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!