Buy and Hedge
Jay Pestrichelli and Wayne Ferbert · 2012 · 306 pages
A buy-and-hold discipline for people who already own stocks and ETFs and want to stop taking full downside on every position. It replaces gut-feel risk management with four measurable metrics and three repeatable option tactics, at the cost of options approval, extra cash, and constant rolling.
The one idea
Buy and Hedge is not a stock-picking system. The authors, both former online-brokerage executives, start from one premise: capital lost is capital that cannot grow. They run two backtests on the S&P 500 (2001 to 2010) to prove it. Avoiding the ten worst days over that decade turns a 13% ten-year return into 132%. Avoiding the four worst quarters turns it into 126%. Their point is not that you can time those days (they say directly that this is impossible) but that a portfolio which caps its losses gets far more benefit from compounding than the raw arithmetic of the avoided loss would suggest.
From that premise they build Five Iron Rules: hedge every investment, know your risk metrics, build a long-term diversified portfolio, use your own edge only where you actually have one, and harvest gains and losses on a schedule. The risk metrics are their real contribution: capital at risk (CaR), a homegrown measure of the absolute dollar floor a hedged position can lose; volatility, measured at 90-day and one-year windows; implied leverage, which adds the equity value controlled through options to the leverage formula so an options-heavy portfolio doesn't look artificially unlevered; and correlation, tracked one-year and three-year, with anything above 0.75 flagged as high.
The hedging itself runs through three basic option tactics applied to stocks and ETFs the investor already wants to own: married puts (a protective put bought against long stock), collars (a married put partly or fully paid for by selling a call above the market), and in-the-money option substitution. Two advanced tactics, vertical and diagonal spreads, are covered later for investors comfortable with options. None of this is a market-timing or stock-selection edge. It is a discipline for capping the downside on whatever edge you already believe you have.
What it actually teaches
The book's structure is the Five Iron Rules themselves, presented one per chapter and meant to be applied in this order when building or auditing a portfolio.
RULE 1: HEDGE EVERY INVESTMENT
A position only counts as hedged if a loss on it is capped or reduced compared to owning it outright. The book's litmus test is delta: for a bullish position, if total delta (sum of the delta on the stock plus every option leg) is less than 1.0 but greater than 0, it's hedged. For a bearish position, delta between -1.0 and 0 counts as hedged. The three basic tactics for building that hedge are the married put, the collar, and buying in-the-money calls or puts instead of the underlying stock.
RULE 2: KNOW YOUR RISK METRICS
Track four numbers on every position and on the whole portfolio: capital at risk (CaR, the worst-case dollar loss including the hedge's cost), volatility (90-day and one-year standard deviation of daily percentage changes, annualized by multiplying by the square root of 252, roughly 15.87), implied leverage (nonderivative market value plus the implied equity controlled by every option position, divided by total portfolio value minus borrowed money; the book targets 1.0), and correlation (one-year and three-year, with anything above 0.75 called high and treated as a signal to hedge more conservatively).
RULE 3: BUILD A LONG-TERM, DIVERSIFIED PORTFOLIO
Set position sizing and sector weightings so no single correlated cluster dominates the portfolio, and hold every position with at least a multi-month horizon. This is the rule that keeps Rules 1 and 2 from being applied to a portfolio that's already too concentrated to hedge cheaply.
RULE 4: UNLEASH YOUR INNER GURU
Concentrate your own research and conviction only in the sectors or names where you actually have an edge over the market; index or hold broadly everywhere else. The book frames this as identifying your investing strengths and then sizing positions in line with them, always inside the hedge structure from Rule 1.
RULE 5: HARVEST YOUR GAINS AND LOSSES
Close and reset positions on three triggers: the position hits its predefined target price or the original thesis breaks; the unrealized gain reaches roughly 50% of the position's CaR, at which point the hedge should be reset (ideally so the new unrealized gain becomes 150% or more of the new CaR, locking in profit); or a tax-loss or tax-gain harvesting opportunity appears between October and December, respecting the 30-day wash-sale rule when re-establishing a position.
What it looks like Monday morning
A reader who already owns individual stocks or ETFs opens their brokerage account and checks whether every position has options trading on the same underlying symbol. For each one, they calculate capital at risk as it stands today, unhedged: the full position value. That number is the baseline they're trying to shrink.
They then pick one position, price a six-month-out married put using the book's downside percentage and cost percentage formulas (DP = (stock cost minus strike) / stock cost; CP = put cost / (stock cost plus put cost), with the book's rule of thumb that CP should come in under DP), and compare that against a collar on the same stock priced with an upside strike roughly 10% above market. They are not trying to predict where the stock goes next; they are deciding how much of the downside they're willing to keep paying for.
| Metric | Married put (long 17 put) | Collar (long 17 put, short 20 call) |
|---|---|---|
| Downside percentage (DP) | 2.9% | 2.9% |
| Cost percentage (CP) | 5.4% | 2.7% |
| Upside percentage (UP) | Unlimited | 14.3% |
| Max loss on $1,850-$1,800 position | $150 (8.1%) | $100 (5.5%) |
| Max gain | Unlimited | $200 (11%) |
The collar's short call cuts the cost of the hedge roughly in half by giving up upside above the $20 strike; the married put keeps unlimited upside at double the hedging cost.
Capital lost is capital that cannot grow.Pestrichelli and Ferbert, Buy and Hedge
Where it fails
- The worked examples are frozen in 2011 options pricing. Every strike, premium, and expiration in the married put, collar, and IBM/BIDU comparisons uses live quotes from around April and May 2011 with JAN12 expirations, in a near-zero interest rate environment. Options pricing (and therefore the exact cost percentages the book presents as reference points) has moved with rates and volatility regimes since; a reader pricing a collar today with 2011's CP numbers as a benchmark is comparing against a different rate environment than the one those numbers were built in.
- The book's own example violates its own rule of thumb. The authors state the cost percentage should be lower than the downside percentage, or the hedge isn't worth buying. Their flagship GE married put example has a DP of 2.9% and a CP of 5.4%, the opposite of what they just said to look for, and they wave this off by saying it 'means the volatility of the underlying warrants a higher premium' rather than showing a real example that clears their own bar.
- Transaction costs are never modeled. The collar chapter's own preferred approach is to write calls monthly or every one to three months against a six-month put rather than writing one call for six months, explicitly to capture more premium. Every dollar figure in that comparison (the BIDU example claims $27 from nine monthly calls versus $15.75 from one nine-month call) ignores commissions, bid-ask spread on shorter-dated options, and the labor of rolling a position that often. For a retail account this gap between gross premium and net premium after costs is not small.
- It assumes an account most retail readers don't have. Every tactic requires options trading approval, margin for collateral on short calls, and enough capital to trade in round lots of 100 shares plus the option contracts against them. The book never addresses how to apply Buy and Hedge with a small account, fractional shares, or a broker that restricts naked or covered option writing, which describes a large share of retail brokerage accounts.
- Capital at risk, implied leverage, and the DP/CP/UP formulas are the authors' own inventions, not industry-standard metrics. None of the four core risk metrics as defined in this book (particularly CaR and implied leverage) map cleanly onto what a brokerage platform, a risk-management tool, or another options book will show you. A reader has to compute all of them by hand or in a spreadsheet; there's no software referenced anywhere in the text that produces these numbers automatically.
- The case for hedging leans on two cherry-picked backtests. The ten-worst-days and four-worst-quarters studies (S&P 500, 2001 to 2010) are presented as the entire empirical justification for the book's premise. Both windows are dominated by the 2008 crash (eight of the ten worst days fall in the second half of 2008 alone), so the studies mostly demonstrate that avoiding one specific crisis helps a lot, not that the specific married put and collar structures taught later would have captured that avoidance at a cost worth paying.
Who it is for
Buy it if
You already hold a taxable stock or ETF portfolio, have options approval on your brokerage account, and want a structured, repeatable way to cap downside on positions you plan to hold for years. It's also useful as a vocabulary primer if you're new to married puts, collars, and portfolio-level hedging with index puts.
Skip it if
You're looking for a system that tells you what to buy or when, you trade a small account without margin or options approval, or you want current options pricing and cost benchmarks rather than 2011-vintage examples you'll have to rebuild yourself with today's numbers.
As an Amazon Associate I earn from qualifying purchases. It costs you nothing extra, and it does not change what gets recommended or what the verdict says.