Puts are valuable beyond their payoffs

Loss comes with loss of opportunity

For the business of options selling to be viable market makers have to be able to sell options on average above their cost of hedging them. Hence, the volatility risk premium.

This is no different than a manufacturer charging a price above cost of goods sold. This means options on average are sold at a price above their expected payoffs. 

The question then becomes what's in it for the buyers? The short answer is continued access to optionality. Whenever you lose, you actually lose twice. Money and opportunity. Conversely, loss mitigation has optionality value.

A real world illustration can be found in option market making.

Market makers buy out-of-the-money puts, knowing full well these are expensive in terms of volatility risk premium, not as black swan bets, but for the purpose of business continuity.

When volatility picks up, the profitability of market making increases exponentially: higher volume, wider spreads, and market share concentration. That is, of course,  on the condition that the market maker is not constrained by losses or elevated margin utilization. A market maker should be willing to pay for options that will enable her to be positioned to monetize a fast market.

Puts if you're bullish?

If you systematically buy puts, you should expect to lose money.

The puts stand-alone will cost more in premium than they give back in payoff, especially for an asset like Bitcoin which we should expect to drift upwards over time.

The merit of tail hedging could be dismissed on these grounds. The puts lose money so you're better off not hedging and white knuckling through volatility?

This misses the optionality of reinvesting the payoffs from puts.

If you buy and hold Bitcoin and protect downside with puts, the cash you get during drawdowns can be used to buy more Bitcoin.

Think of the puts as midfield defence. Their job is to intercept the ball and start a counter-attack. At a portfolio level, the puts 'intercept' losses and allow to counter-attack by buying the underlying during dips.

While the puts may be a losing trade in isolation, their effect on the portfolio, if properly rebalanced, is to increase Bitcoin exposure over time.

Ultimately, the return on investment on the hedge comes in the form of higher exposure to the risk premia of being long.

Implementation questions

While the concept of a tail-hedged long portfolio is straightforward, there are many implementation details to consider. For instance:

• Which strikes and maturities do you select for the puts?
• Do you delta-hedge the puts?
• What is your rolling strategy over time?
• How do you monetize the puts?
• Do you roll down put protection?
• How to handle times when IV is elevated?

For further reading on this topic, we recommend Common Hedging Discussions part one & two by Benn Eifert, which can be found under QVR's research section on their website: Research — QVR Advisors.

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