buying index puts vs dollar cost averaging

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Dxbinvestor
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buying index puts vs dollar cost averaging

Post by Dxbinvestor »

Friend was asking about this.

If one has a lump sum, what does the board think about going all in now and buying index puts as insurance vs dollar cost averaging?

I checked at the money Jan 2015 SPY puts and they cost a bit over 6% of the current share price.
madbrain
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Re: buying index puts vs dollar cost averaging

Post by madbrain »

Buying index puts makes sense in those cases (and probably others) :
1) speculation that the market will go down . Remember puts can expire worthless and are subject to up to 100% principal loss
2) buying insurance to protect an existing gain instead of outright selling

If you have a lump sum to invest, presumably you are not sitting on a gain to protect. Thus you are not in case 2).
You must then be in case 1) . Bogleheads don't believe in being able to time the market. So you are not going to get a recommendation to buy puts as investment.

Perhaps you meant to invest partly in the index and partly in puts. But that doesn't really make sense unless you have a gain. That would be like buying a stock and then shorting it.
Choose a proper asset allocation for your portfolio instead.

As insurance against a market downturn, puts are generally expensive.

I just checked on fidelity and SPY $180 Jan 17 2015 puts last traded at $11.48 . Which means 6.3% of the strike.
But SPY is actually at $182.93 . So it's not protecting you completely on the downside, only about 98.3% which is pretty good.

6.3% for 98.3% downside protection seems like a bargain compared to what puts usually cost, meaning the market thinks there is not much downside and that the puts are likely to expire worthless.
If they expire worthless, you will lose that 6.3% however.

But you need to compare that with the tax cost of selling part of your position that's presumably in the money, vs the cost of buying the puts assuming they expire worthless.

Let's say you have a position in SPY and are sitting on a 30% gain . Your combined tax bracket is 35%. If you sold your entire position today, you would pay about 30% x 35% = 10.5% in taxes.
Instead of buying the puts, you could sell 60% of your SPY and just pay the taxes on that. It will cost you the same 6.3%.
If your tax bracket is much higher, then these particular puts might make sense. But only if you already have a gain that you are trying to protect. Not if all you have is a lump sum in cash.
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Dxbinvestor
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Re: buying index puts vs dollar cost averaging

Post by Dxbinvestor »

Thx for the input! I was thinking the puts might not be a bad buy because market is at record high in real terms, it could keep running further obviously.. so 6% seems like you're getting a bit of a free shot. Worst case market stays flat and you are down 4% (the 6% minus your dividends), otherwise you win either way, those were my thoughts anyway.. and if there is any volatility in 2014 you might be able to profit off the puts in the meantime if they spike... a 5% drop in a week will get you a pretty good profit on the ATM ones.
Akiva
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Re: buying index puts vs dollar cost averaging

Post by Akiva »

Dxbinvestor wrote:Friend was asking about this.

If one has a lump sum, what does the board think about going all in now and buying index puts as insurance vs dollar cost averaging?

I checked at the money Jan 2015 SPY puts and they cost a bit over 6% of the current share price.
Generally speaking buying index options doesn't pay and I see no reason to think that it would pay here either.

If you wanted to get some downside protection, you could sell out of the money calls and buy equivalent out of the money puts. (This is a net-zero transaction.) Assuming you have an underlying stock position, this will cap your gains and limit your losses. But I'm not really sure that this is a good idea either.
madbrain
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Re: buying index puts vs dollar cost averaging

Post by madbrain »

Dxbinvestor wrote:Thx for the input! I was thinking the puts might not be a bad buy because market is at record high in real terms, it could keep running further obviously..
There have been many record highs in the past, too. Bogleheads invest in the equity markets because they believe it will go up over the long term.
Of course, it doesn't go straight up in a linear fashion. There are ups and downs. Unfortunately, there is no accurate way to predict what the ups and down of the market will be.
If you believe the market will go up in the long term, then buying puts doesn't make sense. Certainly, it doesn't as a long-term investment. Puts expire and are short-term by definition. Even the LEAPS only go a few years out.
so 6% seems like you're getting a bit of a free shot. Worst case market stays flat and you are down 4% (the 6% minus your dividends), otherwise you win either way, those were my thoughts anyway.. and if there is any volatility in 2014 you might be able to profit off the puts in the meantime if they spike... a 5% drop in a week will get you a pretty good profit on the ATM ones.
Well, the dividends could in theory go away and the market could also stay flat, so that would be the worst case, and you would lose the 6.3%. But it's not a particularly likely scenario.
Good luck predicting which week the market will drop 5% and buying the right puts. You will need luck to make a profit.
SpaceCowboy
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Re: buying index puts vs dollar cost averaging

Post by SpaceCowboy »

Akiva wrote:If you wanted to get some downside protection, you could sell out of the money calls and buy equivalent out of the money puts. (This is a net-zero transaction.) Assuming you have an underlying stock position, this will cap your gains and limit your losses. But I'm not really sure that this is a good idea either.
This type of cashless collar isn't usually a good investment with index options due to skewness. The implied volatility, and hence price, of the lower strike which is being bought for protection is higher than that of the upper strike, which is being sold. Part of this is due to the popularity of buying puts for portfolio insurance. Cashless collars are more popular with large concentrated individual stock positions.
Akiva
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Re: buying index puts vs dollar cost averaging

Post by Akiva »

rrppve wrote:
Akiva wrote:If you wanted to get some downside protection, you could sell out of the money calls and buy equivalent out of the money puts. (This is a net-zero transaction.) Assuming you have an underlying stock position, this will cap your gains and limit your losses. But I'm not really sure that this is a good idea either.
This type of cashless collar isn't usually a good investment with index options due to skewness. The implied volatility, and hence price, of the lower strike which is being bought for protection is higher than that of the upper strike, which is being sold. Part of this is due to the popularity of buying puts for portfolio insurance. Cashless collars are more popular with large concentrated individual stock positions.
Yeah. Maybe I should have spelled out why I didn't think this was a good idea. There are lots of other things you could do to cap your losses, but they are all similarly bad for similar reasons. The only one I've ever seen that might be workable is buying out of the money calls on the VIX (b/c the VIX will go up if the market goes down), but I'm skeptical of even that. (You can also use VIX futures to hedge, but there's negative roll and some convergence issues you have to worry about. So while this seems to work reasonably well in other markets, b/c of the way the VIX is, it's much trickier to do here in the US.)

So the bottom line is that the OP's friend should just pick a reasonable allocation and invest according to the plan. This other stuff is not likely to help, and if you thought it would, then you'd make it part of your allocation instead of just doing it as a one-shot thing.
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Dxbinvestor
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Re: buying index puts vs dollar cost averaging

Post by Dxbinvestor »

Yeah, he was just nervous of jumping in all at once so we were brainstorming things he could do. I'm aware that all 'studies' say all in vs DCA over a year or so with a lump sum is better, but people are people, (nervous, timid, etc) and I thought maybe the puts would quell his fears. Worst case lose 4%, but if market goes up another 15-20%, he doesn't lose that while he's toeing in gradually.
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Phineas J. Whoopee
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Re: buying index puts vs dollar cost averaging

Post by Phineas J. Whoopee »

Dxbinvestor wrote:Yeah, he was just nervous of jumping in all at once so we were brainstorming things he could do. I'm aware that all 'studies' say all in vs DCA over a year or so with a lump sum is better, but people are people, (nervous, timid, etc) and I thought maybe the puts would quell his fears. Worst case lose 4%, but if market goes up another 15-20%, he doesn't lose that while he's toeing in gradually.
First paragraph deleted because I misunderstood Dxbinvestor.

Historically the market has gone up about 2/3 of the days. Past performance does not guarantee future results. Expectantly it's better to go all in now rather than to wait.

If your friend is nervous, it may be because h/er/is proposed asset allocation is too aggressive: that is to say, has too much in risky assets (usually equities); and too little in less-risky assets like fixed income. If the problem is an overly-aggressive asset allocation going in gradually is no better than going in all at once. It's inappropriate regardless of the timing. As a stock market sage has written: "Sell to the sleeping point."

If that's not the case, but your friend's emotions are preventing h/er/im from investing, it's better to go in slowly than not at all. About 1/3 of the market days have been down. Not investing at all means gaining on 0/3 of the days.

If the planned allocation is appropriate the most rational move is to invest in it immediately. Doing so does not guarantee a better outcome than any other course of action. It merely improves the odds.

But going in a little at at a time is better than not going in at all.

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Re: buying index puts vs dollar cost averaging

Post by Fundhunter »

What are the costs of "puts"? That is money lost for sure.

He should learn to get less timid and do neither, but jump in with all of it. He can diversify potential downside risk by diversifying equities with fixed income and less risky assets. TIPS often perform opposite of stocks, although to a lesser degree.
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grabiner
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Re: buying index puts vs dollar cost averaging

Post by grabiner »

Puts only limit your losses to a specific amount if you exercise them, or sell them and get out.

For example, suppose you buy at $100 and buy a put at $80. If the market drops to $60 when the put is ready to expire, you can exercise the put to sell at $80, or sell the put for $20 and sell the stock for $60. Either way, you have limited your losses to 20%.

This works if you plan to sell the stock by the put expiration anyway. Otherwise, once you have taken your 20% loss (or a loss of less than 20% and let the put expire worthless), you haven't limited your losses to 20%, because you will remain invested somehow, with the potential for further losses. If you buy another put 20% below the new market price, you could have a 36% cumulative loss when that put expires.

Therefore, if you are investing for the long term, it makes more sense to limit your risk by not holding 100% stock, rather than by using puts.

And the purpose of dollar-cost averaging is to become better acquainted with risk, so that you are less likely to invest beyond your risk tolerance. As a long-term investor, if you can tolerate a 50% loss (and many can and did in 2007-2009) because you have time to wait for the market to recover and won't panic, you can have a stock-heavy portfolio
Wiki David Grabiner
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