Put option as portfolio insurance - perhaps not the right choice

Buying puts is supposed to be a good way to hedge downside risk, but the cost of such hedges can be expensive. Options can be valued to determine their richness or cheapness in the market. If you buy an option for an implied volatility, the value of that option can be viewed through the subsequent realized volatility. If the option's implied vol (IV) is less than the realized vol, the option is cheap. If the IV is high relative to the realized vol, it is rich. Consequently, we can look at the vol risk premium as measured by the IV versus realized volatility to get an idea of the true cost of a hedge as embedded in the price.

A new paper from the folks at AQR, "Still not cheap, portfolio protection in calm markets", provides an interesting perspective on using puts to protect from downside risk. They find that there is a positive risk premium such that put buyers are paying up for the right to hold an option. There is more bad news because the premium is usually higher when IV's are high; consequently when you try and hedge at those market extremes, it will cost more for the investor. Unfortunately, the premium also exists even when IV's are low. There is no getting around the fact that you have to pay-up for buying options. 

If you have to hedge, be careful of doing it when implied volatilities are high. Paying for the right to an option may not be the best way to gain protection. At the very least, determine whether you are paying an excessive premium for the option. The premium will not be known until the volatility is realized but by bucketing risks, you can get some idea of the true cost of hedging.