Have you been unnerved by this roller-coaster of a market? Want a cushion against market falls? Yeah, I bet.
A Falling Market
I’ve been interested in option strategies for a long time and their ability to shape the risk and return of my portfolio but I just have not found the time to execute them in a safe way. There are a number of concepts that give me heartburn, like leverage, margin calls etc… These can go wrong if you don’t spend the time understanding the potential pitfalls. However there are definitely some benefits to options and you can give up some upside in exchange for protection on the downside. Given the recent market gyrations this could be pretty attractive.
Have you read the important notes before proceeding any further?
Selling put options
Over the last couple of years I’ve been looking at one particular strategy – selling put options.
If you sell a put option then you earn a premium. You earn that premium come rain or shine. Whether the market goes up or down, you get that premium. But it’s not without risk…
Let’s recap the reasons why selling put options might be helpful:
- You earn the option premium whatever the weather, and in down-markets it will help cover equity losses. Selling a straight put option does truncate the upside returns but the benefits on the downside can help smooth the ride. It is possible to leverage the strategy, where the payoff is magnified, but in our case here we will consider a straight put option.
- The chart below shows the payoff of selling a put option compared to holding the stock. You can see that when the market shows very strong growth you make money by selling the put, but less than if you held the stocks (red line lower than blue). However in a strong downturn you lose less than if you had held the stock (blue line lower than red).
- Owning a put option provide you with equity protection and therefore demand for put options is high since everyone is frightened of the recent market falls and general over-valued nature of the equity market. However, there are very few natural sellers of put options since banking regulations effectively stopped banks and hedge funds playing hard in this space. So, if you have lots of buyers and few sellers then you can potentially earn a great premium. In historical terms this premium is relatively high, and is indirectly measured by something called the Credit Suisse Fear Barometer (CSFB). We won’t go into this measure in detail but it has been at historical highs over the last 12 months. See below. When this measure is high then put options are relatively expensive and therefore the premium you can earn by selling them, is high.
- The price of an option depends to some extent on volatility. If you want some portfolio protection from rising equity volatility then earning a premium from options will likely do well when volatility increases.
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Show me the numbers
The great thing about put selling is that there is a well-established index, and if there is one thing that lovers of financial independence are comfortable with it is index investing! So it is straightforward to analyze past performance of this strategy. The CBOE has the performance of a hypothetical portfolio that sells cash collateralized put options on a monthly basis at-the-money and invests the cash in short-term Treasury bonds. So if you are nervous about actively investing these things, then there is a ready-made index.
There is considerable data on this strategy stretching back over 30 years and the CBOE website has it there to download, but even easier they have a number of academic papers that do the analysis for you. See for example this paper from the University of Illinois At Chicago. They describe the benefits as:
- The PUT index has outperformed the S&P500 index over the last 30 years with lower volatility.
- The volatility of the strategy has about two-thirds of the volatility of the S&P 500.
There is a load of great material in this paper so please take a look. Alternatively here is a paper by Ennis Knupp (now AON) that reaches the same conclusions.
Actuary on FIRE Analysis
Not content to take anybody’s word for it I ran some numbers myself. I compared risk and return with the US equity market, World equity market and US Bond market.
Over very long periods it has outperformed the S&P500 but over shorter periods has under-performed, but it has done so with consistently lower volatility. I also ran some correlations and a strategy of selling put options is around 80% correlated to the S&P500.
So this strategy is not a home run in my opinion. You definitely sacrifice some upside in the recent red-hot equity markets but you gain some risk management and diversification benefits.
If you are seeking maximum portfolio growth then the benefits are limited in that provides some diversification benefits. However I think it could have a more prominent place in a portfolio during the drawdown phase of retirement. At this point you could well be willing to sacrifice some upside in order to reduce portfolio volatility. Especially during those crucial early years where sequence of returns risk is so key.
However, given recent events how has this strategy performed?
You can see in the above chart that over the last three months the PUT selling strategy has under-performed the S&P500. That’s not surprising – remember we said it was giving up upside performance? However it did provide some cushioning in the recent turbulence. Since January 26th the S&P500 is down 8.8% and the PUT selling strategy is down 6.4%.
It’s useful to look at this over the longer period.
Clearly PUT selling has badly under-performed in this high octane bull market, and this was expected. But was this compensated by the downside protection? Not really. Not in this case.
But how do I do implement it?
Back to my original point – how do you do this if you are not happy to dabble with leverage, a brokerage account and margin calls? Wisdom Tree offers a product that is a straightforward fund, and it is available through Vanguard (Ticker PUTW). What could be easier? It’s a cash investment and so you are only on the hook for that amount – no worrying about margin calls!
This is not an active fund, in the sense that they are not making tactical bets, however the cost is not the low Vanguard cost of 4bps. The cost of PUTW is 38bps, and that is a further return drag on your investment.
So what have we learnt? You give up upside in return for some downside cushioning and you have to pay over 30bps more in fees than a passive equity fund. For me at this point, it is a pass. I may revisit it after I enter the spendown phase of my retirement where some equity returns, tempered with lower downside, could be desirable for avoiding some of the worst effects of sequence of returns risk.
Further Reading – You may have seen Big ERN’s article here on writing put options to generate a passive return. This is a recommended and detailed guide that will take you to the next level and turns this from a ho-hum strategy to something with more teeth.
What do you think about options? Too crazy? Do they have an insurmountable PR problem resulting from the Global Financial Crisis? What have you been doing through the recent market turmoil?