Why You Shouldn’t Invest in “Buffer ETFs” and the Role of Delta Hedging

This March, Samsung Asset Management reportedly launched Asia’s first “buffer ETF.” It tracks the S&P 500 index while aiming to provide about 10% downside protection in a market downturn. In other words, if the S&P 500 falls roughly 20% from its peak, this ETF targets a decline of only about 10%.

At first glance, this ETF may look like an innovative new financial product, but in essence it is a packaged combination of options. The core of the strategy is as follows.

And typically, a short put option is added on top. This creates a collar options structure that limits downside while also capping upside. For example, a rough structure could be designed as follows:

By combining steps 1 and 2, you can build an options strategy that protects against a 10% decline. But if step 1 alone fully offsets losses from a market drop, why bother with step 2? Because you have to pay the option premium for step 1.

The exact amount depends on market conditions and time to maturity, but ATM put option premiums are generally very expensive. From the seller’s perspective, even a small drop from the current price creates an obligation to compensate the buyer for their losses.

Even if you sell the OTM put option at 90, the premium paid by the buyer is unlikely to be enough to fully cover the ATM put premium. In simple arithmetic terms, the insurance premium for protection against downside from the current price cannot be the same as the premium for protection starting at (current price × 0.90). Naturally, the former option premium (insurance cost) will be higher.

This is where step 3 comes in to fill the remaining gap in option premiums. By selling an OTM call option at 115, you hand over any gains beyond a 15% rise from today’s market level to the option buyer. For the buyer, this provides exposure to a market surge at a much lower cost (option premium) than buying an ATM call option.

If, as in the example, a “buffer ETF” actually delivered a 10% downside cushion through the integrated long/short options strategy in steps 1, 2, and 3, it could certainly be an attractive product for some investors, depending on their objectives. But that is an assumption under idealized conditions. If the world really moved according to our designs and plans, I doubt fortune-tellers would still be so numerous in Korea.

According to a June 1 Wall Street Journal article titled “Funds Promising Shelter From Wild Swings Are Booming. But Do They Deliver?”, U.S. funds (including ETFs) that use strategies similar to Samsung Asset Management’s “buffer ETF” have gained popularity since 2024, attracting a total of $56 billion in assets. Samsung Asset Management likely saw this data and concluded there would be investor demand in Korea as well, prompting them to develop the product. These funds:

The article concludes that most of these funds delivered only marginal results. The main culprit cited is “the excessive cost of option premiums relative to the level of protection they actually provide.” In my view, this is an inherent weakness that inevitably comes with using option strategies.

To borrow the CME Group’s definition, in options, delta is the amount by which an option’s price or premium changes in response to a change in the underlying futures price. In other words, delta reflects part of the underlying asset’s movement and is measured as a percentage.

The image above is a graph that explains “option delta.” The green line (call option delta) and the light blue line (put option delta) visualize how delta changes depending on the underlying asset price and the option’s moneyness (OTM, ATM, ITM). Call options have deltas between 0 and 1, and put options have deltas between -1 and 0.

Most option sellers (mainly institutions) aim for a “delta hedge” or “delta-neutral” strategy. It is an active/dynamic investment strategy that keeps the portfolio’s delta at 0 regardless of market direction.

For example, suppose you sell four at-the-money put options with a delta of -0.5. The total portfolio delta position becomes +2 (-0.5 * -4). To build a delta-neutral (0) position, you would need to short 2 shares of the underlying stock (delta -2).

In theory, the option strategy embedded in a “buffer ETF” should work as designed, but in real markets unexpected variables come into play. In particular, market makers’ delta-hedging strategies are a key factor that can distort this ideal structure.

For instance, imagine the market falls by 8% and then suddenly rebounds by 5%. On paper, the buffer ETF’s option positions should cap losses at -10%, but in reality the premium on the sold put options (leg 2) may become excessively inflated, so the protection does not work as well as expected. The same applies in a rebound phase. If buying pressure for short covering flows into the short call positions (leg 3), call premiums can rise much faster than anticipated, causing the upside cap to be reached earlier than planned or unintentionally suppressing the ETF’s performance below the designed level.

In other words, the static structure of 10% downside protection and a 15% upside cap can break down earlier than expected in the real market due to market makers’ dynamic delta hedging and distortions in option premiums. And this distortion is less about bad luck or poor timing and more about a structural limitation inherent in the strategy itself.

For this reason, instead of feeling reassured by the label “buffer ETF,” investors need to understand in advance how the product is structured and how that structure can deviate from expectations in real markets. Just because an ETF holds options does not mean those options will behave as intended. Markets are not static. In fact, the uncertainty embedded in those options can behave in ways that are far more complex and sensitive than the marketing phrase “downside protection” suggests. This is why buying “insurance” does not automatically guarantee peace of mind.