Calls and Cash: talk me out of it

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CheepSkate
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Joined: Thu Nov 07, 2019 10:23 pm

Calls and Cash: talk me out of it

Post by CheepSkate » Thu Nov 07, 2019 11:12 pm

Long time lurker, first time poster! I am considering a defensive options strategy and need counterarguments.

Suppose one wanted to de-risk a portfolio, which for discussion's sake is comprised of 2000 shares of SPY. The obvious answer might be to buy protective put options, but this would reduce one's exposure because one must sell stock to buy the options. Another choice with a similar risk profile would be to sell all 2000 shares and replace them with 20 at-the-money call option contracts expiring in 2.2 years. This would consume only about 10% of the portfolio, and the other 90% would sit in cash or short-term debt instruments, earning about the same as the 1.78% dividend yield on SPY that one is missing.

Possible outcomes:
If SPY is flat or down by any amount over 2.2 years, the portfolio's performance would be negative 10% plus interest earned. Let's say -6% is the worst case scenario because you're earning ~2% interest a year.
If SPY is somewhere between flat and up 10% over 2.2 years, performance would fall somewhere between -10% and zero, plus interest earned. So 0% to -6%.
If SPY is up over 10% over 2.2 years, performance would be the price performance of SPY, minus 10%, plus interest earned. This is obviously the most probable scenario. One would underperform the SPY's total return by about 3% per year, but the upside is technically unlimited.

Basically this:
Image

In a nutshell, the goals would be:
1) to avoid any risk of a correction adding several years to one's retirement age and to just sit things out for the next 2 years,
2) WHILE also avoiding the risk of markets running up in price while one is not exposed,
3) AND WHILE remaining poised with cash in hand to take advantage of any correction opportunities offered up during that time.

Maximum downside is mathematically set in stone, so there's no need for a bond allocation (which yields nearly nothing and has its own sources of risk). This portfolio would be very low volatility, and would have been a lifesaver circa 2007 or 1928 if mature options markets had existed then.

With one's maximum possible loss in the single digits, one would rewrite their IPS to say "In the event of any xx% reduction in the S&P 500, switch back to a 100% stock AA." And/or, "...in the event of any XX% reduction in the S&P 500, increase the number of ATM call options by 50%." Even if you didn't catch the exact bottom, you'd come out far better than an all-stock portfolio and reduce the risk of being hit by a SORR event.

One could maintain the strategy beyond 2 years, or basically forever, by purchasing new call contracts when the old ones expire.

Talk me out of it if you can.

ThrustVectoring
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Re: Calls and Cash: talk me out of it

Post by ThrustVectoring » Fri Nov 08, 2019 2:39 am

Between buying 5% of your portfolio in intrinsic option value and missing out on a roughly 2% dividend yield, you're going up against a 7% CAGR headwind in flat and bull markets. Considering that stocks only have something like a 7% real return, this is a huge deal.
Current portfolio: 60% VTI / 40% VXUS

Topic Author
CheepSkate
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Joined: Thu Nov 07, 2019 10:23 pm

Re: Calls and Cash: talk me out of it

Post by CheepSkate » Fri Nov 08, 2019 2:10 pm

The missed dividends (1.78%) are offset by having 90% of the portfolio invested in short-term cash/debt instruments like BSV which yield about the same.

Thus the true maximum loss is the time decay of the call options, which is about -10%/2.2 years = -4.5% per year, plus interest of maybe 1.7% of the portfolio each year. The likelihood of losing the maximum 2.8% per year is equal to the risk of the S&P being flat or down in 2.2 years. I couldn’t find the historical odds on this exact scenario, just a rule of thumb that the market has gone down about 25% of years. So being down after 2 years is something less than 25%.

By next year, let’s say for simplicity’s sake the downside (25% odds) is -2.8% and the upside (75% odds) is 7%. The expected return is 4.55% which is not bad for a portfolio with less downside risk than a fund of 10 year treasuries.

It’s also not bad for a portfolio that leaves one with 90% of one’s wealth ready to deploy in the event of a correction while simultaneously avoiding the risk of missing a runaway stock market.

bryanm
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Re: Calls and Cash: talk me out of it

Post by bryanm » Fri Nov 08, 2019 7:17 pm


Thesaints
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Joined: Tue Jun 20, 2017 12:25 am

Re: Calls and Cash: talk me out of it

Post by Thesaints » Fri Nov 08, 2019 7:25 pm

CheepSkate wrote:
Thu Nov 07, 2019 11:12 pm
Another choice with a similar risk profile would be to sell all 2000 shares ...
Don't you have to pay taxes on that ?

jdilla1107
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Re: Calls and Cash: talk me out of it

Post by jdilla1107 » Fri Nov 08, 2019 8:31 pm

CheepSkate wrote:
Fri Nov 08, 2019 2:10 pm
Thus the true maximum loss is the time decay of the call options, which is about -10%/2.2 years = -4.5% per year, plus interest of maybe 1.7% of the portfolio each year.
This is a huge cost. (I'm not sure you are calculating it correctly as that seems too large.) Realize that people are forecasting things like 5-6% nominal returns for stocks over the next 10 years. So, you may be looking at a 0% nominal return and negative real return with this strategy.

Options always look brilliant in the short term and are a slow bleed in the long term. The whole point of holding stocks is to do so for long periods of time where the earnings and growth transcends everything else. You are basically giving away all the earnings and growth for 1) a lottery ticket and 2) downside protection.

This will be the correct call if volatility increases significantly and the wrong call if it does not. But, this is a silly bet to make, because stocks are for the long term and this is a short term bet.

Topic Author
CheepSkate
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Joined: Thu Nov 07, 2019 10:23 pm

Re: Calls and Cash: talk me out of it

Post by CheepSkate » Mon Nov 11, 2019 11:07 am

The thing is, it's a limited downside. A normal S&P 500 index fund position has, realistically, 40% possible downside per year. So to compare the odds of a single-digit annual loss with the odds of losing so much more requires some odds-based estimation of potential returns.

Similarly, the certainty of time decay / underperformance of the index must be weighed against the possible returns of a similarly safe portfolio. What mix of stocks and short-term treasuries would yield a maximum 10% downside over 2.2 years? 20/80?

The maximum time decay is the entire value of the options, which I am setting as 10% of the portfolio because at current option prices that means I cannot lose the ability to own the shares in the future, divided by 2.2 years. The worst possible portfolio performance is that plus interest earned. Note how there is value in being able to say "worst possible"!

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