Why options are not the only solution to protect against gap events

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A gap event is a rare but disturbing phenomenon.

The Brexit vote was a classic example–when Britons unexpectedly voted to leave the European Union in June 2016, some major equity markets fell between trading periods. Investors woke to find sharply lower prices the next morning.

While most quickly recovered in the following days, other historical gap events have been less predictable, introducing periods of volatility which flowed into extended downturns.

The S&P 500 has posted 34 gap events (defined as a greater than 5% difference between the intraday low with the prior day’s market close) over the 50 years ended July 2017. That represents just 0.27% of trading days, but some were unforgettable such as the near 25% single-day fall on 20 October 1987.

While most exchanges now implement circuit breakers to prevent falls of that size, the chance of sudden intraday falls of more than 5% still exceeds some investors’ risk tolerance.

The challenge: High costs and poor timing

Investors using put options to protect against gap risk face significant challenges. It’s expensive to maintain ongoing protection, difficult to time and often doesn’t pay off.

Meanwhile, put spreads and deep out of money option purchases still leave many portfolios significantly exposed to gap events.

For example, consider a gap event of 10%. A hypothetical investor has bought a three-month 97%/90% put spread at the top of the market with a cost of 1.5% (6% to run annually). This strategy would still leave the portfolio participating in 45% of the market fall at expiry.1  

However, if the gap event were 20%, this strategy would leave the portfolio exposed to 72.5% of the fall (both assuming the strike was from the top of the market) at expiry.2  

The level of instantaneous gap protection is highly variable and heavily dependent on where the option was struck and the remaining tenor.

‘Hard floor’ style option structures can be useful but are also expensive. The following table shows a simplistic vanilla put option (marked-to-market representing the ‘hard floor’) and the level of protection against a -10% gap event. Highlighting, the level of protection is determined by several factors, including strike level and time remaining to expiry.

For example, holding a three-month 90% put option will generate 1.8% return on the notional–or provide just 18% protection against the gap event (assuming the option notional amount was equal to the underlying holding). If markets trend lower as the option matures, then the hard floor will pay off. However, markets have historically recovered quickly after large drawdowns.

Within a risk management strategy utilising physical options, option strike levels are usually determined arbitrarily by time. The arbitrary nature of the strike level (in spreads and out right purchases) adds uncertainty about the level of protection.

We have previously shown the high cost and difficulty in timing protection with put options by analysing three hypothetical investors in the US, UK and Eurozone looking to protect their end-of-May portfolio values against a Brexit-related selloff.

Managed risk: Assessing an alternative strategy

While options, swaps and swaptions offer benefits, they also bring challenges. Ongoing option protection strategies are less efficient and do not necessarily protect portfolios more than dynamic hedging strategies.

The Milliman Managed Risk Strategy™ (MMRS) has a cash buffer and uses hedge assets (typically exchange-traded futures contracts) to preserve capital and manage volatility during periods of market turbulence.

This means the strategy aims to consistently offer some protection against gap events. The following chart shows the level of protection offered by the managed risk strategy applied to an S&P 500 portfolio over the same 50-year period. It provided protection against more than 50% of the portfolio more than 73% of the time.

This relatively high level of protection occurs because gap events typically strike during periods of high volatility or sustained market drawdowns–this is when managed volatility and managed risk strategies offer the highest level of protection.

This is not a discretionary decision based on a qualitative assessment of market conditions, which can leave some option-based strategies exposed, but a pre-determined rules-based response to quantitative market data.

Milliman also minimises the period in which a gap event can occur by relying on three trading desks covering all major markets, including (where appropriate) night sessions offered by most major future exchanges and ongoing contact with most major brokers. This allows our traders to respond quickly and appropriately as market events happen rather than waking up to a gap event.

There are no simple answers to protecting portfolios against gap risk, but a careful assessment of the strategies at hand will ensure the most efficient and cost-effective approach.

For more information about derivate strategies, please contact Milliman head of fund advisory services Michael Armitage at michael.armitage@millilman.com.

1In a 97%/90% put spread, the long strike at 97% leaves 3% of the portfolio out of the money. With a cost of 1.5%, this would mean that the portfolio would participate in 4.5% of the 10% market fall, which is equivalent to 45% participation of the fall.

2In a 97%/90% put spread, the long strike at 97% leaves 3% of the portfolio out of the money and limits protection to the level of the short strike of 90%. With a cost of 1.5%, the investor would participate in 4.5% of the first 10% fall and would fully participate in the additional 10% fall. This would mean the portfolio would participate in 14.5% of the 20% market fall, equivalent to 72.5% participation of the fall.


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