A hedge payout provides money; the decision to keep or reinvest it determines the next exposure. Reinvestment benefits from a subsequent rebound and loses more if the market keeps falling. The payout alone cannot establish which path will follow.
The comparison concerns total wealth after the stated costs. A lower loss in one scenario does not establish higher expected geometric growth; that requires probabilities and the complete investment path. No trade or allocation is proposed.
The parent put-option study explains why whole-portfolio compounding includes what happens after a hedge pays. This worked example isolates that mechanism with invented inputs, without trying to infer a crash date or a market bottom.
Key takeaways
- Reinvesting a hedge payout increases exposure to the market’s next move.
- That helps in the modelled rebound and hurts in a further decline.
- The scenarios omit earlier hedge premiums and assign no probabilities, so they cannot identify a growth-optimal rule.
Specify the payout rather than inventing an option backtest
Start with a hypothetical $100,000 portfolio. It buys 980 equity units at $100, using $98,000, and spends the remaining $2,000 on a hedge. The equity price subsequently falls to $60, a 40% decline. At that moment the hedge is sold for $20,000.
The $20,000 is an assumed gross sale value, including recovery of the $2,000 premium. It is ten times the premium, equivalent to an $18,000 gain on that sleeve. It is not a quoted option price, observed return or claim that such cover was available at the stated cost.
The equity is now worth $58,800. Together with the sale proceeds, total wealth is $78,800, down 21.2% from the original $100,000. A separate $100,000 all-equity comparator would be worth $60,000. Its initial equity exposure differs, so attributing the entire $18,800 wealth difference to option profit would be incorrect: $800 comes from having started with $2,000 less equity during the decline.
All values are nominal US dollars. There are no dividends, interest, fees or further premiums. The hedge is gone after sale; no continuing protection is assumed.
Three choices from the same $78,800
Keeping the whole payout as cash leaves 980 equity units and $20,000 cash. Reinvesting half buys $10,000 ÷ $60 = 166.67 additional units, leaving 1,146.67 units and $10,000 cash. Reinvesting all buys 333.33 units, leaving 1,313.33 units and no cash.
Each version has exactly $78,800 immediately after this decision. The arithmetic creates no wealth at execution; it changes sensitivity to the next equity move.
| Subsequent equity price | Keep payout as cash | Reinvest half | Reinvest all |
|---|
| $40 | $59,200 | $55,867 | $52,533 |
| $60 | $78,800 | $78,800 | $78,800 |
| $80 | $98,400 | $101,733 | $105,067 |
| $100 | $118,000 | $124,667 | $131,333 |
These are conditional hypothetical outcomes, rounded to whole dollars. The payout and reinvestment CSV contains precise quantities, tax assumptions and portfolio returns.
A return from $60 to $100 is a 66.67% equity gain, not 40%. With all proceeds reinvested, the extra 333.33 units grow from $20,000 to $33,333. That explains the $13,333 advantage over retaining cash in that rebound scenario.
If the price instead falls to $40, those units are worth only $13,333. The same decision then leaves $6,667 less than keeping cash. Neither calculation assumes the initial sale happened at the bottom.
A tax bill changes the capital available
For a separate illustration, assume an immediate 25% tax on the $18,000 hedge gain, with no offsets. The $4,500 payment leaves $15,500 for reinvestment at $60. Combined equity ownership becomes 1,238.33 units.
At a subsequent $100 price, that version ends at $123,833, compared with $131,333 in the before-tax full-reinvestment case. The $7,500 terminal difference includes the $4,500 tax and the rebound forgone on that money. This is a tax sensitivity, not an after-tax comparison with an unhedged investor, whose own tax position is unspecified.
What this example can and cannot show
It makes the cash-flow decision reviewable. It does not establish a positive expected return, an appropriate allocation, or a rule for recognising a crisis. The preceding years of hedge premiums are omitted; including them could materially change the full strategy's compound return. See recurring hedge-budget drag.
FAQ
Does reinvesting a hedge payout always improve the result?
No. In our hypothetical example, putting a $20,000 payout into equities at $60 produces $131,333 if the price later reaches $100, but only $52,533 if it instead falls to $40. Retaining the payout as cash produces $118,000 and $59,200 respectively.
Is the payout assumed in this article an observed option return?
No. A $2,000 premium and a $20,000 realised hedge sale are specified hypothetical inputs. The article does not price an option, establish that such a payout was available, or claim that it reproduces a real investment strategy.
How can tax affect hedge reinvestment?
In the explicitly hypothetical 25% tax example, a $20,000 sale against a $2,000 premium creates an $18,000 taxable gain and a $4,500 tax payment. Only $15,500 remains for reinvestment. Actual tax treatment, timing and loss offsets depend on the investor's circumstances.
