Author Topic: Using options to reduce sequence of return risks  (Read 481 times)

yoda34

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Using options to reduce sequence of return risks
« on: November 07, 2018, 03:58:33 PM »
Ok - so a few disclaimers. I'm not an options expert and i'm probably totally wrong on this - a major part of my motivation is to post this here and have someone shoot it down. Second, no one ever should attempt to do the below, options can pose serious risks to a portfolio if used incorrectly.


I've been becoming more and more convinced that options are underappreciated to reduce risk, especially in the early years of retirement. I decided to try and figure out a way to get *most* of the market gains while limiting my risk overall and came up with a few different approaches that I would like feedback on. I priced these out using SPX options yesterday, implied volatility is still high so these numbers can be significantly better to enter the trade later on if volatility reduces.

Approach 1: Married Put

The simplest approach is to own the underlying and then to buy a put that will limit losses in a crash. The totally risk adverse would want to buy at the money put but (as of yesterday morning) that would cost ~8% of the amount invested, which is a significant drag. If we dropped that down, we could buy index puts at at 15% out of the money for ~3% of the invested. That means you'll trail the market gains by 3% but your max loss will be capped at 18%

Approach 2: Synthetic Long + 12 month treasury + Married Put

The next approach that basically replicates the above is to enter into a synthetic long that will replicate the market returns (but a call, sell a put). as long as the difference in the call price and the put price are equal to the strike price minus the current underlying price, the synthetic will exactly equal the gains and losses of the index but for far less capital. Playing around with the prices yesterday I could replicate a synthetic long on the SPX for a 1M portfolio expiring in Jan 2020 for about 100k, leaving me 900k to play with. The synthetic long doesn't have dividends so we'll have to invest that 900k in something easy and safe. A 12 month treasury is yielding ~2.67 %, which would generate a "dividend" of about 2.4% which would slightly beat the SPY dividends (1.8%). Throw in the 15% put from above and you've got a portfolio that will trail the market gains by about 2.4% with a max loss of 17.4%

Approach 3: Do the same as the above but this time invest the 900k in muni's or preferred shares. I can find some muni funds yielding 3.5-4% and preferred shares yielding 5-6%. Using the munis the "dividend" would be about 3.1% which basically covers the cost of the put. In this scenario you would trail the market by 1.8% (the dividends in the S&P) but your max loss would be ~16%. That doesn't seem like a bad trade off and less of a drag than say a 30-40% bond allocation would have. I used SPX options to model this so there would be some tax implications (60% LT, 40% ST) at expiration, but no reason you couldn't do this in SPY options and have the whole thing be LT gains.


I'm open to any thoughts and highlights of any mistakes in the above. Thanks!

Financial.Velociraptor

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Re: Using options to reduce sequence of return risks
« Reply #1 on: November 07, 2018, 04:35:22 PM »
I use options a great deal and couldn't have RE without them.  I generally recommend against BUYING options.  Especially for risk reduction, it makes a lot more sense to SELL them.  You get read more about this at my blog (sig line).

A strategy that focuses on either cash secured (written) puts or covered calls has lower risk than simply buying the underlying.  You will outperform in down markets and sideways markets.  You will have lesser outperformance in markets that are gradually rising and underperformance in markets that are rocketing higher. 

The opposite is true when you buy options.  You tend to underperform in calm markets with your outperformance only coming during "tail" market events.

My strategy uses a 60% equity/options component and 40% high yield (income) component composed of high yield bonds, preferreds, and "bond-like" high yield securities.  The 40% allocation kicks off enough passive income to cover my annual budget over 100%, ensuring I will never be forced to "sell low" in a market crash.  I still recommend following a trailing stop strategy for equity investments however. 


ILikeDividends

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Re: Using options to reduce sequence of return risks
« Reply #2 on: November 07, 2018, 04:53:43 PM »
Approach 1: Married Put

The simplest approach is to own the underlying and then to buy a put that will limit losses in a crash.

Unlike with SPY, you cannot "own the underlying" with index options against the SPX.  Index options are settled in cash, rather than a delivery of stock.

Quote
Approach 2: Synthetic Long + 12 month treasury + Married Put

The next approach that basically replicates the above is to enter into a synthetic long that will replicate the market returns (but a call, sell a put).

With approach 2 or 3, using SPY, you have the potential of an early assignment of your short puts.  If that happens, you would be forced to liquidate a portion of your 900K fixed income investment before maturity or go onto margin to buy the stock put to you.

Early assignment is not possible with index options because they are European style options.  Using those, you would have to make sure your fixed income position matures before option expiration, so you have cash available to settle an assignment if you are underwater on your puts at expiration, or be prepared to use margin to settle the assignment.

In either case, if you take on a million dollar synthetic stock position, then that is your risk.  Taking 900K more of that risk and investing it somewhere else means you are essentially very leveraged; 1.9 to 1.  Depending on your broker, they might not be willing to extend enough margin to even open all the positions.  Some securities aren't even marginable until held for a period of time; like 30 days or so.  The synthetic stock itself would likely be unmarginable no matter how long it was held.

I'm not entirely sure whether you could do either of these approaches without incuring a margin loan.  Best to talk to your broker before pulling the trigger.
« Last Edit: November 07, 2018, 05:24:01 PM by ILikeDividends »

ChpBstrd

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Re: Using options to reduce sequence of return risks
« Reply #3 on: November 09, 2018, 03:20:38 PM »
I moved most of my accounts into the protected put strategy this summer, at prices/implied volatility much lower than is available today. Overall, my portfolio volatility went way down but I had to watch my puts slowly bleed away about 15% of their value (thousands of $) as the market rose. When the October correction came, these losses suddenly disappeared and flipped into gains. I was excitedly rooting for a panic and 20% downturn because my IPS says I can sell my puts for a fat profit and reinvest that profit if the index tanks 20%. That didn't happen, so I held everything.

I would not recommend the synthetic long + bonds strategy because there's no real benefit compared to just going 100% long the stock. You still face the full risk of the market due to selling a put.

I'm more interested in a Long Call + Fixed Income approach. You could spend, say, 10% of your portfolio on at-the-money LEAPS call options and 90% on fixed income. Then you would have exposure to 100% of the stock market's upside and none of its downside, minus the time decay of the put (e.g. 10% loss over 2.5 years = 4%/year). You would also miss dividends of about 1.8% per year using this approach, but earn them back and then some from the fixed income part of your portfolio. Overall, you could aim to underperform the index by 3-4% per year in exchange for a massive reduction in risk.

Have you looked into a collar strategy? This involves buying the stock, protecting it with a long put, and earning back some of that cost by selling a far-OTM call. The result is limited upside and downside. When I ran the numbers on these scenarios a few months ago during low volatility, I found a position in SPY could be hedged for 2.1 years to allow 0% downside and 21% upside for a cost of 3.5% a year (subtract cost from returns to get the net). If I allowed 6% downside and 15% upside, that cost 2.2% per year.

Obviously, now is not the time to set up such a position. Wait until the VIX is below 12 again and market prices have recovered, or you'll pay too much. Make a spreadsheet with a list of 2 year index returns and average only the negative returns. This is a good guide to how statistically unlikely it is that your hedge will pay off. The value is in staying invested and investing more aggressively than you otherwise would.

These are all good plays for people like me who are worried about a near-term recession, have a history of running back and forth from risk, want to stay fully invested, and have enough money at stake to make hedging worthwhile, net of commissions. I don't recommend this to people with only a few tens of thousands to hedge or 5+ years till FIRE.

yoda34

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Re: Using options to reduce sequence of return risks
« Reply #4 on: November 10, 2018, 09:09:15 AM »
Wow a lot to take in here! Thanks everyone for the discussion. A few thoughts to keep the conversation going.

I use options a great deal and couldn't have RE without them.  I generally recommend against BUYING options.  Especially for risk reduction, it makes a lot more sense to SELL them.

I completely agree when I'm focused on income. In fact I've been selling Iron Condors into the market since September, and despite the vol in October I"m still way way ahead. The focus of my initial post wasn't income but was to try and think of a way a traditional investment in an index could be made more safe - especially in the initial years right after retirement.

Unlike with SPY, you cannot "own the underlying" with index options against the SPX.  Index options are settled in cash, rather than a delivery of stock.

Yes of course - i was just using SPX as a way to model. If you wanted to do approach one SPY, QQQ or some other index with a liquid option market would be the only way to do it.

With approach 2 or 3, using SPY, you have the potential of an early assignment of your short puts.  If that happens, you would be forced to liquidate a portion of your 900K fixed income investment before maturity or go onto margin to buy the stock put to you.

Yes excellent point. I think using SPX or XSP options would be the best way to do either approach 2 or 3.

...you would have to make sure your fixed income position matures before option expiration, so you have cash available to settle an assignment if you are underwater on your puts at expiration, or be prepared to use margin to settle the assignment.

Also an excellent point and one I hadn't considered. It would make the entire trade more difficult to pull off because you'll have to time the maturity date of the fixed income to the option expiration.

In either case, if you take on a million dollar synthetic stock position, then that is your risk.

Well yes and no. You certainly get the upside of a 1M synthetic stock position but the entire point of buying the 15% OTM put is to limit the risk. It essentially forms a debit put spread who's max loss of the short put + cost of the long position is 15% or about 150,000 MAX for the stock position.

Taking 900K more of that risk and investing it somewhere else means you are essentially very leveraged; 1.9 to 1.  Depending on your broker, they might not be willing to extend enough margin to even open all the positions.  Some securities aren't even marginable until held for a period of time; like 30 days or so.  The synthetic stock itself would likely be unmarginable no matter how long it was held.
I'm not entirely sure whether you could do either of these approaches without incuring a margin loan.  Best to talk to your broker before pulling the trigger.

Well you do take on more risk with the additional 900k investment, but that's why its in super safe fixed income. If you buy the bonds outright then you're even cushioned for potential price and interest risks inherent in an ETF and are only faced with default risk of the bonds which should be very very low.

Also margin's not an issue. The long call, long put, and long bonds are all bought out right with cash. The only margin position in the setup is the short put for the synthetic. For a 1M portfolio that would be about 4 SPX contracts short. The SPX options themselves are not margin-able but there is a certain amount of "maintenance margin" or equity you have to keep in your account to satisfy Reg T and specific broker requirements. In this case 4 short put contracts in the SPX require about 72k in equity to satisfy the Reg T requirements. If the SPX drops alot the margin requirements will of course go up - but will capped at the max loss of the debit put spread, i.e. the margin maintenance requirements will never go above 150,000.  So as long as the fixed income portion retains a marketable value of above 150k, which it always should, you'll never get a margin call.


I moved most of my accounts into the protected put strategy this summer, at prices/implied volatility much lower than is available today. Overall, my portfolio volatility went way down but I had to watch my puts slowly bleed away about 15% of their value (thousands of $) as the market rose. When the October correction came, these losses suddenly disappeared and flipped into gains. I was excitedly rooting for a panic and 20% downturn because my IPS says I can sell my puts for a fat profit and reinvest that profit if the index tanks 20%. That didn't happen, so I held everything.

Yep - at the end of last year when the VIX was at 9, I bought 2 year ATM puts for about 3%. It seemed like a good move at the time.

I would not recommend the synthetic long + bonds strategy because there's no real benefit compared to just going 100% long the stock. You still face the full risk of the market due to selling a put.

The benefit is that with the synthetic you have more capital to invest in a fixed income that will generate more than the S&P 500 dividends by quite a bit which will offset the cost of the protective put capping your max loss at 15-16%. If you just bought the stock and then bought the put at 15% OTM you would 1. have less invested in the stock overall 2. trail the market by 3-4%. In the position I set out above, assuming you can find a fixed income yielding at least 3.5%, then you trail the market by about 1.5%, have full upside (minus 1.5%) and scale down with the market (i.e. market loses 5% you only lose 6.5%), and essentially have the same max downside (15% vs 16% ish). I know we're only talking percents here but the difference between 3-4% and 1-2% with an uncapped upside seems significant to me.

I'm more interested in a Long Call + Fixed Income approach. You could spend, say, 10% of your portfolio on at-the-money LEAPS call options and 90% on fixed income. Then you would have exposure to 100% of the stock market's upside and none of its downside, minus the time decay of the put (e.g. 10% loss over 2.5 years = 4%/year). You would also miss dividends of about 1.8% per year using this approach, but earn them back and then some from the fixed income part of your portfolio. Overall, you could aim to under perform the index by 3-4% per year in exchange for a massive reduction in risk.

I've considered the long call + fixed income approach as well and it's my second favorite strategy. I had two flavors. The first is exactly what you have listed above ATM call and 90% in fixed income.  However if the market is flat or down any, even 1%, you lose your max loss of 10% minus fixed income return, let's call it 7.5%. So if the market is down 1% you lose 7.5%. Also you trail the market in gains by about 6% (my math may be off here). The approach I put out above has a higher max loss (15%) but it scales down with the market. If the market loses 1% i only lose 2.8%.

I also considered a deep (50%) ITM call with a delta of close to 1. That would cost you about 50% of your capital and the rest goes to fixed income but I didn't like the gain/loss profile.


Have you looked into a collar strategy? This involves buying the stock, protecting it with a long put, and earning back some of that cost by selling a far-OTM call. The result is limited upside and downside. When I ran the numbers on these scenarios a few months ago during low volatility, I found a position in SPY could be hedged for 2.1 years to allow 0% downside and 21% upside for a cost of 3.5% a year (subtract cost from returns to get the net). If I allowed 6% downside and 15% upside, that cost 2.2% per year.

I have, I didn't like the collar because it capped my max gain. A 21% gain for 2 years is close to a 10% annualized cap. I want full exposure to the upside.


Obviously, now is not the time to set up such a position. Wait until the VIX is below 12 again and market prices have recovered, or you'll pay too much. Make a spreadsheet with a list of 2 year index returns and average only the negative returns. This is a good guide to how statistically unlikely it is that your hedge will pay off. The value is in staying invested and investing more aggressively than you otherwise would.

Totally agree on the timing. Even though i priced it out with current prices I would wait to get better prices when the implied volatility drops back down.

Thank you again for all the thoughts and discussion. Much appreciated!
« Last Edit: November 10, 2018, 10:47:49 AM by yoda34 »

ILikeDividends

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Re: Using options to reduce sequence of return risks
« Reply #5 on: November 10, 2018, 04:51:02 PM »

In either case, if you take on a million dollar synthetic stock position, then that is your risk.

Well yes and no. You certainly get the upside of a 1M synthetic stock position but the entire point of buying the 15% OTM put is to limit the risk. It essentially forms a debit put spread who's max loss of the short put + cost of the long position is 15% or about 150,000 MAX for the stock position.

Taking 900K more of that risk and investing it somewhere else means you are essentially very leveraged; 1.9 to 1.  Depending on your broker, they might not be willing to extend enough margin to even open all the positions.  Some securities aren't even marginable until held for a period of time; like 30 days or so.  The synthetic stock itself would likely be unmarginable no matter how long it was held.
I'm not entirely sure whether you could do either of these approaches without incuring a margin loan.  Best to talk to your broker before pulling the trigger.

Well you do take on more risk with the additional 900k investment, but that's why its in super safe fixed income. If you buy the bonds outright then you're even cushioned for potential price and interest risks inherent in an ETF and are only faced with default risk of the bonds which should be very very low.

Also margin's not an issue. The long call, long put, and long bonds are all bought out right with cash. The only margin position in the setup is the short put for the synthetic. For a 1M portfolio that would be about 4 SPX contracts short. The SPX options themselves are not margin-able but there is a certain amount of "maintenance margin" or equity you have to keep in your account to satisfy Reg T and specific broker requirements. In this case 4 short put contracts in the SPX require about 72k in equity to satisfy the Reg T requirements. If the SPX drops alot the margin requirements will of course go up - but will capped at the max loss of the debit put spread, i.e. the margin maintenance requirements will never go above 150,000.  So as long as the fixed income portion retains a marketable value of above 150k, which it always should, you'll never get a margin call.

Ah, yes.  I completely overlooked the hedging feature of the married puts.  I stand corrected.

There is still potentially yet another timing aspect to putting the trade on.  At Schwab (my broker) mutual funds and even some ETFs aren't marginable for 30 days.  I'm not sure how such rules are determined, and I don't know if such restrictions apply to individual bonds.

But this means, depending on your choice of fixed income vehicle, you would have to keep 150K (max possible margin maintenance) in cash or cash equivalents, starting the fixed income position at 750K, and keeping it for 30 days before putting the final 150K into fixed income.  After 30 days, the initial 750K invested will satisfy more than enough margin maintenance to avoid any possible margin call.

Not a show stopper, but it's another something you'd have to pay attention to.
« Last Edit: November 10, 2018, 05:36:51 PM by ILikeDividends »

SnackDog

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Re: Using options to reduce sequence of return risks
« Reply #6 on: November 10, 2018, 05:21:38 PM »
The problem is the market timing requirement for this strategy.  If you do this at the wrong time and the market rises dramatically, you will miss out, weakening your position for the next drop.  You may as well just heavy into treasuries if SOR  scares you.

yoda34

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Re: Using options to reduce sequence of return risks
« Reply #7 on: November 10, 2018, 05:30:32 PM »
The problem is the market timing requirement for this strategy.  If you do this at the wrong time and the market rises dramatically, you will miss out, weakening your position for the next drop.  You may as well just heavy into treasuries if SOR  scares you.

I'm not sure I understand (and there could easily be something I'm missing here) but if the market rises dramatically the strategy I laid out would capture all the gains of the market rise minus 1.8% (ish). So if the market goes up 20%, I'll capture 18.2%. I don't see that as a major issue given the downside protection.

yoda34

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Re: Using options to reduce sequence of return risks
« Reply #8 on: November 10, 2018, 05:33:30 PM »

There is still potentially yet another timing aspect to putting the trade on.  At Schwab (my broker) mutual funds and even some ETFs aren't marginable for 30 days.  I'm not sure how such rules are determined, and I don't know if such restrictions apply to individual bonds.

But this means, depending on your choice of fixed income vehicle, you would have to keep 150K (max possible margin maintenance) in cash or cash equivalents, starting the fixed income position at 750K, and keeping it for 30 days before putting the final 150K into fixed income.  After 30 days, the initial 750K invested will satisfy more than enough margin maintenance to avoid any possible margin call.

Not a show stopper, but it's something you'd have to pay attention to.

Another excellent point and not something I've considered. I use Interactive Brokers and I'm not sure what the policy is on bonds. I know for the margin maintenance the positions must be considered "liquid" by the SEC. I don't know if bonds meet that criteria.

I think the bigger issues for me as I've considered this over the past weeks (and now with the insights from the folks on this thread) is that the SPX options will have tax implications which WILL cause a further drag on the strategy and SPY options have the possibility of early assignment in a downturn which would force an unwinding of most of the positions to meet. Neither of those seems attractive to me and I'm not sure how to overcome those limitations.
« Last Edit: November 10, 2018, 05:36:42 PM by yoda34 »

ChpBstrd

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Re: Using options to reduce sequence of return risks
« Reply #9 on: November 10, 2018, 10:38:35 PM »
Whatever happens, don't rationalize doing something stupid like this guy in 2007:

https://www.bogleheads.org/forum/viewtopic.php?t=5934

ILikeDividends

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Re: Using options to reduce sequence of return risks
« Reply #10 on: November 10, 2018, 10:53:51 PM »

I think the bigger issues for me as I've considered this over the past weeks (and now with the insights from the folks on this thread) is that the SPX options will have tax implications which WILL cause a further drag on the strategy . . .

Another incremental drag (albeit a smaller drag) is that 16.7% (150K) of the targeted 900K fixed income position will be earning far less than the targeted fixed income return for at least 30 days.

« Last Edit: November 10, 2018, 11:09:53 PM by ILikeDividends »