Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve (SWAN)

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guyinlaw
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Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve (SWAN)

Post by guyinlaw » Wed Apr 01, 2020 12:04 pm

Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve.. In uncertain times, people might want to keep a large cash reserve accessible.

<30% in LEAPs and >70% in Treasuries/Cash
Proposing to have a large portion (>70%) in Cash and Treasury ETFs. Remaining <30% can be invested in LEAP options in chosen ETFs/Stocks. (SPY, IWN, QQQ etc)
- Cash and Treasury ETFs will be available to draw-down if necessary (>70%)
- LEAP Options hold for > 1 year to incur only LTCG
- Limit overall exposure to stocks you may consider appropriate ( say 60% or 80%)
LEAP options (or LEAPs) are option contracts that expire at least one year from the date of purchase. The acronym LEAP stands for “Long-term Equity Anticipation.” LEAPs are more affordable than stocks because they're offered at option contract prices.

When LEAPs are sold at a profit, the gain is taxable. The seller of the LEAP is taxed at the long-term capital gain rate if they held the contract for at least a year and a day. If they held the contract for a shorter period, they would be subject to short-term capital gains rates.
Options have an image of Wild Wild West, but LEAPs can be used to build a conservative portfolio..

Look at the example of SWAN ETF.. https://amplifyetfs.com/swan.html
Approximately 90% of the ETF will be invested in U.S. Treasury securities, while approximately 10% will be invested in SPY LEAP Options in the form of in-the-money calls.

Code: Select all

SWAN Holdings
10% in SPY Options
SPDR S&P CLL OPT 6/20 245
SPDR S&P CLL OPT 12/20 283
90% in Treasuries
TREAS NTS 1.5% 10/31/2021 
TREAS NTS 1.625% 11/15/2022
TREAS NTS 1.5% 10/31/2024
TREAS NTS 1.625% 10/31/2026
TREAS NTS 1.625% 08/15/2029
TREAS BDS 2.25% 08/15/2049
The problem with SWAN is it invests in options that only 6 months and 1 years away. So it generated Short Term Capital gains STCG..
SWAN invests 10% in SPY options gives <75% exposure to stocks - giving a 75/90/-65 exposure

Below is the proposal.
Say you are investing $100,000 in such a portfolio

>70% - invest in Treasury ETFs..
Combination of Cash, STT, ITT and LTT as you consider appropriate
CASH
STT - SHY/VGSH - 30%
ITT - VGIT - 20% ,
LTT - VGLT - 10%,
exLTT - EDV - 10%

<30% - Buy LEAPs in stocks and/or stocks
SPY - S&P 500 ETF
IWN - iShares Russell 2000 ETF
QQQ - NASDAQ 100 ETF
maybe Stocks (FB any others?)

Consideration for ETFs or stocks
1. ETFs/Stocks must be highly liquid with LEAP options available
2. ETF/Stock price must be low enough (As a thumb rule <$350)
3. LEAPs > 1.5 years away, to make sure you only get Long Term Capital gains LTCG.
4. Use Limit orders to purchase.
5. Option strike price deep in the money. (<< current price)
6. Keep overall exposure to stocks to under 80%

Risks
1. LEAP option may end up being worthless if ETF/Stock price drops/remains low over >2 years
(right now SWAN behaves like a treasury ladder because its SPY options dropped from 10% to 4.72%)
What is the downside risk of the LEAP options?
The value of the S&P 500 LEAP call options can go to zero; however, it would take an extended significant decline in the S&P 500 for
this to happen. Typically, the S&P 500 LEAP options will retain some time value even if they are out of the money. And the LEAPS
within BlackSwan only comprise approximately 10% of the portfolio.
Example
SPY DEC 16, 2022 180.00 CALL @ $60 -- $6000
(with SPY @220 one leap option gives exposure to $22,000 invested in S&P 500)
IWM DEC 16, 2022 80.00 CALL @ 20 -- $2000
(with IWN @100 one leap option gives exposure to $10,000 invested in Russell 2000)
QQQ DEC 16, 2022 140.00 CALL @ $45 -- $4500
(with QQQ @180 one leap option gives exposure to $18,000 invested in NASDAQ 100)
FB JAN 21, 2022 150.00 CALL @ $25 -- $2500
(with FB @150 one leap option gives exposure to $15,000 invested in Facebook stock)

I have purchased SPY LEAPs via limit orders last time SP500 dropped. Plan to purchase additional additional LEAPs if and when stock prices drop via GTC Limit orders..

Please give your feedback on such a portfolio. What are risks of such a portfolio? Would this be appropriate to hold in taxable and/or ROTH IRA?
Time is your friend; impulse is your enemy. - John C. Bogle

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David Jay
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Re: Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve (SWAN)

Post by David Jay » Wed Apr 01, 2020 12:32 pm

Using LEAPS to build a conservative portfolio in taxable account with a large cash reserve (SWAN)
Grammar check warning (Non-sequitur): LEAPs != conservative portfolio
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

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guyinlaw
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Re: Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve (SWAN)

Post by guyinlaw » Wed Apr 01, 2020 12:44 pm

David Jay wrote:
Wed Apr 01, 2020 12:32 pm
Using LEAPS to build a conservative portfolio in taxable account with a large cash reserve (SWAN)
Grammar check warning (Non-sequitur): LEAPs != conservative portfolio
Would you consider a 60-40 portfolio conservative? You can create it by investing 90% in Treasuries and 10% in LEAPs (like SWAN). Not sure if you read the full post..
Time is your friend; impulse is your enemy. - John C. Bogle

Beliavsky
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Re: Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve (SWAN)

Post by Beliavsky » Wed Apr 01, 2020 12:53 pm

guyinlaw wrote:
Wed Apr 01, 2020 12:04 pm
The problem with SWAN is it invests in options that only 6 months and 1 years away. So it generated Short Term Capital gains STCG.
You can hold the options into expiration, in which case they will automatically be exercised into shares of SPY if they are in the money and there is sufficient money in your brokerage account. I believe there is no capital gains tax due until you sell SPY, as discussed here.

Check with your broker and/or experienced options traders regarding the mechanics of option excercise.

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David Jay
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Re: Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve (SWAN)

Post by David Jay » Wed Apr 01, 2020 1:45 pm

guyinlaw wrote:
Wed Apr 01, 2020 12:44 pm
David Jay wrote:
Wed Apr 01, 2020 12:32 pm
Using LEAPS to build a conservative portfolio in taxable account with a large cash reserve (SWAN)
Grammar check warning (Non-sequitur): LEAPs != conservative portfolio
Would you consider a 60-40 portfolio conservative? You can create it by investing 90% in Treasuries and 10% in LEAPs (like SWAN). Not sure if you read the full post..
No. You. Can't.

You can create a synthetic that has similar exposures to a 60/40, but it is NOT a 60/40.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

MoneyMarathon
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Re: Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve (SWAN)

Post by MoneyMarathon » Wed Apr 01, 2020 1:50 pm

guyinlaw wrote:
Wed Apr 01, 2020 12:04 pm
What are risks of such a portfolio?
Tax efficiency. Shares can be held forever, so they don't have the tax drag of needing to sell and rebuy every couple years.

There's no paying premium if someone buys shares. Negative theta is another drag.

Long term underperformance is the biggest risk, due to the chosen exposure and the inefficiency of using LEAP options.
guyinlaw wrote:
Wed Apr 01, 2020 12:04 pm
giving a 75/90/-65 exposure
guyinlaw wrote:
Wed Apr 01, 2020 12:04 pm
Keep overall exposure to stocks to under 80%
Someone could just buy 80% NTSX and 20% EDV (72% stocks / approximately 78% treasuries if counting EDV as 1.5x exposure). It's outperformed SWAN slightly if starting in Jan 2019. There's tax drag on the treasury futures, but it's less than having tax drag on the stock side. It did better than SWAN when the stock market is up. It would be expected to have higher returns in the long term, given that it doesn't have the tax drag and negative theta drag of buying LEAP options for the stock exposure. It's down 4.5% this year (while SWAN is flat).

https://www.portfoliovisualizer.com/bac ... ion3_2=100
guyinlaw wrote:
Wed Apr 01, 2020 12:04 pm
Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve.. In uncertain times, people might want to keep a large cash reserve accessible.
The volatility and drawdown of the portfolio is more important than the amount of cash or bonds, when it comes to being able to withdraw from the portfolio. When withdrawing, assets must be sold from both stocks and bonds in order to maintain the same asset allocation.

This consideration should be balanced against the underperformance of a portfolio optimized for lower volatility / drawdown.

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watchnerd
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Re: Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve (SWAN)

Post by watchnerd » Wed Apr 01, 2020 1:57 pm

David Jay wrote:
Wed Apr 01, 2020 1:45 pm
guyinlaw wrote:
Wed Apr 01, 2020 12:44 pm
David Jay wrote:
Wed Apr 01, 2020 12:32 pm
Using LEAPS to build a conservative portfolio in taxable account with a large cash reserve (SWAN)
Grammar check warning (Non-sequitur): LEAPs != conservative portfolio
Would you consider a 60-40 portfolio conservative? You can create it by investing 90% in Treasuries and 10% in LEAPs (like SWAN). Not sure if you read the full post..
No. You. Can't.

You can create a synthetic that has similar exposures to a 60/40, but it is NOT a 60/40.

Or if one wants to play the leveraged 60/40 simulation game, just buy NTSX.
70% Global Market Weight Equities | 15% Long Treasuries 15% short TIPS & cash || RSU + ESPP

ChrisBenn
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Re: Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve (SWAN)

Post by ChrisBenn » Wed Apr 01, 2020 3:20 pm

MoneyMarathon wrote:
Wed Apr 01, 2020 1:50 pm

(...)

Someone could just buy 80% NTSX and 20% EDV (72% stocks / approximately 78% treasuries if counting EDV as 1.5x exposure). It's outperformed SWAN slightly if starting in Jan 2019. There's tax drag on the treasury futures, but it's less than having tax drag on the stock side. It did better than SWAN when the stock market is up. It would be expected to have higher returns in the long term, given that it doesn't have the tax drag and negative theta drag of buying LEAP options for the stock exposure. It's down 4.5% this year (while SWAN is flat).

(...)

The volatility and drawdown of the portfolio is more important than the amount of cash or bonds, when it comes to being able to withdraw from the portfolio. When withdrawing, assets must be sold from both stocks and bonds in order to maintain the same asset allocation.

This consideration should be balanced against the underperformance of a portfolio optimized for lower volatility / drawdown.
I think this thread went off the rails a bit trying to compare this fund to a 60/40, or leveraged 60/40 -- eEverything else aside the varying delta of the leap option as the price of SPY changes is going to prevent it from being directly comparable to a static allocation

I think @MoneyMarathon's last sentence is pretty core here; this fund (SWAN) would be expected to have a lower drawdown, while still capturing upside. SWAN is paying a premium for that downside limit via the financing and optionality costs embedded in the leap.

It (SWAN) is sort of coming from the position "let me try and get as much upside as I can while limiting my potential equity losses to 10%". NTSX is almost coming at it from the other angle - "let me get 90% of the upside and downside of SPY, but hedge that with as much of a reasonably low correlation cheap asset as I can for the remaining 10%".

Instead of comparing it via analogy to NTSX or trying to approximate a portfolio (which the optionality of SWAN makes impossible), looking at the upside vs. volatility vs. drawdown (because of the optionality the last two wont scale the same) -- and also the performance in a sideways market (this fund would loose value on the call option) is more functional.

---

Another thing to note about this fund which is an implementation detail, and could be done differently if you were rolling it yourself, is the rebalancing - or lack thereof. I don't believe they rebalance between options and treasuries - except when they roll the options (so twice a year?).

This means what you are buying when you buy in is not the 90/10 -- except if your purchase right after reconstitution.

So really the #1 feature here is the drawdown protection, while still retaining significant equity upside exposure, and the biggest risks are probably the minimum market upside required to break even, and the variable fund allocation (SWAN specific)

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guyinlaw
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Re: Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve (SWAN)

Post by guyinlaw » Thu Apr 02, 2020 2:09 am

ChrisBenn wrote:
Wed Apr 01, 2020 3:20 pm
.. this fund (SWAN) would be expected to have a lower drawdown, while still capturing upside. SWAN is paying a premium for that downside limit via the financing and optionality costs embedded in the leap.

It (SWAN) is sort of coming from the position "let me try and get as much upside as I can while limiting my potential equity losses to 10%". NTSX is almost coming at it from the other angle - "let me get 90% of the upside and downside of SPY, but hedge that with as much of a reasonably low correlation cheap asset as I can for the remaining 10%".

Instead of comparing it via analogy to NTSX or trying to approximate a portfolio (which the optionality of SWAN makes impossible), looking at the upside vs. volatility vs. drawdown (because of the optionality the last two wont scale the same) -- and also the performance in a sideways market (this fund would loose value on the call option) is more functional.

---

Another thing to note about this fund which is an implementation detail, and could be done differently if you were rolling it yourself, is the rebalancing - or lack thereof. I don't believe they rebalance between options and treasuries - except when they roll the options (so twice a year?).

This means what you are buying when you buy in is not the 90/10 -- except if your purchase right after reconstitution.

So really the #1 feature here is the drawdown protection, while still retaining significant equity upside exposure, and the biggest risks are probably the minimum market upside required to break even, and the variable fund allocation (SWAN specific)
ChrisBenn - Agree with your comments. The drawdown for this portfolio would << 10%-30% depending the amount I allocate to LEAPs opetions. That is the downside risk and you can control max loss. For SWAN it is <10%. Below are recent performance..

Since the peak in Feb 19, 2020
SPY is down 26.9%
NTSX is down 21.2%
SWAN is down 5.5%

Since inception of SWAN (Nov 2018)
SPY is down 9.5%
NTSX is up 3.3%
SWAN is up 15%

====
I want to keep a large cash reserve, with around 2 years of expenses. Though I am working now, I want to have this available in these uncertain times.. I hope I wont need to dip into this emergency fund..

70%-90% in Treasuries <--- 2 year emergency fund
30-10% in LEAPs - SPY, IWN, QQQ, Fb etc -- Options are rolled after >1 year.

I plan to maintain my regular retirement portfolio 80-20 allocation.
Time is your friend; impulse is your enemy. - John C. Bogle

madbrain
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Re: Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve (SWAN)

Post by madbrain » Thu Apr 02, 2020 2:32 am

I wouldn't even think about doing what you are doing in a taxable account. If you must do it at all, do it in a traditional IRA or Roth IRA.
But remember that all long options can expire worthless, even LEAPS. So, this is inherently risky. Options are very expensive right now due to the volatility. With your strategy, when it's time to buy new options, you might find that they are too expensive the next time around.

ChrisBenn
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Re: Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve (SWAN)

Post by ChrisBenn » Thu Apr 02, 2020 5:46 am

madbrain wrote:
Thu Apr 02, 2020 2:32 am
I wouldn't even think about doing what you are doing in a taxable account. If you must do it at all, do it in a traditional IRA or Roth IRA.
But remember that all long options can expire worthless, even LEAPS. So, this is inherently risky. Options are very expensive right now due to the volatility. With your strategy, when it's time to buy new options, you might find that they are too expensive the next time around.
If the leaps are held a year you get ltcg (Diy vs swan) - of course it's your current ltcg as opposed to your future ltcg. That takes a good bit of the tax sting out.

The volatility comment is important- the options would also give you a long volatility exposure. This acts like a hedge in times like now, but long term is a loosing position. If you had to roll when the vix was at 70 - well, that would be awkward. Looked at another way it's a downside portfolio insurance cost -- and it makes sense for that to cost more / be worth more in times like now. I would probably wait a bit for vix to drop if i was rolling; that said, you are burning theta to do this (2 year options rolled at one year, say), so there is a tradeoff.

ChrisBenn
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Re: Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve (SWAN)

Post by ChrisBenn » Thu Apr 02, 2020 6:00 am

guyinlaw wrote:
Thu Apr 02, 2020 2:09 am
(...)
Since inception of SWAN (Nov 2018)
SPY is down 9.5%
NTSX is up 3.3%
SWAN is up 15%

====
I want to keep a large cash reserve, with around 2 years of expenses. Though I am working now, I want to have this available in these uncertain times.. I hope I wont need to dip into this emergency fund..

70%-90% in Treasuries <--- 2 year emergency fund
30-10% in LEAPs - SPY, IWN, QQQ, Fb etc -- Options are rolled after >1 year.

I plan to maintain my regular retirement portfolio 80-20 allocation.
Though, to be fair, if you looked at gains in feb NTSX and SPY would have probably had much more upside.

I think the EF use case makes sense (I use swan for that); If you value having a minimum fully liquid base value, but want to bet that markets go up in the long run - and participate in that upside - this fund makes sense. I expect it to do worse than VTI, ntsx in the long run

Probably the 20/80 and 40/60 lifestrategy funds are better comparisons when taking downside limits into account
https://stockcharts.com/h-perf/ui?s=VAS ... 9494834133
For the EF use case it would be one of those (or a MM fund).

Basically it's a bet the markets won't be flat (down enough that your insurance kicks in, or up enough to overcome the theta burn)

Kbg
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Re: Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve (SWAN)

Post by Kbg » Thu Apr 02, 2020 7:38 am

One can be patient and look for periods of low volatility to purchase/roll their options. This is a strategy that is OK to try and market time a bit. This also implies you have more of a window than a date for rolling the options. With SPY and QQQ you can buy some way out there LEAPS so this shouldn't be a problem.

sterjs
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Re: Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve (SWAN)

Post by sterjs » Thu Apr 02, 2020 7:54 am

I'm been interested in implementing this strategy with SPY+EFA+EEM and CDs, but I need to do my research on options math first.

madbrain
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Re: Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve (SWAN)

Post by madbrain » Thu Apr 02, 2020 3:13 pm

ChrisBenn wrote:
Thu Apr 02, 2020 5:46 am
If the leaps are held a year you get ltcg (Diy vs swan) - of course it's your current ltcg as opposed to your future ltcg. That takes a good bit of the tax sting out.
Since my state doesn't have a preferred tax rate for LTCG, the combined federal + state tax rate would still be 24.3% on any LTCG, and 33.3% on STCG. I don't see much point in doing it in taxable when I can do it in a Roth. My Roth has a larger balance than taxable account also, due to Mega backdoor conversions. I'm only adding to 401k and Roth, but never to taxable.

ChrisBenn
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Re: Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve (SWAN)

Post by ChrisBenn » Thu Apr 02, 2020 3:38 pm

madbrain wrote:
Thu Apr 02, 2020 3:13 pm
ChrisBenn wrote:
Thu Apr 02, 2020 5:46 am
If the leaps are held a year you get ltcg (Diy vs swan) - of course it's your current ltcg as opposed to your future ltcg. That takes a good bit of the tax sting out.
Since my state doesn't have a preferred tax rate for LTCG, the combined federal + state tax rate would still be 24.3% on any LTCG, and 33.3% on STCG. I don't see much point in doing it in taxable when I can do it in a Roth. My Roth has a larger balance than taxable account also, due to Mega backdoor conversions. I'm only adding to 401k and Roth, but never to taxable.
I wouldn't run this strategy preferentially in a tax advantaged account - that's mostly because of time horizon though. If you are expecting to start withdrawing from your tax advantaged account soon, and so are willing to pay extra premium for drawdown protection, than sure -- but that's probably an exception rather than the norm for retirement account planning.

A standard 3 funder, 100% equities, ntsx, or equity + options to leverage to taste would all tend to do much better with the typical time horizons one considers with a retirement account. (More exposure to equities for most of those funds + no option insurance premium costs)

Now if your consideration is more driven by savings rate, you are using the roth contributions as an emergency fund, etc. then obviously those factors override things (if your choice is 6k in a roth or 6k in a taxable, and that's it -- obviously the roth is better -- but that would be true for almost any fund, and isn't really unique to this strategy).

madbrain
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Re: Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve (SWAN)

Post by madbrain » Thu Apr 02, 2020 4:03 pm

ChrisBenn wrote:
Thu Apr 02, 2020 3:38 pm
I wouldn't run this strategy preferentially in a tax advantaged account - that's mostly because of time horizon though. If you are expecting to start withdrawing from your tax advantaged account soon, and so are willing to pay extra premium for drawdown protection, than sure -- but that's probably an exception rather than the norm for retirement account planning.
I'm not looking to withdraw from the tax advantaged accounts any time soon - I have at least 7 years left to work most likely; maybe as many as 15. I haven't run all the numbers, but I think drawdown protection in tax-advantaged may be worth it given how many big crashes I have seen in my lifetime (dot-com, 2008, and now coronavirus). It all comes down to whether the insurance is worth it in the long run or not, vs the big draw downs. I think the closer one gets to retirement, the more valuable it becomes.
A standard 3 funder, 100% equities, ntsx, or equity + options to leverage to taste would all tend to do much better with the typical time horizons one considers with a retirement account. (More exposure to equities for most of those funds + no option insurance premium costs)
I have never gone higher than 70% equities, and probably never will.
Now if your consideration is more driven by savings rate, you are using the roth contributions as an emergency fund, etc. then obviously those factors override things (if your choice is 6k in a roth or 6k in a taxable, and that's it -- obviously the roth is better -- but that would be true for almost any fund, and isn't really unique to this strategy).
I'm not using my Roth as EF.

lurker415
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Re: Using LEAPs to build a conservative portfolio in taxable account with a large cash reserve (SWAN)

Post by lurker415 » Thu Apr 02, 2020 5:08 pm

I've had a good-sized holding in SWAN and have been happy with its performance -- the 0.49% expense is worth it to me to avoid the headache of rebalancing. As of late, the price has been a bit more volatile than I would like, but that seems to be more a function of the low trading volume rather than the fundamental strategy.

The question you'll have to answer is how deep in the money would you go with the options? My understanding is that SWAN shoots for a 0.7 delta on the SPY options that it holds, so it actually has to go pretty deep in the money in order to achieve that target. That reduces the risk that the 30% allocation will go to zero (although, in this market, who knows?).

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