, Canada, Asia, and Europe; the global financial crisis of 2008; and the European crisis of 2011 or a five-session jump in Sensex from 16000 to 17000 in September 2000; all underline one common theme: the financial markets are always in flux and the trends shows that volatility will only increase in the coming future. This heightened price volatility, coupled with factors such as greater integration of financial markets, volatile risk environment, access to cheap and faster information, and better ability to analyse it have lead to a greater need for protection against risk factors such as price risk, counter-party risk, and operating risk (Lodha, 2008). The need for protection is higher for the portfolios that are concentrated or un diversified.
Today, a number of specialized instruments are available that allow market participants to protect themselves against downward market movements. These include short-selling, futures, and options. Short-selling involves very high costs due to its associated collateral and margin requirements, loan interest, and potential risk of a short squeeze or even non-availability of short-selling (for example, NSE allows short-selling...