Using options in a retirement portfolio

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NeedLotsOfHelp
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Using options in a retirement portfolio

Post by NeedLotsOfHelp » Tue Dec 04, 2018 8:30 pm

I am in my mid-50s thinking about retirement. I am in the process of switching my financial advisor/money manager. I am a little late to the game in understanding best investment practices. My big fear is sequence of return risk in retiring at a young age. In my search for financial advisors I have come across many different philosophies to address this risk.

One advisor believes in the overall efficiency of the market and following a long-term strategy with low-cost index funds and asset allocation to address risk while keeping funds in cash for money needed immediately so that I would not have to sell low if the market starts dramatically falling

Another advisor totes high quality dividend paying stocks and bond ladders

Another advisor promotes options as an insurance policy against a down market and believes that options can protect a portfolio the best in a down market

Help!? How on earth to decide on the right strategy/right advisor?

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David Jay
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Re: Using options in a retirement portfolio

Post by David Jay » Tue Dec 04, 2018 9:09 pm

Welcome to the forum.

You are going to find a lot of support here for #1. Because it is who we are. Here is the Boglehead philosophy: https://www.bogleheads.org/wiki/Boglehe ... philosophy
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

NeedLotsOfHelp
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Re: Using options in a retirement portfolio

Post by NeedLotsOfHelp » Tue Dec 04, 2018 10:35 pm

Thanks for replying. I am happy to be here. While I understand and believe in the Boglehead philosophy, I guess what I’m really asking might be:

Is investing while in retirement or the distribution phase different from investing in the accumulation phase?

The other two advisers also believe in low-cost index funds in the accumulation phase but feel that a different strategy is needed for retirement…

They are very persuasive and keep giving examples as to how their strategies mitigate risk in retirement in a downturn market...I’m really having a hard time with this

stlutz
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Re: Using options in a retirement portfolio

Post by stlutz » Tue Dec 04, 2018 11:18 pm

What is the options strategy in question? Options trading can be very risky or very conservative. Some approaches can also be quite costly.

NeedLotsOfHelp
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Re: Using options in a retirement portfolio

Post by NeedLotsOfHelp » Wed Dec 05, 2018 9:50 am

Thanks for asking this question. I guess it speaks to my ignorance that I can’t exactly answer it.

He states that he takes a conservative approach and uses it as an insurance policy where he will set a limit as to how much I can lose. He has provided me with multiple recent examples of how his approach has mitigated losses in the recent downturns. He freely admits that there is no free lunch and that the consequence to this approach is that if the market goes really high I won’t get extreme high returns either. But overall he says it’s a win and tells me that he believes he can even put me in a higher percentage of equities because his approach is so safe. He is asking for one percent of assets under management, but I guess I am unsure of what the actual cost of the options themselves are… Although, he does tell me he uses low-cost index funds

alex_686
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Re: Using options in a retirement portfolio

Post by alex_686 » Wed Dec 05, 2018 10:08 am

NeedLotsOfHelp wrote:
Tue Dec 04, 2018 8:30 pm
One advisor believes in the overall efficiency of the market and following a long-term strategy with low-cost index funds and asset allocation to address risk while keeping funds in cash for money needed immediately so that I would not have to sell low if the market starts dramatically falling
Closest to Bogleheads philosophy. I personally don't like the idea of "cash drag" and would throw that extra amount into bonds.
NeedLotsOfHelp wrote:
Tue Dec 04, 2018 8:30 pm
Another advisor totes high quality dividend paying stocks and bond ladders
Ah, the allure of false security. High quality dividend paying stocks is a nuanced debate and I can make an argument for it. It is more complex to execute and hence has higher fees. It will have a lower return than a stock index fund, and might have a higher risk. While I understand the emotional appeal, bond ladders are as risky as bond funds, and require more work. You will need a fairly hefty portfolio to get enough diversification and overcome fees. Say, north of 5m.
NeedLotsOfHelp wrote:
Tue Dec 04, 2018 8:30 pm
Another advisor promotes options as an insurance policy against a down market and believes that options can protect a portfolio the best in a down market
Another valid choice. Options are complex. Also, they will cause a drag on your performance. Most of the time you would be better off by having a higher portion in bonds instead of stocks.

Lastly, none of the above determines if these people are good advisers. Why do you need a adviser? Bobleheads is a DIY place but I do think some people need expert advice. To clarify goals, set up asset allocations, and hold your hand when the market blows up. Which of these will do the best job for the cost? Not only explicit costs (i.e. fees) but also opportunity costs (drag caused by options, having too much cash).

megabad
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Re: Using options in a retirement portfolio

Post by megabad » Wed Dec 05, 2018 10:39 am

NeedLotsOfHelp wrote:
Tue Dec 04, 2018 8:30 pm
I am in my mid-50s thinking about retirement. I am in the process of switching my financial advisor/money manager. I am a little late to the game in understanding best investment practices. My big fear is sequence of return risk in retiring at a young age. In my search for financial advisors I have come across many different philosophies to address this risk.

One advisor believes in the overall efficiency of the market and following a long-term strategy with low-cost index funds and asset allocation to address risk while keeping funds in cash for money needed immediately so that I would not have to sell low if the market starts dramatically falling
I agree with the approach but I do not like the reasoning at the end. Market performance should have no impact on your selling/buying if you believe the markets efficient.

Another advisor totes high quality dividend paying stocks and bond ladders
I am not a stock picker nor do I differentiate between LTCG and QDI so this one is not for me.

Another advisor promotes options as an insurance policy against a down market and believes that options can protect a portfolio the best in a down market
For options to benefit you, you would have to be able to predict the future in the short/intermediate term. I am not good at this so this strategy is not for me. If I was good at it, you would not find me in options, you would find me in the casino.

Help!? How on earth to decide on the right strategy/right advisor?
Only you can decide this. Personally, I value low expenses, diversity, a lack of market timing, and most importantly, a strong behavioral guidance for the client (to stay the course). I am not sure any of your listed "strategies" appeal to me. Agree with the above poster that one of the most effective ways to deal with risk (including sequence of return risk) is to increase fixed income holdings and decrease equity holdings. I don't think you need a fancy "strategy" to do that. An early retiree is dramatically less exposed to sequence risk than a "normal" retiree so you should feel pretty good about that.

alex_686
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Re: Using options in a retirement portfolio

Post by alex_686 » Wed Dec 05, 2018 10:49 am

megabad wrote:
Wed Dec 05, 2018 10:39 am
Another advisor promotes options as an insurance policy against a down market and believes that options can protect a portfolio the best in a down market
For options to benefit you, you would have to be able to predict the future in the short/intermediate term. I am not good at this so this strategy is not for me. If I was good at it, you would not find me in options, you would find me in the casino.
This is not true. There are simplish rules based trading strategies - that is passive strategies. For example, buying a protective put that is 10% out of the money, and then buying a new one when the old one expires.

NeedLotsOfHelp
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Re: Using options in a retirement portfolio

Post by NeedLotsOfHelp » Wed Dec 05, 2018 10:51 am

Yep. That’s what he says he’s going to do

Shallowpockets
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Re: Using options in a retirement portfolio

Post by Shallowpockets » Wed Dec 05, 2018 11:09 am

The third scenario, options, requires you to pay that guy 1% of assets, annually. That is a no-go right there. Throw that one out unless you want to investigate that yourself.

megabad
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Re: Using options in a retirement portfolio

Post by megabad » Wed Dec 05, 2018 11:12 am

alex_686 wrote:
Wed Dec 05, 2018 10:49 am
megabad wrote:
Wed Dec 05, 2018 10:39 am
Another advisor promotes options as an insurance policy against a down market and believes that options can protect a portfolio the best in a down market
For options to benefit you, you would have to be able to predict the future in the short/intermediate term. I am not good at this so this strategy is not for me. If I was good at it, you would not find me in options, you would find me in the casino.
This is not true. There are simplish rules based trading strategies - that is passive strategies. For example, buying a protective put that is 10% out of the money, and then buying a new one when the old one expires.
It is exactly true per your proposed strategy. A protective put is not free. You have spent money to protect against a decline. The only way you would see a relative financial benefit is if the market declined during the selected time frame. Whether this is "passive" or not is very much arguable, but I believe that is certainly less efficient and "more active" than simply shifting your bond allocation.

NeedLotsOfHelp
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Re: Using options in a retirement portfolio

Post by NeedLotsOfHelp » Wed Dec 05, 2018 11:19 am

Yes, the 1% AUM was really bothering me. As my username states, I am new to this game and need lots of help. I am getting out of a very bad situation with my current financial advisor and just trying my best to pick the right person. I’m not yet ready to do this by myself but hopefully if I stay on this site I’ll get enough courage to do so…

Thank you for your reply

Shallowpockets
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Re: Using options in a retirement portfolio

Post by Shallowpockets » Wed Dec 05, 2018 11:31 am

Since you are, at this point, trying to get out of a situation with your present financial advisor, just focus on that aspect. Get out, use the BH three funds, then see what happens. Give yourself some breathing room. No sense in jumping from one FA to another. Not necessary.

Withdraw from this present advisor. If you are not sure of the mechanics someone here can give advice on that. Or you can call Vanguard or Fidelity and ask them. Tell them exactly what you want to do. Look up the BH funds and tell them that.
Even if you just get out by moving all your money to a money market until you make further decisions. This way you do not have the pressure of leaving one FA and getting another all in one swoop. Get out, take a breath. Evaluate after you have made that first move.

Forget the three guys and their approaches for now. Maybe forever.

URSnshn
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Re: Using options in a retirement portfolio

Post by URSnshn » Wed Dec 05, 2018 12:00 pm

How do you decide on the correct strategy for you? What I did was take about 6 - 8 months and study - my starting off point was this site. I'm grateful I landed here.

After the 6 - 8 months I had an Investment Policy Strategy (IPS) and asset allocation that I thought would meet my needs and the confidence to do this on my own. I did interview several financial planners - I wasn't satisfied with any of them. I also did one other thing. I kept visiting this site and reading and learning - I actually have an even better understanding now than I did when I began (about 7 years ago give or take).

So my suggestion would be to relax, learn, develop your own IPS and keep dipping your toe in the water to continue the learning process. Feel free to ask questions on the site. I believe it will be well worth your time.

Good luck!

alex_686
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Re: Using options in a retirement portfolio

Post by alex_686 » Wed Dec 05, 2018 12:04 pm

megabad wrote:
Wed Dec 05, 2018 11:12 am
It is exactly true per your proposed strategy. A protective put is not free. You have spent money to protect against a decline. The only way you would see a relative financial benefit is if the market declined during the selected time frame. Whether this is "passive" or not is very much arguable, but I believe that is certainly less efficient and "more active" than simply shifting your bond allocation.
I will point to my earlier post in this thread. It does fall into the passive strategy bucket because it is rules based and transparent. Plus it does not try to guess where the market is going via treading values, P/E ratios, etc.

The 2 strategies (increased bonds, protective puts) and covered call writing are all roughly equivalent efficient in terms of risk / return profile. During times of stress all will react differently so you need to figure out what one's goals and risk tolerances are.

That being said, in all of the cases I have seen - both academic and practical - we can ignore transaction and adviser costs. That is, really big disciplined institutional investors. Going back to my first post, while this strategy is valid I would gently nudge the OP away from this option.

NeedLotsOfHelp
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Re: Using options in a retirement portfolio

Post by NeedLotsOfHelp » Wed Dec 05, 2018 12:42 pm

Thank you all for your help. I have learned a lot already.

To alex_686: I really found your last post helpful. And I believe in your last paragraph you were saying that although options can be a viable strategy, particularly in my case where I am not a savvy investor, I would be better off without the cost and advisor fees… I believe that’s what you meant?

I am very risk adverse ( don’t like this about myself ) But I do believe I will be able to stick to a plan and weather out stressfull times

alex_686
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Re: Using options in a retirement portfolio

Post by alex_686 » Wed Dec 05, 2018 1:10 pm

NeedLotsOfHelp wrote:
Wed Dec 05, 2018 12:42 pm
To alex_686: I really found your last post helpful. And I believe in your last paragraph you were saying that although options can be a viable strategy, particularly in my case where I am not a savvy investor, I would be better off without the cost and advisor fees… I believe that’s what you meant?

I am very risk adverse ( don’t like this about myself ) But I do believe I will be able to stick to a plan and weather out stressfull times
To backtrack a little bit, sometimes that way to minimize risk to take more risk. I will point to the dividend strategy. GE was a quality dividend stock until it was not. Bank stocks were quality dividend stocks until 2008, and then they weren't. There are many easy and false answers to lower ones risk.

Back to your question.

As a rational man I am 67% confident that a higher bond allocation would work better than protective puts. This is partly because of the inferences of big crashes (a.k.a. tail events) and the cost of executing the strategy. Note, for costs I am working off the premium of buying the protective puts plus a very small fee (>less than 2 bps, or .2% of the stock portfolio) to run the strategy. However, how many big crashes do you see happening over the next 2 years? How confident are you of your predictions?

However, we have behavioral issues to deal with - which is the downfall of most investors and is one of the hardest things to change. Maybe the only way for you to meet your goals is to load up on equities, and the only way for you to do that is to hire an adviser, or buy protective puts, or do both.

So when I say I am nudging you away from protective puts to a higher bond allocation it is just that - a nudge.

Ben Mathew
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Re: Using options in a retirement portfolio

Post by Ben Mathew » Wed Dec 05, 2018 1:42 pm

You don't need any of the three advisors. First advisor is okay, though the cash should be in bonds. Second advisor is wrong to promote dividends over total return. The third advisor promoting options is the most dangerous:

Options should not be part of a passive strategy, even when it's advertised as risk reducing insurance. The passive strategy relies on buying the entire market: total stocks + total bonds and manipulating the stock-bond mix to adjust the risk. Risk reduction comes from less stocks and more bonds. The payoffs remain straightforward and linear--you're just changing the overall slope by changing the stock-bond mix. The problem with buying puts to to reduce risk is that your payoffs become non-linear, which creates a new and unnecessary risk: volatility. Your return now depends not only on whether the stock market goes up or down over the long term, but also on how it goes up and down. If it's jiggly, you end up with more. If it's smooth, you end up with less. But fundamentally you don't care about whether it's jiggly or smooth, so what's the point of contracting around that? Options could be part of an active strategy where you are trading on your beliefs about the probability distribution of short-term returns. I can't imagine why a passive long-term investor will need non-linear payouts, especially over the short horizons offered by options.

NeedLotsOfHelp
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Re: Using options in a retirement portfolio

Post by NeedLotsOfHelp » Wed Dec 05, 2018 2:35 pm

Wow. This has been so helpful, thank you so much to all of you. I really appreciate the time you all have taken to help me, lots to think about, but I feel like I have been pointed in the right direction…

Thanks again to all of you!

alex_686
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Re: Using options in a retirement portfolio

Post by alex_686 » Thu Dec 06, 2018 2:16 pm

Ben Mathew wrote:
Wed Dec 05, 2018 1:42 pm
The problem with buying puts to to reduce risk is that your payoffs become non-linear, which creates a new and unnecessary risk: volatility. Your return now depends not only on whether the stock market goes up or down over the long term, but also on how it goes up and down. If it's jiggly, you end up with more. If it's smooth, you end up with less. But fundamentally you don't care about whether it's jiggly or smooth, so what's the point of contracting around that? Options could be part of an active strategy where you are trading on your beliefs about the probability distribution of short-term returns. I can't imagine why a passive long-term investor will need non-linear payouts, especially over the short horizons offered by options.
What you are saying is correct but wrong. It holds in certain portfolio constructions but not the one the OP is suggesting.

We are talking about holding a long portfolio in stocks with a offsetting short (economic) position in protective puts (which are long bonds - which goes goes to show you how confusing the terminology is.) In this case the upward movement of the portfolio is muted by having to make insurance payments. However it also eliminates the sharp downward spikes.

The result is that the portfolio disruptions of returns are tighter, the returns are smoother, the output is more liner, and less jiggly.

And all of this can be done without having a opinion about the short term movements of the market.

It is a solid, robust, valid plan of action. It has a rich history both on the theoretical and practical side.

That being said, I would still nudge the OP towards more bonds.

megabad
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Re: Using options in a retirement portfolio

Post by megabad » Thu Dec 06, 2018 3:09 pm

alex_686 wrote:
Thu Dec 06, 2018 2:16 pm
And all of this can be done without having a opinion about the short term movements of the market.
Can it? How do you buy/sell a put without a cost and a duration? What should the put be worth? If you believe in the value of equity investing, statistically across the entire market and in the ultra long term (infinite), buying a put is a fool's errand so the only reason to buy is a comparatively short term decline. By selling a put, you are betting against this buyer (in the short term). Buying or selling a put is by definition a bet on market performance in the term defined in the contract (which is less than infinite and which I would usually define as short). You can say you don't have an opinion about short term market movements, but when you decide to sell a put, you have exercised your opinion that it is worth selling at a certain cost and duration.

alex_686
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Re: Using options in a retirement portfolio

Post by alex_686 » Thu Dec 06, 2018 3:38 pm

megabad wrote:
Thu Dec 06, 2018 3:09 pm
alex_686 wrote:
Thu Dec 06, 2018 2:16 pm
And all of this can be done without having a opinion about the short term movements of the market.
Can it? How do you buy/sell a put without a cost and a duration? What should the put be worth? If you believe in the value of equity investing, statistically across the entire market and in the ultra long term (infinite), buying a put is a fool's errand so the only reason to buy is a comparatively short term decline. By selling a put, you are betting against this buyer (in the short term). Buying or selling a put is by definition a bet on market performance in the term defined in the contract (which is less than infinite and which I would usually define as short). You can say you don't have an opinion about short term market movements, but when you decide to sell a put, you have exercised your opinion that it is worth selling at a certain cost and duration.
I no more need to have a opinion on the short term performance of the stock market to invest in the stock market than I need to buy a put.

There are simply algorithmic trading strategies for buying puts that meet the definition of passive investing. For example, buying a 1 year puts each year to limit your loss to no more than 10%. It costs about the same as the dividend kicked off by the S&P 500. Histrionically it is about equivalent as increasing your asset allocation to treasury bonds by 5% to 10%.

The OP would not be going short and betting against the market. He is insuring himself against catastrophe. If you want to use gambling language instead of insurance language, he is taking a bet against large "tail event" crashes, not against the normal vagaries of the market.

NeedLotsOfHelp
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Re: Using options in a retirement portfolio

Post by NeedLotsOfHelp » Thu Dec 06, 2018 3:58 pm

That is exactly how the 3rd advisor explained it to me. But with 1% AUM fees and the inherent costs associated with #3, I think I am better off with advisor #1. Like you said, the psychology of investing and bad habits can be the hardest to address, For me, at least now I need an advisor and my gut is saying #1.

Your posts have been VERY helpful, thanks so much!!!

megabad
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Re: Using options in a retirement portfolio

Post by megabad » Thu Dec 06, 2018 4:21 pm

alex_686 wrote:
Thu Dec 06, 2018 3:38 pm
I no more need to have a opinion on the short term performance of the stock market to invest in the stock market than I need to buy a put.
Investing in options requires you to exercise a short term position contractually. Investing in the equity market does not have a contractual term (barring specific circumstances..RSUs etc).

There are simply algorithmic trading strategies for buying puts that meet the definition of passive investing. For example, buying a 1 year puts each year to limit your loss to no more than 10%. It costs about the same as the dividend kicked off by the S&P 500. Histrionically it is about equivalent as increasing your asset allocation to treasury bonds by 5% to 10%.
The algorithm strategy has been a very common pitch from salespeople in the investing world for years. Does an simple algorithm equal a passive strategy? I can create a simple algorithm that invests me in the 1sr,3rd, and 5th highest market cap stock that has a company name beginning with B. Is this passive? In this manner, all investing could be construed as passive. As I said before, I would say that the passive assumption here is pretty abstract and could be easily argued against.

The OP would not be going short and betting against the market. He is insuring himself against catastrophe. If you want to use gambling language instead of insurance language, he is taking a bet against large "tail event" crashes, not against the normal vagaries of the market.
How do you define normal or catastrophe? I agree that such an investor would be making a bet. As I said before, if you correctly predict the future, you will come out ahead. Hence the bet.

The original premise from the advisor in the OP was that "options can protect a portfolio the best in a down market". Clearly, I believe that a much better way to protect against a down market is using diversified bond investments (rather than options). This requires absolutely no determinations of option durations, discounts or anything else. A correctly selected option might also protect you in a down market, but you undoubtedly added many more variables.

alex_686
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Re: Using options in a retirement portfolio

Post by alex_686 » Thu Dec 06, 2018 5:12 pm

megabad wrote:
Thu Dec 06, 2018 4:21 pm
Investing in options requires you to exercise a short term position contractually. Investing in the equity market does not have a contractual term (barring specific circumstances..RSUs etc).
So? Sure, it is true statement of fact. If I invest in a money market fund I am investing in short term contracts that are being constantly rolled over as well? Is that not investing? If I invest in the market using rolling equity futures and get equivalent results, why does it matter?
megabad wrote:
Thu Dec 06, 2018 4:21 pm
The algorithm strategy has been a very common pitch from salespeople in the investing world for years. Does an simple algorithm equal a passive strategy? I can create a simple algorithm that invests me in the 1sr,3rd, and 5th highest market cap stock that has a company name beginning with B. Is this passive? In this manner, all investing could be construed as passive. As I said before, I would say that the passive assumption here is pretty abstract and could be easily argued against.
Yes it would be since it is rules based and transparent. However, what is the theory and historic performance of such a index? Why would I want to invest in it? What goal is it trying to meet? I will point out that Value Indexes have more complexity and moving parts than a protective put strategy.
megabad wrote:
Thu Dec 06, 2018 4:21 pm
How do you define normal or catastrophe? I agree that such an investor would be making a bet. As I said before, if you correctly predict the future, you will come out ahead. Hence the bet.

The original premise from the advisor in the OP was that "options can protect a portfolio the best in a down market". Clearly, I believe that a much better way to protect against a down market is using diversified bond investments (rather than options). This requires absolutely no determinations of option durations, discounts or anything else. A correctly selected option might also protect you in a down market, but you undoubtedly added many more variables.
Lots of things to unpack here.

Most of the academic and practical applications I have seen of this strategy have defined "catastrophe" as either been down 10% or more or being down by more than 1 standard deviation down as measured by VIX. That being said, I am a modest proponent of advisers and this is one case. The point of investing is to meet one's goals. A good adviser should be able to clarify those goals and figure out where the break points are, and figure out the best way to minimize the chance of failure. Maybe a catastrophe is set as some other level. Note - there are few high quality adviser who are worth their fee out there.

Next, why do you think bonds are better protection than options? I generally agree with you but it might behoove you to review the opposing strategy. The outcomes are pretty close, and there are specific situations of market expectations or risk tolerance where the protective put strategy works better. I don't know what "option durations, discounts" are but you don't need to know the Greeks to implement this strategy.

Yes, if you pop the hood off the car a protective put strategy is more complex than a simpler stock / bond. On the flip side, it is still simpler than popping the hood off a value strategy. That being said, does one need to know how value works in order to add a value fund to your AA? No.

Daryl
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Re: Using options in a retirement portfolio

Post by Daryl » Thu Dec 06, 2018 6:20 pm

OP might want to consider the Vanguard Personal Advisor Services. The annual fee is reasonable and it can be handy to have a certified financial planner to talk to when first getting started. Ideally this would be an opportunity to move money to lower cost funds while learning a little more about personal finances. You can always cancel the advisor services once you are ready.

megabad
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Re: Using options in a retirement portfolio

Post by megabad » Thu Dec 06, 2018 6:39 pm

alex_686 wrote:
Thu Dec 06, 2018 5:12 pm
So? Sure, it is true statement of fact. If I invest in a money market fund I am investing in short term contracts that are being constantly rolled over as well? Is that not investing? If I invest in the market using rolling equity futures and get equivalent results, why does it matter?
It is investing. But the things required to achieve the desired outcome are completely different. Deciding to invest in a completely different asset class, money market fund or otherwise, is completely different than making a bet that a specific asset class will decline 10% in the next year.

Yes it would be since it is rules based and transparent. However, what is the theory and historic performance of such a index? Why would I want to invest in it? What goal is it trying to meet? I will point out that Value Indexes have more complexity and moving parts than a protective put strategy.
I generally subscribe to the model that past performance is not indicative of future results. I would also add that generally, basing investments on historical returns does not lead to what is typically defined as "passive" investing. Value investing is roughly the same level of complexity in my mind. Both Value investing and your options strategy are active strategies to me. These strategies might allow an investor to reach his/her goals or they might not, both are bets.

Lots of things to unpack here.

Most of the academic and practical applications I have seen of this strategy have defined "catastrophe" as either been down 10% or more or being down by more than 1 standard deviation down as measured by VIX. That being said, I am a modest proponent of advisers and this is one case. The point of investing is to meet one's goals. A good adviser should be able to clarify those goals and figure out where the break points are, and figure out the best way to minimize the chance of failure. Maybe a catastrophe is set as some other level. Note - there are few high quality adviser who are worth their fee out there.
Just as I doubt my own ability to predict future catastrophes (and the bands they will occur in), so do I doubt academics and advisors. I do not agree that this is a good case for advisors. I would actually argue the exact opposite. It is fully my belief that making active investment decisions is where advisors on average will add the least value relative to other functions.

Next, why do you think bonds are better protection than options? I generally agree with you but it might behoove you to review the opposing strategy. The outcomes are pretty close, and there are specific situations of market expectations or risk tolerance where the protective put strategy works better. I don't know what "option durations, discounts" are but you don't need to know the Greeks to implement this strategy.
Because fundamentally, not owning an asset will eliminate my direct exposure to it (ups and downs). The options strategy indicated does not eliminate exposure. The only way it can protect you is if you know exactly what and when your exposure is ahead of time. You don't need to know the Greeks to implement such a strategy successfully, you just need to know the future. The return of any two strategies over a specific time period can be equal, but that does not mean they are fundamentally similar.

Yes, if you pop the hood off the car a protective put strategy is more complex than a simpler stock / bond. On the flip side, it is still simpler than popping the hood off a value strategy. That being said, does one need to know how value works in order to add a value fund to your AA? No.
I would strongly suggest than investors understand everything that they or their advisors invest in. I would no more push them toward Value than I would to options. Both are what I what consider active strategies and may or may not prove fruitful in the future. In my portfolio these take the appearance of slight tilts. The vast majority is market cap index based. I may very well lose out to more active investors and have lower returns, but I can be certain that I will capture very closely the market return (with a small amount of expenses deducted).

Ben Mathew
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Re: Using options in a retirement portfolio

Post by Ben Mathew » Thu Dec 06, 2018 8:45 pm

alex_686 wrote:
Thu Dec 06, 2018 2:16 pm
Ben Mathew wrote:
Wed Dec 05, 2018 1:42 pm
The problem with buying puts to to reduce risk is that your payoffs become non-linear, which creates a new and unnecessary risk: volatility. Your return now depends not only on whether the stock market goes up or down over the long term, but also on how it goes up and down. If it's jiggly, you end up with more. If it's smooth, you end up with less. But fundamentally you don't care about whether it's jiggly or smooth, so what's the point of contracting around that? Options could be part of an active strategy where you are trading on your beliefs about the probability distribution of short-term returns. I can't imagine why a passive long-term investor will need non-linear payouts, especially over the short horizons offered by options.
What you are saying is correct but wrong. It holds in certain portfolio constructions but not the one the OP is suggesting. We are talking about holding a long portfolio in stocks with a offsetting short (economic) position in protective puts
Protective puts will introduce volatility risk in the portfolio. Volatility risk comes from non-linearity in the payoffs. Protective puts result in a non-linear payout, so it will create volatility risk. Options can seem simple and straightforward in some ways. But the introduction of non-linearity and the resultant exposure to volatility risk makes it a very complex product that is hard to fully understand and can behave in unexpected ways. I would say that it is unnecessary unless you're an active trader betting against others with different views.

Insurance should fundamentally reduce risk. If everybody buys homeowners insurance, everybody loses a small premium and nobody loses their house. So a society where everybody buys homeowners insurance has lower risk for everyone than one where no one is insured.

While legitimate insurance products reduce a risk that already exists, protective puts create a risk that was never there. Take a simple example. Suppose everyone owns a share with a value of $100 today. It drops to $80 after a year and then rebounds back to $100 after two years. If someone sold someone else protective puts, whoever sold the puts will now have less than $100 and whoever bought the puts will have more than $100. But there was no aggregate loss. Everyone could have walked away with $100. If they didn't, then they weren't insuring each other--they were betting against each other! Risk got introduced to both parties, not taken away.

[Note that since a firm's stock can be viewed as a call option on the firm's assets, these arguments would technically apply to stocks as well. But when talking about diversified stock and bond funds, the payout can be considered close enough to linear for all practical purposes.]
In this case the upward movement of the portfolio is muted by having to make insurance payments. However it also eliminates the sharp downward spikes.

The result is that the portfolio disruptions of returns are tighter, the returns are smoother, the output is more liner, and less jiggly.
Tilting towards bonds would create returns that have those characteristics. Protective puts would generate some unexpected and undesirable characteristics, as in the above example.
And all of this can be done without having a opinion about the short term movements of the market.
Because options are almost always short term, the stock's short term movements will affect outcomes. This would be true for protective puts as well. In the above example, temporary price movements over the one year horizon affected outcomes over the two year horizon.

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