Is There A Role For Options Insurance In Equity Portfolios?

[Retireby45ish]

I guess the % isn't as important to me as the $ amounts. So to extend Sunsets's example, let's say that I buy 10 contracts rather than invest $316,830 in the SPY and my investment in the LEAPs is $158,000.

If index rises to 450, 1000 shares of SPY are worth $450,000 and a $133,170 gain where at expiry the LEAPs are worth $290,000 and a gain of $132,000.

If index is flat then 1000 shares of SPY are worth $316,830 and $0 gain where at expiry the LEAPs are worth $156,830 and loss of $1,170.

If index is 266.83 then 1000 shares of SPY are worth $266,830 and a loss of $50,000 where at expiry the LEAPs are worth $106,830 and a loss of $51,170.

So in that scenario it seems to me that you are getting roughly the same investment gain as directly investing in the SPY but with your downside limited to $158,000 loss at worst.

Now all of that said, I was thinking of LEAPs that were more like 15% or so in-the-money vs 50% in-the-money.

That makes sense. If you look at it as a dollar amount there is no real difference. And I guess the only thing you give up is that $1170 (optionality) plus the dividends you would have gotten along the way in the SPY, which is another 1.8% or so yearly.

 

[pb4uski]

....And yes, the Dividend discount is imbedded in these options already so you aren’t missing out on this. ...

.... And I guess the only thing you give up is that $1170 (optionality) plus the dividends you would have gotten along the way in the SPY, which is another 1.8% or so yearly.

I guess that I am confused as to whether I'm giving up the dividend or not.
There was an options price calculator on the CBOE site that included dividends in the calculation of option price but that calculator is no longer there.

Also, if I am giving it up with SPY, would it be different if I used a different broad based index?

I tried doing some research on this and couldn't find anything definitive. Since I plan to invest in long-term options (~2 years) I think it is a relevant issue.

 

[pb4uski]

Ok, so a hypothetical with $1 million portfolio. Alternatives are to:

• buy $600k SPY and $400k fixed income at 3% per annum or
• achieve equity allocation by buying Dec 2022 LEAPs for $600k notional and investing remainder at 3% per annum.

Assumptions:

• SPY at inception: 315
• Cost of Dec 2022 LEAP at 245 strike is $85
• SPY dividends are 2%/yr and are reinvested
• Term is 2.5 years (for easy figuring)

Direct investment of $400k fixed income is $431k after 2.5 years ($400k*(1+3%)^2.5).

For LEAPs scenario, I spend $162k on LEAPS ($600k/315*$85) and have $838k left which after 2.5 years at 3% is worth $902k ($838k*(1+3%)^2.5).

• After 2.5 years, the index has declined 30% to $221.... a IRR of -11.30%... with 2% dividends a total return of -9.30%.
• After 2.5 years the index is flat at $315... an IRR of 0%... with 2% dividends a total return of 2.0%
• After 2.5 years the index has increased 30% to $410... an IRR of 11.07%... with 2% dividends a total return of 13.07%

$600k direct investment in SPY is worth, after 2.5 years, $445k, $630k and $816k respectively ($600k*(1+total return)^2.5).... total direct investment portfolio is $876k, $1,061k and $1,247k, respectively, after including the $431k of fixed income.

After 2.5 years, the LEAPs are worth $0, $133k and $313k, respectively ($162k/85 *(ending SPY-245 strike)).... total LEAPs strategy portfolio is $902k, $1,035k and $1,215k respectively, after including the $838k of fixed income.

If the index declines, the LEAPs strategy outperforms the direct investment by $26k. If the index is flat, the LEAPS strategy comes out behind by $26k and if the index increases then the LEAPs strategy come out $32k behind.

So even if the SHTF and we had a horrible bear market your losses are limited to $98k ($1 million - $902k value of fixed portfolio) because under the LEAPs scenario even if the LEAPs are worthless the fixed portfolio will be worth $902k.

But with the direct investment portfolio, losses could be as much as $600k... I concede $600k is not realistic, but even if 1/3 that would be $200k of losses.

OTOH, the protection from losses in excess of $98k looks to be about $25-$41k over the 2.5 years.... even if the index doubled over the 2.5 years the difference in the strategies would only be $41k (about 2.5% or 1% a year).

Am I missing anything? I realize that I included dividends rather crudely.

 

[bmcgonig]

Ok, so a hypothetical with $1 million portfolio. Alternatives are to:

• buy $600k SPY and $400k fixed income at 3% per annum or
• achieve equity allocation by buying Dec 2022 LEAPs for $600k notional and investing remainder at 3% per annum.

Assumptions:

• SPY at inception: 315
• Cost of Dec 2022 LEAP at 245 strike is $85
• SPY dividends are 2%/yr and are reinvested
• Term is 2.5 years (for easy figuring)

Direct investment of $400k fixed income is $431k after 2.5 years ($400k*(1+3%)^2.5).

For LEAPs scenario, I spend $162k on LEAPS ($600k/315*$85) and have $838k left which after 2.5 years at 3% is worth $902k ($838k*(1+3%)^2.5).

• After 2.5 years, the index has declined 30% to $221.... a IRR of -11.30%... with 2% dividends a total return of -9.30%.
• After 2.5 years the index is flat at $315... an IRR of 0%... with 2% dividends a total return of 2.0%
• After 2.5 years the index has increased 30% to $410... an IRR of 11.07%... with 2% dividends a total return of 13.07%

$600k direct investment in SPY is worth, after 2.5 years, $445k, $630k and $816k respectively ($600k*(1+total return)^2.5).... total direct investment portfolio is $876k, $1,061k and $1,247k, respectively, after including the $431k of fixed income.

After 2.5 years, the LEAPs are worth $0, $133k and $313k, respectively ($162k/85 *(ending SPY-245 strike)).... total LEAPs strategy portfolio is $902k, $1,035k and $1,215k respectively, after including the $838k of fixed income.

If the index declines, the LEAPs strategy outperforms the direct investment by $26k. If the index is flat, the LEAPS strategy comes out behind by $26k and if the index increases then the LEAPs strategy come out $32k behind.

So even if the SHTF and we had a horrible bear market your losses are limited to $98k ($1 million - $902k value of fixed portfolio) because under the LEAPs scenario even if the LEAPs are worthless the fixed portfolio will be worth $902k.

But with the direct investment portfolio, losses could be as much as $600k... I concede $600k is not realistic, but even if 1/3 that would be $200k of losses.

OTOH, the protection from losses in excess of $98k looks to be about $25-$41k over the 2.5 years.... even if the index doubled over the 2.5 years the difference in the strategies would only be $41k (about 2.5% or 1% a year).

Am I missing anything? I realize that I included dividends rather crudely.

This offers some potential behavioral advantages to me:

I can sleep better at night knowing my losses are limited.

If we do have another crash like event I have an option to convert fixed income to stocks with minimal fear, ie buy more leaps (although VIX would be high probably) something I'm normally nervous about doing.

Maybe I missed it but where would you get 3% on FI?

 

[Retireby45ish]

Ok, so a hypothetical with $1 million portfolio. Alternatives are to:

• buy $600k SPY and $400k fixed income at 3% per annum or
• achieve equity allocation by buying Dec 2022 LEAPs for $600k notional and investing remainder at 3% per annum.

Assumptions:

• SPY at inception: 315
• Cost of Dec 2022 LEAP at 245 strike is $85
• SPY dividends are 2%/yr and are reinvested
• Term is 2.5 years (for easy figuring)

Direct investment of $400k fixed income is $431k after 2.5 years ($400k*(1+3%)^2.5).

For LEAPs scenario, I spend $162k on LEAPS ($600k/315*$85) and have $838k left which after 2.5 years at 3% is worth $902k ($838k*(1+3%)^2.5).

• After 2.5 years, the index has declined 30% to $221.... a IRR of -11.30%... with 2% dividends a total return of -9.30%.
• After 2.5 years the index is flat at $315... an IRR of 0%... with 2% dividends a total return of 2.0%
• After 2.5 years the index has increased 30% to $410... an IRR of 11.07%... with 2% dividends a total return of 13.07%

For each of these scenarios you don't get any of the dividends since you just bought the calls. (You asked this in another thread so I'm responding here, but can go into more detail on how the calls are priced with dividends baked in).

I think for this part your math seems off for this part:
*After 2.5 years with index flat at $315, the calls are worth 315-245 = 70, but you paid $85 for them, so you lose $15,000, so not 0% IRR. And no divs

What are the puts worth on the 245 strike? The more value they have the more you'll be paying, unintentionally for the strategy. You want to find a strike that has min put value for this (but still high enough where you're getting the leverage you want)

I agree with the Q from bmc above, where can I get 3% FI to stash all this cash that's not working for me? I have some in BND but even that has risks.

 

[tdv2]

Glad to be of help.

Technically, those options are actually slightly OVERPRICED. because they are akin to lottery tickets people shy away from selling them. They work until some 5 standard deviation event happens once a decade or two and you lose the farm. Everyone knows this so they are slightly worth more than they should be. But if you make, say, $10 every month but then stand to lose $100k once every decade, is it worth it? No. Even if they are overpriced and I collect $12 instead of $10? nope,not for me.

I believe in your example you are suggesting selling the contracts and collecting the small premium on the out of the money options. Very dangerous should you have one of those 5 sigma events. Telab says these options strategists "eat like chickens and go to the bathroom like elephants". I really like that quote.

Now if you purchase these far out of the money options knowing that you are going to lose 99% of the time, when that 5 SD event happens, if it ever does, you make a windfall. Your only risk is having an unknown number if options expiring worthless....possibly for a really long time. @oldshooter, I think this is what Telab describes as one strategy he employs.

 

[pb4uski]

.... Maybe I missed it but where would you get 3% on FI?

I gourged on 3.0% and 3.5% 5-year credit union CD specials in 2019 and I have a preferred stock portfolio that yields about 5.7%... put it all together and ~60% of my portfolio is in fixed income yieldng ~3.65%.

So I concede that the strategy might be unique to me because I have those attractive yielding CDs in hand.

 

[pb4uski]

.... I think for this part your math seems off for this part:
*After 2.5 years with index flat at $315, the calls are worth 315-245 = 70, but you paid $85 for them, so you lose $15,000, so not 0% IRR. And no divs

What are the puts worth on the 245 strike? The more value they have the more you'll be paying, unintentionally for the strategy. You want to find a strike that has min put value for this (but still high enough where you're getting the leverage you want)

I agree with the Q from bmc above, where can I get 3% FI to stash all this cash that's not working for me? I have some in BND but even that has risks.

On the first part perhaps I didn't word it clearly. The 0% IRR is for the market movement of the direct investment alternative... I'll have bought SPY at 315 and 2.5 years later is still trading at 315 but since for the direct investment I'm receiving 2% in dividends, my $600k initial investment is worth $630k.

For the calls, if the index ends the 2.5 years at 315, they would be worth $133k [(315-245)*$162k/85] for a loss of $29k which is the unembedded value of the options at the purchase date.

The puts at 245 are worth ~$24, but I'm not sure how to assess the relationship between the $85 for the call and the $24 for the put. I agree that the cost is currently high. Do you know of a source that would tell me the price of a 0.75 delta Dec 2022 LEAP call back in January? I suspect that the time value of the option was probably a lot lower than it is today, which would make the strategy a lot more attractive.

 

[Sunset]

I guess that I am confused as to whether I'm giving up the dividend or not.
There was an options price calculator on the CBOE site that included dividends in the calculation of option price but that calculator is no longer there.

Also, if I am giving it up with SPY, would it be different if I used a different broad based index?

....

This issue of missing out on the dividends, was what lead me years ago, to buy some leaps in a non-dividend paying stock, BRK.B as a pseudo-broad based fund.
Unfortunately, now it has fell out of favor, and I have not looked for a replacement if there is one.

 

[Retireby45ish]

I believe in your example you are suggesting selling the contracts and collecting the small premium on the out of the money options. Very dangerous should you have one of those 5 sigma events. Telab says these options strategists "eat like chickens and go to the bathroom like elephants". I really like that quote.



Now if you purchase these far out of the money options knowing that you are going to lose 99% of the time, when that 5 SD event happens, if it ever does, you make a windfall. Your only risk is having an unknown number if options expiring worthless....possibly for a really long time. @oldshooter, I think this is what Telab describes as one strategy he employs.

I'm not saying to sell them. I'm saying the same thing Taleb. Not worth it to sell lotto tickets for me. And I don't buy them either

 

[OldShooter]

... Now if you purchase these far out of the money options knowing that you are going to lose 99% of the time, when that 5 SD event happens, if it ever does, you make a windfall. Your only risk is having an unknown number if options expiring worthless....possibly for a really long time. @oldshooter, I think this is what Telab describes as one strategy he employs.

I think we both understand Taleb's (note correct spelling) strategy the same way. But the problem is, as I have mentioned in other posts, is that the "windfall" may only be enough to cover the cost of all those cheap, expired, lottery tickets unless the options are underpriced for the risk the sellers are assuming. @Retireby45ish's statement that in fact they may tend to be overpriced doesn't surprise me because I tend to think the starting point for looking at any investment is to assume the EMH, then start thinking about how behavioral factors may be affecting the price.

So the "windfall," if it arrives for the bettor, will be due to getting lucky with the statistics and not to any kind of genius or bulletproof strategy. IMO this is true of most speculative investments.

 

[tdv2]

I think we both understand Taleb's (note correct spelling) strategy the same way. But the problem is, as I have mentioned in other posts, is that the "windfall" may only be enough to cover the cost of all those cheap, expired, lottery tickets unless the options are underpriced for the risk the sellers are assuming. @Retireby45ish's statement that in fact they may tend to be overpriced doesn't surprise me because I tend to think the starting point for looking at any investment is to assume the EMH, then start thinking about how behavioral factors may be affecting the price.

So the "windfall," if it arrives for the bettor, will be due to getting lucky with the statistics and not to any kind of genius or bulletproof strategy. IMO this is true of most speculative investments.

Agree. For there to be any sustainable advantage over luck there would have to be mis-pricing involved. BTW....I have a mental block in transposing the e and a in his name.

 

[Months.in.Wyoming]

Pricing the Puts for Income

I have been considering something similar but have yet to do any real work modeling, back testing, etc.

My thinking is along the lines of selling puts on things (likely all or mostly indexed ETF's) that I want to own at a lower entry point anyway.



Some of the many things I still need to work out:

1. Pricing the puts
2. Cash covered only or using margin for more flexibility
3. Tax implications

I’m selling Puts on fundamentally sound companies that are slightly out of the money and within 45 days of expiration. The strike I choose is the one out of money where the premium yields me 48% annualized (Premium / Strike Price annualized). You’ll find a number of potential underlying equities that will easily yield 25% and I’m often beating the 48%. Actual results were 211k income last year utilizing 300k cash to cover. Regarding taxes - it’s simply income tax - not worried about it. Just keep testing / tweaking my strategy... Plan though is to implement this in a Roth in retirement - which at first seems counterintuitive as you’d normally think to buy and hold and let compound there. But - I’m going to have tax free income as long as I can successfully do this. Plan to live on some and yes, invest some earnings towards the long term buy and hold.

 

[CoolChange]

Puts for Income

I’m selling Puts on fundamentally sound companies that are slightly out of the money and within 45 days of expiration. The strike I choose is the one out of money where the premium yields me 48% annualized (Premium / Strike Price annualized). You’ll find a number of potential underlying equities that will easily yield 25% and I’m often beating the 48%. Actual results were 211k income last year utilizing 300k cash to cover. Regarding taxes - it’s simply income tax - not worried about it. Just keep testing / tweaking my strategy... Plan though is to implement this in a Roth in retirement - which at first seems counterintuitive as you’d normally think to buy and hold and let compound there. But - I’m going to have tax free income as long as I can successfully do this. Plan to live on some and yes, invest some earnings towards the long term buy and hold.

Months.in.Wyoming,

Congratulations on your 2020 returns, impressive!

Thank you for reviving this thread and sharing your pricing strategy.


I am just now coming back to my plans for doing something similar since I have accumulated cash in my IRA's (called preferreds, dividends, and selling a few things that are just too frothy for my liking). Yes, I realize many would tell me to just hold my nose and rebalance; but, I am having trouble doing that in today's market.

Rather than selling puts on individual companies, I am planning to sell puts on ETF's that I would actually like to own, just at better purchase prices. So, if I get put into the ETF, I am not going to be unhappy; or, if I can generate anything close to your returns from the puts, I will be VERY happy.

....
I’m relatively (few months) new to the board and learning lots but options are the one thing I know. Been working with them professionally for almost 2 decades....

Retireby45ish,

I would definitely appreciate your insight and commentary on this use of puts.

 

[Sunset]

I’m selling Puts on fundamentally sound companies that are slightly out of the money and within 45 days of expiration. The strike I choose is the one out of money where the premium yields me 48% annualized (Premium / Strike Price annualized). You’ll find a number of potential underlying equities that will easily yield 25% and I’m often beating the 48%. Actual results were 211k income last year utilizing 300k cash to cover. Regarding taxes - it’s simply income tax - not worried about it. Just keep testing / tweaking my strategy... Plan though is to implement this in a Roth in retirement - which at first seems counterintuitive as you’d normally think to buy and hold and let compound there. But - I’m going to have tax free income as long as I can successfully do this. Plan to live on some and yes, invest some earnings towards the long term buy and hold.

I can see this for volatile stock like ARKG for example, but wondering what you mean by "fundamentally sound companies"

Have you accidentally ended up buying any of the companies due to a price swoon , and what do you do at that point ?

Do you sell calls on it, until it gets taken, or keep it ?

 

[Months.in.Wyoming]

I can see this for volatile stock like ARKG for example, but wondering what you mean by "fundamentally sound companies"

Have you accidentally ended up buying any of the companies due to a price swoon , and what do you do at that point ?

Do you sell calls on it, until it gets taken, or keep it ?

Hi Sunset;
So I run a stock screener in Schwab that I’ve named “Cash Strong-Undervalued Mid-Cap” which generally looks for current ratio over 1, asset:liability over 1, low short interest (which I might need to tweak! ) institutional ownership and some other items.. It resulted in tickers like USCR, MCS, CMC, VST, HP (Helmerich & Payne - not computer)... the list is usually around 25-30 results. I then dig into them and apply a “Narrative Test” meaning is the story a tailwind or is there some future risk. I also have a screen for large cap undervalued that I’ve developed and it brings me F, JPM, etc last year. So I wrote puts that were 30 and sometimes 15 days out, once I did a 45 day out. I have been put to and like CoolChange I don’t mind being put to if it happens. I’ll stay long until I can get out and make the 48% target (if they had expired with no Put-to it would have been 50-60, etc.). I have thought about writing calls - but the problem is 1) it’s not my stated strategy and there is value in holding to your discipline and 2) If for some reason it falls further and I just want to pull the plug, I need to buy that call back... So I normally don’t do it. Out of my last 95 put sales I’ve lost money 4 times, I’ve been put to: 8 times. I track every detail about every trade in a spreadsheet including my thought process for deciding to sell that particular put. The 95 sales have occurred over the past year to give you an idea of frequency. I will close out a put and roll it forward to another at the same expiration date if the stock has risen substantially and I can close out for substantially less than the new premium.