Calls and Cash: talk me out of it

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CheepSkate
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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

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CheepSkate
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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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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.

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CheepSkate
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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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market timer
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Re: Calls and Cash: talk me out of it

Post by market timer » Wed Nov 27, 2019 11:30 pm

As you know, buying a call has the same payoff profile as buying the underlying shares and buying a put. However, there are differences in taxes. When you own the underlying shares, you can delay realizing gains and paying taxes, potentially forever. Also, puts tend to depreciate on average over time (they are like an insurance product), so you should expect to realize capital losses on those, which can offset taxes you'd owe elsewhere. Therefore, the tax code favors buying protective puts against the underlying instead of buying calls.

As for the economics of your strategy, you should compare the risk/return vs. a standard 60/40 or 80/20 stock/bond portfolio of similar risk. I suspect you'll find the balanced portfolio has historically offered better returns for the same risk. Investors tend to get compensated for taking left-tail risk. When you invest in a call, you are not taking much of the left-tail risk, so should not expect as high a return as if you bought the underlying shares unhedged.

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

Post by CheepSkate » Fri Dec 06, 2019 2:57 pm

market timer wrote:
Wed Nov 27, 2019 11:30 pm
As you know, buying a call has the same payoff profile as buying the underlying shares and buying a put. However, there are differences in taxes. When you own the underlying shares, you can delay realizing gains and paying taxes, potentially forever. Also, puts tend to depreciate on average over time (they are like an insurance product), so you should expect to realize capital losses on those, which can offset taxes you'd owe elsewhere. Therefore, the tax code favors buying protective puts against the underlying instead of buying calls.

As for the economics of your strategy, you should compare the risk/return vs. a standard 60/40 or 80/20 stock/bond portfolio of similar risk. I suspect you'll find the balanced portfolio has historically offered better returns for the same risk. Investors tend to get compensated for taking left-tail risk. When you invest in a call, you are not taking much of the left-tail risk, so should not expect as high a return as if you bought the underlying shares unhedged.
Good points about taxes and left-side risk. Because this portfolio has close to the same downside risk as a 100% bond portfolio, expected future returns (based on analysis of past returns) should be close to a 100% bond portfolio. This calls and cash portfolio or a protective put portfolio have an optionality, though, that is hard to express on a 2 dimensional risk/return chart:
An ability to survive a big correction is combined with an ability to preserve purchasing power in terms of stock. A 100% bond portfolio offers the first benefit, but not the 2nd, because if stocks rise the bond investor gets left behind.

My philosophy is that one can retire when one’s earnings from interest and the sum of the earnings per share from all the shares one owns add up to one’s spending needs. I.e. regardless of market price fluctuations, one’s retirement is secured in the long run by earnings, not portfolio value. My “FIRE number” is expressed in portfolio earnings, not liquidation value. That’s why it is important that I preserve the ability to own the exact number of shares as I was able to afford before.

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

Post by sergeant » Fri Dec 06, 2019 3:31 pm

I will not talk you out of it. I want you to do it and report your results here. Good luck.
Lincoln 3 EOW! AA 40/60.

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

Post by CheepSkate » Mon Dec 09, 2019 10:14 pm

sergeant wrote:
Fri Dec 06, 2019 3:31 pm
I will not talk you out of it. I want you to do it and report your results here. Good luck.
The result of the strategy at any given market outcome is known, but the future market outcome is not. A year or two from now, when market outcomes are known, we will also know the outcome this strategy would have yielded.

This insight tells us our question about what to do is about what's the most rational decision, given what we know today?

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305pelusa
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Re: Calls and Cash: talk me out of it

Post by 305pelusa » Mon Dec 09, 2019 10:36 pm

CheepSkate wrote:
Thu Nov 07, 2019 11:12 pm
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.
It's not a similar risk profile. It's an identical risk profile. If you choose the right numbers, you can mimic an "All calls + cash" strategy with "All stocks + puts" strategy. But the latter is more tax efficient. All of the gains can stay unrealized on the stocks while you realize all of the losses on the puts. OTOH, the calls strategy would realize all of your gains every 2 years.

EDIT: My dumbass didn't realize that's literally what MT said.

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

Post by guyinlaw » Mon Dec 09, 2019 10:50 pm

If these are in Tax deferred account,you could replace SPY with NTSX or SWAN ETFs which provide better downside protection. NTSX is 90/60 Wisdomtree ETF with only 0.2% expense. 10% is invested in Treasury Futures giving exposure to 60% bonds. SWAN uses LEAPs has better downside protection.

As others have suggested, you could go with 80-20.

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

Post by jbuzolich » Mon Dec 09, 2019 10:51 pm

If you're looking to minimize or lock in some level of downside risk why not just buy enough puts at the target price and duration you're comfortable with? No tax that way from selling the stock yet. If the market continues up, you can ignore your puts and let them expire or sell them for some small amount if there is time remaining. If the market tanks, you can decide to exercise the puts and sell your underlying stocks at the price you locked in, or buy an offsetting call to close your options if you wanted to continue holding the stock longer.

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

Post by msk » Tue Dec 10, 2019 2:32 am

I played with options between the mid 1980s till my retirement early 2000. Don't kid yourself that you can ever find a "sure" way of beating the very well paid quants who set the prices of Options, especially on something as pervasive as SPY. Basically, all you are doing, and what I did, was to second-guess the macro-economics assessment of the quants as to the short to medium term probability of SPY moving up or down. I played with one year Calls and Puts. If you do it often enough you will be in profit 50% of the time and loss making the other 50%, but also out of pocket regarding frictional losses (e.g. you pay more commission on your paltry few contracts than the major banks pay for their 100k contracts. Should you play? Most certainly. I did for a couple of decades. I suspect that the quants have a tendency to use quantitative analysis for their macro economics. You have the luxury of using gut feel. We all know that markets swing between irrational exuberance and irrational gloom. So, indeed you may come out in profit if you have a good gut. What I found most profitable is the irrational gloom when markets collapse, i.e. post 2000. Surprisingly, my play area of one-year Options does not become super expensive, still costing around 5 to 7%. If the market falls more than 20% my gut feels that's when irrational gloom launches. So I would buy at-market price one-year Calls on SPY using margin (!). Further fall to 30% down from peak, buy more Calls. This strategy worked well for me during the last couple of recessions post 2000. I plan to continue with this strategy but I do not play with Options if the fall is < 20% (not enough panic...). I did not have the luxury of BH chats to gauge irrational panic and exuberance till very recently. Why did I stop playing with Options during normal times? As long as you own some Options that are still running you are anxious about missing an opportunity to replace your Options with a new set more attuned to the latest value of the SP500. I am retired now and wish to quit this constant anxiety. The OP sounds young. Do play and enjoy a couple of decades. Just beware that all you are doing is market timing, trying to outguess those quants. It's fun, with some anxiety :mrgreen:

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

Post by SovereignInvestor » Tue Dec 10, 2019 8:24 am

A call plus cash invested at risk free rate is identical to just having 200 shares of SPY and buying protective put. Assuming strikes of each option is the same. As others have pointed out.

The protective put will almost always be more tax efficient since over time the market rises and we would expect gains so with put the gains are unrealized via SPY but with the call method you will constantly need to realize them.

If one wants significant principle protection a manually created equity linked CD can be solid. Life insurers offer these at high fees but basically one puts the entire portfolio in bonds whether risk free or IG. Then they take the interest and buy SPY at the money call options periodically say annually.

Say the bond portfolio yields 2.5%, and on average ATM 1 year SPY calls are 5% of SPY, then one can generate 50% of the upside of S&P in terms of price and no price downside just risk of losing interest. Only be exposed to fluctuatons in price of bonds they own. Call prices are correlated to rho or the risk free rate so if yields drop then all else equal S&P ATM call prices would tend to be lower and vice versa.

deltaneutral83
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Re: Calls and Cash: talk me out of it

Post by deltaneutral83 » Tue Dec 10, 2019 9:15 am

Just a fancier way to time the market. I think it may be a good idea to just paper trade covered calls to get a feel for options if that's the direction OP is going. Buying puts (on a broad market index like the S&P) tends to have total loss of premium more often than people think, the market is rising 66% of the time after all. If you pay attention to the pundits and trade on that your portfolio has a much greater probability of going down than up over time.

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