The Money Mustache Community
Learning, Sharing, and Teaching => Investor Alley => Topic started by: brooklynguy on March 05, 2015, 11:43:01 AM
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Can someone who is knowledgeable about derivative instruments please let me know how much it would cost to purchase S&P 500 Index Super LEAPS with a five-year expiration date at various strike price levels? Are they even available for purchase to retail investors? I made a half-hearted attempt to find out myself by researching quotes on the CBOE's website (http://www.cboe.com/delayedquote/quotetable.aspx), but derivatives make my head spin and I can barely make heads or tails out of the quote information, so that attempt quickly ended in vain.
I'm sure the concept of using hedging instruments as "stash insurance" for the sensitive early years of retirement has come up before, but I wanted to find out exactly how expensive that insurance would be. My sense is that, while it may be expensive, it probably costs less than the cost of shoring up your portfolio to a level that would provide the equivalent amount of downside protection, and can therefore accelerate the retirement date for the prospective early retiree who already has "enough" but is working OMY (or two or three MYs...) to obtain buffer protection primarily against sequence of returns risk.
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"Super LEAP" was a new term to me, but I've educated myself on options pretty well, so here's my attempt to answer.
[BTW, I've also decided they're generally not for me and have been super careful when I have played around with them. In all honesty, if you can't read an option chain, you probably shouldn't be shopping for 5-year derivatives contracts. That's not meant to be snarky at all, options are like flammable liquids, possibly useful in the right situations, but they'll burn the house down if you don't know what you're doing.]
I can't actually find quotes for options dated beyond December 2017. Not on my brokerage website, or on the CBOE's site. Here's what I found for a couple of strike prices for that date:
For downside protection, you're either talking about buying a put or selling a covered call, lets look at some puts...
SPY Puts for 12/15/2017
Strike: $210 (at the money)
Ask: $27.18
S:$190 (~10% drop from today)
A: $19.80
S: $170 (~20% drop from today)
A: $13.50
S: $145 (~30% drop from today)
A: $8.88
The SPY ETF shares are valued at 10% of the S&P Index. The option price is quoted per-share, but each contract is for 100 shares. So if you bought one contract for the $210 strike, it would cost you $2,718, and it gives you the right to sell 100 shares at the strike.
So, let's say you've got $210,000 invested in the S&P, and you want puts to hedge all of it. You'll need 10 put options, which give you the right to sell 1,000 shares of SPY to someone in December 2017.
If you buy 10 contracts at a strike of $190, that costs you (10 contracts) x (100 shares) x ($19.80) = $19,800
Now skip ahead to expiration date, and look at some possible results:
If the S&P is up 20%, your shares are worth $252,000 ($210,000 x 1.20), and your option is worth nothing. Your net gain is ($252,000) - ($210,000) - ($19,800) = +$22,200
If the S&P is flat, your shares are worth $210,000, and your option is worth nothing. Your net gain is ($210,000) - ($210,000) - ($19,800) = -$19,800
If the S&P is down 20%, your shares are worth $168,000 ($210,000 x 0.80), but your option lets you sell them for $190,000 ($190 strike x 100 shares x 10 contracts). Your net gain is ($190,000) - (210,000) - ($19,800) = -$39,800
If the S&P is down 50%, your shares are worth $105,000, but your option still lets you sell them for $190,000. Your net gain is ($190,000) - ($210,000) - ($19,800) = -$39,800 (note that this is the same as the previous gain)
On the other hand, without the option, these are your gains under the same circumstances:
Up 20% = +42,000
Flat = +$0
Down 20% = -$42,000
Down 50% = -$105,000
So, at the $190 strike price you have capped your losses at about 10% over 2 years but it costs you 10% to do so.
BTW, if you want to learn the basics of options, I recommend the "Blue Collar Investor". His game is covered calls and he wants to sell you his option-picking service, but his basic info is thorough and easy to understands. He's got a book, but most of what he's written is available on his blog if you want to search through it.
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As Dr A says you can buy some protection against falling values through buying puts but this comes at a considerable price. What's more if you rationally believe that in the long run the market will go up, the premium you pay will act as a significant drag to your portfolio.
Bear in mind also that this protects you to an extent against a sudden significant drop in values, which is the nightmare scenario most people imagine. However the real risk in terms of sequence of return is probably an extended period say 10 years of low returns - these may even be positive in real terms but just not enough to replenish the portfolio.
Disclaimer: I work in the banking industry in an Internal control role so I have some exposure to how these things work but am not an expert and am certainly not familiar with how they can be used by retail investors.
Something that might work better, and which some funds managers do, is selling covered calls. Imagine you manage a pension fund and your bonus depends on making a 5% return per year (ignoring inflation for the purposes of this exercise). If the price today is 100 and you can earn a premium of 1 by selling a call struck at 106 you can improve your chances of hitting your bonus because you're already up by the 1% premium you collect. Sure if the price soars to 110 you only make 7 (ie the upside up to 106 plus your 1% premium) but you already collected your bonus at 104 (plus your premium) so what do you care? You could argue that managing a withdrawal portfolio is in some ways similar to this, but bear in mind the 4% swr is calculated as an average any way, rather than needing a return of 4% every year.
This is not an approach I would recommend or advocate to anyone - far better to keep it simple and retain some flexibility to cut costs, increase income or both in the event of a run of bad years
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Thanks for the detailed response! I have no interest in options trading; I was just trying to determine the cost of effectively establishing a floor on your portfolio's value (which, as you described, can be accomplished by purchasing puts). Many prospective early retirees attempt to mitigate the risk of encountering a bad sequence of returns (where the first few years after retirement are the most critical) by (in all likelihood) grossly over-saving. If the cost of the puts (which is equivalent to the cost of the premiums on an insurance policy against a market crash in the early years of your retirement) were cheap enough, that could be a better option for someone who is only continuing to work in order to mitigate sequence of return risk. But from your numbers, it sounds like the cost of the "insurance" is too high for that to be a viable option.
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What's more if you rationally believe that in the long run the market will go up, the premium you pay will act as a significant drag to your portfolio.
Yes, I recognize that. I was thinking about this as a potential cure for one manifestation of OMY syndrome: the person who saved up what should by all accounts be "enough" but decides to continue working to further bolster their portfolio against bad outcomes. If the cost of portfolio insurance were a fraction of the number of dollars needed to shore up the portfolio to provide the same level of downside protection during the period of the insurance policy, the person could retire sooner.
Bear in mind also that this protects you to an extent against a sudden significant drop in values, which is the nightmare scenario most people imagine. However the real risk in terms of sequence of return is probably an extended period say 10 years of low returns - these may even be positive in real terms but just not enough to replenish the portfolio.
Yes, this is true, and it may mean that none of the available options for "portfolio insurance" are a good substitute for simply increasing the portfolio size even if they were cheap enough.
far better to keep it simple and retain some flexibility to cut costs, increase income or both in the event of a run of bad years
Yep, flexibility on the back-end is always important. But my idea of using portfolio insurance in lieu of additional assets was only looking at the front-end; it wouldn't change your ability to employ flexibility on the back-end.
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If the cost of the puts (which is equivalent to the cost of the premiums on an insurance policy against a market crash in the early years of your retirement) were cheap enough, that could be a better option for someone who is only continuing to work in order to mitigate sequence of return risk. But from your numbers, it sounds like the cost of the "insurance" is too high for that to be a viable option.
I think that's right. The possibility of a -20% two year stretch is not tiny, so if I'm going to insure you against it I expect a sizable premium.
I would agree that a covered call strategy might align better with what your thinking, but I went with the simpler example. I'm curious now, so I may do a post tomorrow to work out those numbers if I have time.
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Puts are insurance, and as with most insurance, the people who provide it add on a profit margin to compensate for the risk transfer.
They can be useful in some situations.
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Puts are insurance, and as with most insurance, the people who provide it add on a profit margin to compensate for the risk transfer.
They can be useful in some situations.
Yes, this would be one of those situations, if only the "stash insurance" were cheap enough. I was hoping this thread would spur some brainstorming about creative ways to insure against sequence of returns risk beyond the brute force method of asset-accumulation for the "tail of the tail" of worst-case scenarios most commonly employed by extremely risk-averse aspiring early retirees, but so far I haven't gotten many takers.
Maybe I should change the title of the thread to remove the reference to derivatives, which might be scaring people away (I know it would do so in my case, if I weren't the OP...).
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I completely understand where you're coming from - however much you accumulate you can never be 100% confident that you'll never deplete it under any scenario. Sure you can get close, but for someone who is really conservative like my wife even 99% may leave you with a nagging doubt.
The approach we're taking is a graduated retirement; rather than trying to get a super low swr up front were shooting for 4% on a fairly low budget, compared to our current lifestyle. Then having reached that point and retired from our careers we plan to aim not to spend from our portfolio for the first few years, say between 5-10 years. This gives the portfolio a chance to accumulate further, and more importantly you get to see whether it will grow exponentially before you decide to start living from it. Before the Internet Retirement Police pull me over there's lots of ways to do this, some we've considered include volunteering in a third world county for a year or two where you can do some good and have your modest expenses covered, traveling round low col areas in south America or Asia for a few years. If you want to stay at home you can choose to do low stress minimum wage work that fits your own passion eg book store, good range, sailing instructor. Our your can do higher paid professional work for a few hours a day or a few months a year.
This gives you a lot of robustness as in the event of a downturn early on you're not depleting your portfolio and could even look to ramp up your earnings to get extra cash to invest. Sure you're not 100% retired but by going from 60 or 75% savings rate in a high cost area during accumulation phase to 0% savings rate in a low cost area you are massively cutting the amount you need to earn and so improving your quality of life. Importantly you may even be able to quit your party time job (if you decide to) sooner than you would have been ready to quit your high paid, hight stress job that you can't quite bring yourself to quit because of omy syndrome.
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You won't find equity index puts priced cheap anymore. That ended in the crash of 1987. You'll be paying the true odds of the market crashing, plus some profit to the market maker. The lowered volatility from missing the crashes is going to come at a high cost from the premiums you pay when the market doesn't crash. Google "tail risk insurance"
I'd suggest if you want lower portfolio volatility- to just allocate less to stocks vs. bonds.
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Short the call and long the put. It'll cover some of the debit put premium but not all. Notice that the OTM calls are worth less than the OTM puts.
http://www.theoptionsguide.com/volatility-smile.aspx
You can always follow this method:
http://lifeinvestmentseverything.blogspot.com/2012/01/rolling-your-own.html
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Quite a few institutions use trend following managed futures hedge funds for this. It's uncorrelated to stocks and bonds, and usually offers 'crisis alpha' during equity bear markets/crashes. The fact that it has long term returns similar to stocks is icing on the cake.