Proceedings of 3rd Global Accounting, Finance and Economics Conference
5 - 7 May, 2013, Rydges Melbourne, Australia, ISBN: 978-1-922069-23-8
Hedging Growth Stocks and Value Stocks: Differences
and Costs
L. Mick Swartz
The empirical literature on stock returns shows overwhelming evidence of stock
anomalies related to value investing and growth investing. This paper studies the
relative cost of using stock put options to hedge value and growth stocks.
Significant results are obtained for differences in the cost of hedging using put
options across value and growth stocks. This means that different strategies should
be employed in attempting to hedge some of these types of stocks. The cost of
hedging for one or two months using put options is examined from 1995 to 2004.
The costs of puts are analyzed with a corresponding discussion of other strategies
directly linked to these results. In particular, evidence is found that the put options
on some growth stocks and the option returns on some value stocks outperform
the average option return for puts deep out of the money. For puts deep in the
money, buying puts for the most extreme category or decile of value stocks is
significantly less expensive than other deciles. For, both puts and calls across the
value and growth deciles, writing options had higher returns than buying options.
Strategies with profitable returns over the decade included bull spreads on value
stocks and growth stocks (but not the highest decile for growth). A third strategy
that was profitable for the decade included buying deep out of the money puts for
deciles 2, 3 (growth) and 10 ( most extreme value). Implementing a protective put
strategy for the underlying stocks will vary depending on the type of asset and it’s
relative value of growth label. The relative cost of hedging stocks in the options
markets does depend on value versus growth characteristics.
Highlights
•
•
•
•
•
•
•
•
Stock Anomalies and Option Returns are examined from 1995-2004
Value Stocks have different hedging costs than growth stocks
Risk Management
Protective Puts
Hedging with Put Options
Buying Deep Out of the Money Puts was profitable for some deciles
Deep in the Money Puts are less expensive for Value Stocks
Some bull spreads were profitable strategies throughout the time period
Keywords: Risk management, Cost of Hedging, Hedging, Put Options,
Protective Puts, stock anomalies, option anomalies, stock option returns, In the
Money Options, Out of the Money Options, At the Money Options, Value Stocks,
Growth Stocks, Bull Spread, Bear Spread
Introduction
For almost two decades, the most puzzling aspect in finance has been the risk
and reward profiles of value investments.
________________________________________________________________
L. Mick Swartz, Marshall School of Business, University of Southern California, Los Angeles,
Email: mick.swartz@marshall.usc.edu
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Proceedings of 3rd Global Accounting, Finance and Economics Conference
5 - 7 May, 2013, Rydges Melbourne, Australia, ISBN: 978-1-922069-23-8
Existing models do not fully capture risk and return to explain how an asset with
higher returns could have less risk. Many attempts to classify value stocks as
having more risk have failed to fully capture the dynamics in the marketplace. In
a seminal article, Fama-French give evidence of a 3 factor model using beta, size
and value. Value is expressed as a M/B ratio and this ratio is commonly used as
a standard for investment performance. The value and size anomalies show
significant abnormal returns for companies displaying those characteristics. The
option markets, therefore, should reflect such behavior and the costs of using
these assets should vary depending on their factor loadings in the model. As a
result, the cost of hedging using options on value stocks should be different than
the cost of hedging growth stocks.
In this study, we examine the cost of using put options for different types of
stocks on a monthly basis to determine if option returns display different
characteristics depending on whether the stock is a a value stock or a growth
stock, as defined by Fama-French. These results will help portfolio managers
determine the relative costs of hedging portfolios depending on the
characteristics of the underlying assets.
If the option returns are significantly different, then the relative costs of
hedging will differ. If option returns are not different, then the options markets
may not be correcting for volatility differences in the option pricing models. .
The basic question addressed in this paper include: Does the cost of hedging
a value stock differ from the cost of hedging a growth stock in the put options
market?
Literature Review
The literature in finance has documented many anomalies in an attempt to
gain insight into the factors that affect stock returns. However, the literature does
not address the cost of hedging using options. Asset pricing anomalies were
studied in Basu (1981) and Reinganum (1982) documenting a size effect. In
addition, Fama-French (1993,1994, 2005) document a value premium. Stock
market anomalies pose many problems for options markets, since the stocks is
often considered mispriced. What is the cost of a derivative of a “mispriced” asset
? Other anomalies that have been documented include the momentum effect
(special type of growth stocks) by Carhart (1997). The literature for these
anomalies has created a great deal of interest, however, this topic has not been
addressed in terms of hedging these types of assets. This study examines the
put option returns or costs to implement these options for different types of
underlying stocks
Methodology and Data
The stock option returns from 1995 to 2004 are examined on a daily and
monthly basis from Optionmetrics (IVY Database). Daily stock returns and the
risk free rate are obtained from CRSP. The Compustat database is used to
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Proceedings of 3rd Global Accounting, Finance and Economics Conference
5 - 7 May, 2013, Rydges Melbourne, Australia, ISBN: 978-1-922069-23-8
classify firms on a monthly basis into value or growth deciles. CRSP and
Compustat data are used to sort firms into size deciles each month.
Stock returns are sorted based on Fama-French deciles of M/B and size
each month. The portfolios are then examined based on option returns for 5
different exercise prices each month. The five exercise prices include at the
money, one price in the money, two prices in the money, one price out of the
money and two prices out of the money. The option returns examined are one
month or the closest option with at least one month left until expiration. This
means the effective time period is between one and two months in the portfolio.
This is a difference between this study and other studies that did not find
significant differences. The mean time horizon is between 5-6 weeks for each
portfolio depending on the closest option maturity. Option prices and returns are
individually accumulated and averaged for a portfolio. Each portfolio (decile) has
roughly 270-300 individual stock returns and option returns each month. The
daily observations per month are approximately 20 per security. Holding period
returns are examined on a daily and monthly basis. Results are accumulated on
a monthly basis to interpret and relate to existing stock return research. The
options studied have one month to two months until expiration.
Empirical Results
Put Options
Table One results indicate that many deciles had positive returns for deep in the
money puts. This decade included the tech boom and subsequent bust. It
appears the strategy of buying deep in the money puts was profitable over this
decade for many deciles. As a hedging tool that is important to realize.
Sometimes the price of the insurance is too cheap. Put options were significantly
re-priced after the crash of 1987, however this category of deep in the money
puts was too cheap in this time period.
Table Two results show negative 7% to -14% returns for most deciles, however,
not for deciles 2 (growth) or 10 (deep value). These deciles had option returns
that were not significantly different from zero. The cost of hedging using these
two deciles was different during this decade. The return is the negative of the
cost of hedging using a put option to hedge. One trend in the tables is the
difference between deciles one and two in terms of option returns. The highest
growth rated stocks are more expensive to hedge using put options. Growth
managers should realize that even among growth stocks significant differences
can occur for the cost of hedging.
Table Three shows at the money put options and the average monthly returns for
the deciles ranged from -19.7% (decile 10 deep value) to -42.4% . The growth
stock option returns (deciles 1,2 and 3) were in the -32% range. Decile 10
(extreme or deep value category) was the least negative return and therefore, the
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Proceedings of 3rd Global Accounting, Finance and Economics Conference
5 - 7 May, 2013, Rydges Melbourne, Australia, ISBN: 978-1-922069-23-8
least expensive to use as a hedging tool. Again, the return is the negative of the
cost of hedging.
Tables Two and Three are important because as a hedging tool they are the
most obvious choices for a portfolio manager picking individual securities.
Table Four indicates that using In-The-Money put options (one strike price in)
had option returns from -24% to -47% , on average per month. This cost could
cause significant drag to a stock portfolio if used frequently. This choice is
expensive as a hedging tool and requires more initial capital than some other
choices listed.
Table Five has option returns ranging from -4% to -54%. Value stocks, deciles 9
and 10, have option returns/costs of -4.3% and -11.9%, so the cost of hedging is
much smaller. Deciles 1, 2 and 3 have option returns of -28%, -19.1% and 25.1%, respectively. Deciles five thru eight have the most negative returns.
Summary
For the decade 1995-2004, the empirical evidence indicates that buying
. The
value deciles have negative option monthly returns of 3-5% and the growth
deciles have negative option monthly returns of 8-13.5%.
Evidence is found that the option returns on some growth stocks and the option
returns on some value stocks outperform the average option return for puts deep
out of the money. For puts deep in the money, buying puts for the most extreme
decile (decile 10) of value stocks is significantly less expensive than other
deciles. For both puts and calls across the value and growth deciles, writing
options had higher returns than buying options. Strategies with profitable returns
over the decade bull spreads on value stocks and growth stocks (but not the
highest decile for growth). A third strategy that was profitable for the decade
included buying deep out of the money puts for deciles 2, 3 (growth) and 10
(value).
References
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Blume, M. and R. Stambaugh. 1983. Biases in Computed Returns: An Application to the
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Proceedings of 3rd Global Accounting, Finance and Economics Conference
5 - 7 May, 2013, Rydges Melbourne, Australia, ISBN: 978-1-922069-23-8
Financial Economics 12, 387-404.
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Proceedings of 3rd Global Accounting, Finance and Economics Conference
5 - 7 May, 2013, Rydges Melbourne, Australia, ISBN: 978-1-922069-23-8
Reinganum, M. 1981. A Misspecification of Capital Asset Pricing: Empirical Anomalies
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Proceedings of 3rd Global Accounting, Finance and Economics Conference
5 - 7 May, 2013, Rydges Melbourne, Australia, ISBN: 978-1-922069-23-8
Empirical Tables
Table 1: Put Option (Out of the Money Two Strike Prices)
Decile
1
2
3
4
5
6
7
8
9
10
Monthly Stock Return
.003
.004
.010
.011
.017
.018
.017
.021
.020
.024
Monthly Option Return
.036
.264*
.315*
.086*
.056*
.405*
.086*
.062*
.026
.338*
Decile 10 is Value and Decile 1 is Growth.
There are approximately 270 – 300 firms per day for 20 days per month.
*Significant at a one percent level.
**Significant at a 5 percent level.
Table 2: Put Option (Out of the Money One Strike Price)
Decile
1
2
3
4
5
6
7
8
9
10
Monthly Stock Return
.003
.002
.009
.009
.014
.015
.016
.019
.020
.024
Monthly Option Return
-.123*
-.014
-.101*
-.141*
-.109*
-.075*
-.120*
-.121*
-.110*
.002
Decile 10 is Value and Decile 1 is Growth.
There are approximately 270 – 300 firms per day for 20 days per month.
*Significant at a one percent level.
**Significant at a 5 percent level.
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Proceedings of 3rd Global Accounting, Finance and Economics Conference
5 - 7 May, 2013, Rydges Melbourne, Australia, ISBN: 978-1-922069-23-8
Table 3: Put Option (At the Money)
Decile
1
2
3
4
5
6
7
8
9
10
Monthly Stock Return
.002
.002
.008
.008
.013
.014
.015
.019
.019
.021
Monthly Option Return
-.326
-.323
-.366
-.387
-.411
-.424
-.401
-.398
-.374
-.197
Decile 10 is Value and Decile 1 is Growth.
There are approximately 270 – 300 firms per day for 20 days per month.
*Significant at a one percent level.
**Significant at a 5 percent level.
Table 4: Put Option (In the Money One Strike Price)
Decile
1
2
3
4
5
6
7
8
9
10
Monthly Stock Return
-.001
.002
.007
.008
.013
.013
.013
.015
.015
.007
Monthly Option Return
-.257
-.243
-.256
-.257
-.355
-.378
-.391
-.431
-.476
-.378
Decile 10 is Value and Decile 1 is Growth.
There are approximately 270 – 300 firms per day for 20 days per month.
*Significant at a one percent level.
**Significant at a 5 percent level.
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Proceedings of 3rd Global Accounting, Finance and Economics Conference
5 - 7 May, 2013, Rydges Melbourne, Australia, ISBN: 978-1-922069-23-8
Table 5: Put Option (In the Money Two Strike Prices)
Decile
1
2
3
4
5
6
7
8
9
10
Monthly Stock Return
-.004
-.003
.005
.005
.010
.010
.009
.012
.011
.005
Monthly Option Return
-.280
-.191
-.251
-.258
-.441
-.546
-.469
-.574
-.043
-.119
Decile 10 is Value and Decile 1 is Growth.
There are approximately 270 – 300 firms per day for 20 days per month.
*Significant at a one percent level.
**Significant at a 5 percent level.
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