Protect Portfolio Downside with Protective Puts

Introduction

What if you could guard your stock portfolio against sharp market drops—without constantly watching the markets or selling your holdings? In an era of rising uncertainty and unpredictable drawdowns, more investors are turning to strategies that add downside protection while keeping their core investment plan intact. One such method is the protective put overlay, a disciplined risk-management approach used by conservative investors, institutions, and retirement planners.

A protective put overlay involves purchasing a put option—essentially an insurance contract—on a broad index like SPY, while continuing to hold your core portfolio of equities. This creates a safety net that cushions large losses during market downturns, without compromising long-term growth exposure.

At WealthEngine.AI, we apply this protective layer on top of our Momentum, Value, and Smallcap portfolios using monthly SPY put options. Instead of buying puts on each individual stock, we use a single SPY index put to keep the strategy simple, scalable, and efficient. This index-based approach ensures cost-effective protection while maintaining full participation in the upside of our factor-driven portfolios.

How It Works

Here’s how the protective put overlay is implemented step-by-step across WealthEngine portfolios:

• •Hold the base portfolio: e.g., WealthEngine’s Momentum, Value, or Smallcap portfolio
  
• •Buy an out-of-the-money SPY put option
  
• •Maintain the position until expiry or exit early during sharp drawdowns
  
• •Repeat monthly to maintain continuous protection
  

The overlay is non-disruptive—it operates independently of your portfolio’s rebalancing, stock selection, or factor exposures. It simply provides a defensive shield in volatile or declining markets.

Why Use SPY Options Instead of Stock-Specific Puts?

Using SPY index puts offers several advantages over buying individual stock puts:

• •Cost Efficiency: Buying one index put is cheaper than hedging every single stock
  
• •Liquidity: SPY options offer tight spreads and deep markets
  
• •Macro Protection: SPY captures systemic market risk, the primary source of portfolio drawdowns
  
• •Simplicity: Easy to implement, manage, and roll month-over-month
  

This makes the protective put overlay a low-maintenance, high-impact strategy that aligns with WealthEngine’s data-driven investment philosophy.

Modeling & Simulation Framework

To evaluate the effectiveness of this strategy, we conducted a systematic backtest using monthly SPY put overlays across all WealthEngine.AI portfolios. Key assumptions:

• •Put strike selection: Monthly SPY put, ~0.2 delta
  
• •Initiated at the start of each month and systematically rolled to the next expiry a few days prior to the current contract's expiration.
  
• •Pricing model: Cox-Ross-Rubinstein framework, incorporating the VIX index as a proxy for implied volatility and the U.S. 3-month Treasury yield as the risk-free rate"
  

This framework ensures realistic hedging costs and risk-adjusted outcomes under varying market regimes.

Backtest Results Across WealthEngine.AI Portfolios

We applied the protective put overlay to three core WealthEngine.AI portfolios: Momentum, Value, and Smallcap. While this strategy slightly reduces long-term returns due to the cost of protection, it delivers significantly lower drawdowns and higher Sortino ratios.

Value Portfolio + SPY Put Overlay

Momentum Portfolio + SPY Put Overlay

Smallcap Portfolio + SPY Put Overlay

During periods of heightened volatility—like COVID-19, 2022’s rate-driven selloff, or geopolitical shocks—the put overlay served as a reliable buffer, preventing large losses and enabling faster recovery. The strategy provides particular value for capital preservation-focused investors or those closer to retirement.

Conclusion

A protective put overlay, especially using SPY index options, is a prudent way to reduce downside risk while staying invested in high-conviction equity portfolios. At WealthEngine.AI, this approach complements our factor-based strategies by adding a layer of defense—without significantly diluting the alpha potential of the core portfolio.

With this strategy, investors gain:

• •Shallower drawdowns
  
• •Stronger risk-adjusted returns in adverse markets
  

For investors focused on long-term growth with downside control, the protective put overlay offers an elegant solution. As always, portfolio protection should be tailored to your financial goals, risk appetite, and investment horizon.