Author Topic: Minimizing Sequence of Return Risk - Long-Term Put Options  (Read 2370 times)

Parkingmeter

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Minimizing Sequence of Return Risk - Long-Term Put Options
« on: June 04, 2016, 02:19:42 PM »
I've seen lots of articles discussing minimizing downside risk with purchasing covered puts, even long term (LEAPS) with 1+ year timeframes. There's even good traffic for index leaps, specifically for the S&P500.

However, I haven't seen any of this address Sequence of Return Risk in particular. As the first few years' performance are the strongest indicator of overall success, with heavy losses in the first few years being the primary sign of portfolio failure, it might make sense to pay a premium in order to limit the risk of this happening.

While considering this, I've noticed a few issues:
The only index I see with good activity on the options market, at least available publicly, is SPY - the S&P 500 etf. There's some activity on VWO, the emerging markets ETF, however, I don't see any good options for hedging VTI (a total US market ETF) or VXUS (total non-US international index). This makes it significantly less useful, especially when you consider that the S&P500 tends to do better in downturns than VTI.

Secondly, this puts you at greater risk of a flat/very slightly increasing market over the first few years. As you've added a ~3% (guesstimate) cost to hedge against a loss of >5-10% in the market, you would have an effective 7% withdrawal rate instead of the standard 4%.
This could be covered somewhat by limiting your upside, selling covered calls. I've done less research on this side, so I'd love some input on how much of this cost could be recuperated this way.

The final issue is deciding how long this strategy would be prudent. Set a number of years? Set an inflation-adjusted portfolio value that you would consider "safe" to stop paying the premium?

Has anyone else here considered something like this, and resolved any of the issues mentioned above (or that I'm failing to see)?

forummm

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Re: Minimizing Sequence of Return Risk - Long-Term Put Options
« Reply #1 on: June 04, 2016, 03:08:00 PM »
BTW, covered puts means you are selling (short) the puts but have cash to cover being assigned. That's not what you actually mean in this case.

This is an interesting idea. But I don't think it's likely to make sense.

It doesn't matter if you have all your money in VTI but then get SPY puts. If the market is tanking to the point that sequence of returns is a problem, then SPY will be tanking as well (and SPY is essentially 75% of VTI anyway). So if you were to do it, then I would say that SPY leaps is definitely the way to go--even if that's the only thing in your brokerage account and your other holdings are elsewhere.

However, this strategy is not free. An at-the-money ($210) SPY put for Dec 18 costs $27. So whatever portion of your portfolio you were insuring would cost about 13% in insurance premiums. You'd need the market to go down 13% to break even on the "investment" of buying the puts.

A 4% SWR is already incredibly safe. If you were to insure this further, you'd have to work even longer and most likely would have those options expire worthless (so 13% of your money would be gone if you insured the whole portfolio).

I wouldn't do this. And even if you did, I wouldn't trade away your upside (via covered calls) to pay for this  (a huge uptick in the market is what would help ensure your portfolio won't hit one of those rare failure scenarios).

beltim

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Re: Minimizing Sequence of Return Risk - Long-Term Put Options
« Reply #2 on: June 04, 2016, 03:40:39 PM »
However, this strategy is not free. An at-the-money ($210) SPY put for Dec 18 costs $27. So whatever portion of your portfolio you were insuring would cost about 13% in insurance premiums. You'd need the market to go down 13% to break even on the "investment" of buying the puts.

As forummm suggested, the key to this strategy is pricing.  I don't think an at-the-money put is where this strategy would be useful, although I suspect the cost would indeed be too high for this to be a great strategy.  A put ~10% out of the money would cost about 4.5% for the next year (Jun 2017 Put @ 190 currently trading for ~9).

According to my data, the S&P falls more than 10% in about 12% of all years.  And it falls more than 15% (where the puts could actually cover the full portfolio loss) in about 7% of all years.

Comparing 4.5% to 7% suggests that this strategy is workable.  However, that's based on current option prices, and times of high volatility will increase option prices significantly.  I don't know of any good option pricing databases to see if this strategy would work over the long term.

brooklynguy

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Re: Minimizing Sequence of Return Risk - Long-Term Put Options
« Reply #3 on: June 04, 2016, 04:19:00 PM »
Here's a thread I had started on the same topic that had some good discussion:

http://forum.mrmoneymustache.com/investor-alley/'stash-insurance'-seeking-info-from-derivatives-buffs/

Parkingmeter

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Re: Minimizing Sequence of Return Risk - Long-Term Put Options
« Reply #4 on: June 05, 2016, 01:04:23 PM »
Here's a thread I had started on the same topic that had some good discussion:

http://forum.mrmoneymustache.com/investor-alley/'stash-insurance'-seeking-info-from-derivatives-buffs/

Thanks, there is some interesting information and discussion. I missed that one on my search.
Especially interesting the idea of using CD's and calls as a fixed-bottom portfolio. Unfortunately with the crazy low interest rate environment and the poor tax implications, especially if while building your stash you built up a decent sized non-sheltered brokerage with a low cost basis, it's a less than ideal solution.
I'd also be interested in seeing some numbers where you overexpose your equity by allowing some (5-10%?) loss during down years.

It doesn't matter if you have all your money in VTI but then get SPY puts. If the market is tanking to the point that sequence of returns is a problem, then SPY will be tanking as well (and SPY is essentially 75% of VTI anyway). So if you were to do it, then I would say that SPY leaps is definitely the way to go--even if that's the only thing in your brokerage account and your other holdings are elsewhere.

However, this strategy is not free. An at-the-money ($210) SPY put for Dec 18 costs $27. So whatever portion of your portfolio you were insuring would cost about 13% in insurance premiums. You'd need the market to go down 13% to break even on the "investment" of buying the puts.

A 4% SWR is already incredibly safe. If you were to insure this further, you'd have to work even longer and most likely would have those options expire worthless (so 13% of your money would be gone if you insured the whole portfolio).

I wouldn't do this. And even if you did, I wouldn't trade away your upside (via covered calls) to pay for this  (a huge uptick in the market is what would help ensure your portfolio won't hit one of those rare failure scenarios).

As mentioned by beltim, the idea isn't to insure against at-the-money drops, but instead to cover against the steeper declines at a lower cost. Again, the idea is not meant to be executed long-term, so you're trading away upside to minimize the cost does cause a negative impact on those years where there would have been a huge upside. However, I would think having a +5% year instead of a +20% year is less likely to result in a failure than walking into a -20%year.
I'd think if you employed this type of strategy ~3-7 years, you'd reduce the "amazing" performances where you end up with 3x+ inflation-adjusted value, but also remove some of the failures.

It'd be very interesting if CFiresim was capable of testing it. Is anyone aware of a more flexible tool, or just one that has access to options data/strategy?

I was hoping someone would have experience regarding the S&P500 issue. I don't have any specific numbers in front of me, but the S&P500 tends to fall less during the large downturns than VTI, and especially less than Mid and Small Cap indexes. This means that the S&P500 put option is going to underperform it's "name" value if you run a standard VTI index, and significantly underperform if you prefer a Small-Mid/Tilt portfolio.

maizeman

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Re: Minimizing Sequence of Return Risk - Long-Term Put Options
« Reply #5 on: June 05, 2016, 02:39:04 PM »
The worst periods for simulated 4% guided retirement portfolio tend to be those that start a few years before the 1973-1974 stock market collapse. The stock market dropped 42% over two years (52% when accounting for inflation).

My two concerns with this strategy would be that 1) one year out isn't far enough to act as a meaningful hedge. The two worst years to have retired early were 1966 and 1969, which suggests one would really one would need downside risk protection over a period closer to a decade 2) Inflation is a big part of the risk. In 1974 inflation was up to 11% a year. An options-based strategy doesn't help in a scenario where the market is flat in nominal dollars, but declining 5-10% a year in "real" dollars which, from historical data, seems to be the most likely failure scenario.

NorCal

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Re: Minimizing Sequence of Return Risk - Long-Term Put Options
« Reply #6 on: June 05, 2016, 02:46:19 PM »
This sounds like a very complex way to solve a simple problem.  If the market is generally high when you retire, directly buy short term bonds (not bond funds) to cover the first 3-5 years of retirement.  These bonds should be timed to mature as you need the money.

In good stock market years, you can add a year or two of bonds maturing at the right point in time, while keeping everything else in stocks.

In really bad years for the stock market, you can choose to withdraw nothing from your equity portfolio.

Roland of Gilead

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Re: Minimizing Sequence of Return Risk - Long-Term Put Options
« Reply #7 on: June 05, 2016, 04:39:28 PM »
BTW, covered puts means you are selling (short) the puts but have cash to cover being assigned. That's not what you actually mean in this case.

This is an interesting idea. But I don't think it's likely to make sense.

It doesn't matter if you have all your money in VTI but then get SPY puts. If the market is tanking to the point that sequence of returns is a problem, then SPY will be tanking as well (and SPY is essentially 75% of VTI anyway). So if you were to do it, then I would say that SPY leaps is definitely the way to go--even if that's the only thing in your brokerage account and your other holdings are elsewhere.

However, this strategy is not free. An at-the-money ($210) SPY put for Dec 18 costs $27. So whatever portion of your portfolio you were insuring would cost about 13% in insurance premiums. You'd need the market to go down 13% to break even on the "investment" of buying the puts.

A 4% SWR is already incredibly safe. If you were to insure this further, you'd have to work even longer and most likely would have those options expire worthless (so 13% of your money would be gone if you insured the whole portfolio).

I wouldn't do this. And even if you did, I wouldn't trade away your upside (via covered calls) to pay for this  (a huge uptick in the market is what would help ensure your portfolio won't hit one of those rare failure scenarios).

Another option (no pun) would be to sell the Dec 18 $210 put for $27 and thus lock in a 13% return over your peers in a flat market scenario.  As you point out, in order to beat this return, the market would have to shoot up 13% (somewhat less because of dividends).


forummm

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Re: Minimizing Sequence of Return Risk - Long-Term Put Options
« Reply #8 on: June 05, 2016, 06:17:29 PM »
BTW, covered puts means you are selling (short) the puts but have cash to cover being assigned. That's not what you actually mean in this case.

This is an interesting idea. But I don't think it's likely to make sense.

It doesn't matter if you have all your money in VTI but then get SPY puts. If the market is tanking to the point that sequence of returns is a problem, then SPY will be tanking as well (and SPY is essentially 75% of VTI anyway). So if you were to do it, then I would say that SPY leaps is definitely the way to go--even if that's the only thing in your brokerage account and your other holdings are elsewhere.

However, this strategy is not free. An at-the-money ($210) SPY put for Dec 18 costs $27. So whatever portion of your portfolio you were insuring would cost about 13% in insurance premiums. You'd need the market to go down 13% to break even on the "investment" of buying the puts.

A 4% SWR is already incredibly safe. If you were to insure this further, you'd have to work even longer and most likely would have those options expire worthless (so 13% of your money would be gone if you insured the whole portfolio).

I wouldn't do this. And even if you did, I wouldn't trade away your upside (via covered calls) to pay for this  (a huge uptick in the market is what would help ensure your portfolio won't hit one of those rare failure scenarios).

Another option (no pun) would be to sell the Dec 18 $210 put for $27 and thus lock in a 13% return over your peers in a flat market scenario.  As you point out, in order to beat this return, the market would have to shoot up 13% (somewhat less because of dividends).



I imagine you are thinking that if you have $100k you are looking to "insure", that you would hold this 100k in short term treasury bonds, and sell 100k worth of SPY puts. For the OP's benefit, I'll describe the scenario. Using current dividend levels, you would be locking in a maximum of 13% return over 2.5 years (about 5% per year) but would retain almost all the downside. So if the market went down 50% during that timeframe, you'd have roughly $63k ($13k in premiums and shares worth $50k that you paid $100k for) after you were assigned the shares. On the other hand, if the market went up 50% during that time frame, you'd only have $113k (instead of roughly $154k if you just held the index shares).

So your losses are slightly decreased, but your possible gains are capped.