Prepare for landing: time for schemes to PUT equity protection in place?

Talk of a potential soft landing in some developed economies has led to a number of key equity indices hitting new highs in 2023. This has been twinned with a material reduction in implied equity volatility, with levels[1] now at less than 50% of the highs seen in 2020.

What do equity protection strategies aim to do in practice?

Much like car insurance aims to protect against the financial loss from an accident above the excess amount, equity protection strategies aim to insure against a fall in the value of equities past a certain point. One such type of strategy is to buy put options.

The first chart below illustrates a put option pay-off profile where the premium is paid at the outset for potential protection against losses over the ‘excess’ of 5%. The premium can be reduced by a put spread (buying put options with a certain strike price and selling put options with a lower strike price) which seeks to protect against losses within a certain range (e.g. between -5% and -30% as shown in the second chart).

The chart below shows the premium, as a percentage of the notional equity exposure held, that an investor needs to pay to seek to be protected against equity losses beyond 5% (i.e. the 95% put in the first of the two charts above) or equity losses between 5% and 30% (i.e. the 95-70% put spread in the second of the charts above).

For example, to seek to protect £100 of exposure to the S&P 500 for any loss greater than 5% (£5) over the next year, a c. 3% (£3) premium is paid at outset. In this instance, if equity markets fell by 30% an unhedged investor would lose £30, whereas the investor with the put option would potentially only lose £5, plus the premium paid.

As shown in the chart below, the premium for such strategies has come down significantly this year and is now at the lowest level of the past five years.

There are two key reasons behind this fall in the premium:

1. Fall in implied volatility

One of the key drivers of options pricing is the level of implied volatility in the market, with lower levels of volatility decreasing the price of the options. For any option structure where you are going to be a ‘net buyer of volatility’, such as a put option, pricing may look increasingly attractive; particularly if you think there is a material chance of market volatility increasing over the next year.

2. Increase in interest rates

The second driver has been the continued increase in global interest rates. US and UK one-year funding rates have increased by c. 0.5% and c. 1.3% respectively since the beginning of the year. [2] The impact of rising interest rates is typically to decrease the value of put options, meaning they are likely to be cheaper to buy.

How does equity protection sit within the pension scheme’s overall investment portfolio?

Over the past 18 months, many pension schemes have found themselves much better funded as interest rate expectations have risen and liability values have typically fallen faster than asset prices overall.

At a point when equity put options would appear to be particularly cheap in our view, and global equity markets have staged a recovery, we believe it is potentially a good opportunity for pension schemes to consider how such strategies can help them ‘lock-in’ gains in their funding levels.

For schemes in their journey-planning phase, put options can provide an opportunity for schemes to continue to participate in any potential equity upside, but in a risk-managed manner tailored to their individual needs. With the ability to flex the term of the contracts, a scheme could, for example, look to align a put option with its next actuarial valuation, effectively crystallising gains achieved so far this year (noting actual returns will likely have far exceeded expectations).

For schemes that are well-funded on a low-dependency basis, holding equities overlaid with put options can seek to enable the scheme to lock in their strong position while still providing exposure to upside potential. This could help to bridge the gap to a possible ultimate goal of being fully funded on a buyout basis.

Glossary of terms

• Equity put option: a derivative that gives the holder the right, but not the obligation, to sell a security at a predetermined price. One practical application of put options is to act as a form of insurance against a fall in the value of equities past a certain point in return for a premium
• Equity put option spread: the premium paid by the buyer of put options can be reduced by a put spread (buying put options with a certain strike price and selling put options with a lower strike price), which seeks to protect against losses within a certain range
• Implied volatility: a metric that captures the market’s estimate of the likelihood of changes in the price of a particular security. Implied volatility is used to price options contracts

[1] As at 24 July 2023, based on one-year 95% (total return) S&P 500 implied volatility

[2] Based on LGIM internal data as at 31 July 2023.