One of the ironclad truths of investing is that with higher reward comes higher risk.

I’ve been thinking a lot, years actually, about how to bend that relationship to earn higher returns while simultaneously lowering risk. Covered calls, which protected clients from significant downside risk during the February correction, had some promise as a method that could give you positive returns with lower risk, as it lets you earn positive returns in upward, modestly downward, and sideways moving markets, but the past year in the stock market exposed some of its most significant weaknesses, namely, its limited returns during big market runs and not being paid enough for rising risks in rapidly falling markets if you’re locked into longer term contracts.

Covered calls, in order to maximize their profit potential, effectively require you to make a best-guess estimate as to where markets will be every 3 to 6 months, depending on the length of the option contract, and the closer you can get to the mark, the higher your profit, and the farther away you are, the more limited the profit becomes. And as we know, projecting where markets may be on a quarterly to semi-annual basis can be quite difficult and imprecise, like trying to approximate a circle with 4 points:

 

 

I needed something more elegant, adaptable, and precise, and the solution occurred to me during the February stock market correction. In the midst of the widening fear among investors that the bull market would meet its end (it didn’t, and I explained in my previous post why fear was a good thing for the market), I started looking at prices people were willing to pay to protect their portfolios in case markets fell further. These types of contracts, called “put options,” can be easily bought and sold in something called the options market. They are basically the stock market’s version of fire insurance: you can buy them to cover you over a short or a long period of time, and they can become very expensive or very cheap, depending on the outlook for risk. You can also sell them and play the role of insurer.

Here’s where the insurance analogy becomes helpful to illustrate the solution that came to mind:

Imagine you’re an insurance company that insures homes against fires. Every year the policy sells for about $800 for a house. Now imagine that instead of selling them on a yearly basis for $800, you are able to sell them for one week at a time for $25. It’s certainly a lot more work, but with 52 weeks in a year, you would earn $1,300, for a much better profit.

The stock market is basically providing a similar offer. They allow us to play the role of the insurance company – we guarantee to buy the stock market at price X if it gets there, and in exchange for that guarantee, the market will pay us about 0.25% per week, for example. Multiply that by 52 weeks, and that comes to about 13% per year annualized, which is much higher than the average return of 8% in the stock market.

There are times when this insurance premium will rise significantly too, like when investors are panicking, and when that happens, I have seen these insurance premiums go up to 30%, 40%, even 50% annualized (like during the correction), which can increase returns further.

This approach to investing will pay you an upfront premium to own something you would already own anyway (stocks). By guaranteeing to own the stocks, you would collect the insurance premium every week, and it’s my belief that these premiums, collected over the course of a year, will on average exceed the actual return of the stock market by a healthy margin.

I put together a graph that shows how much these contracts pay on an annualized basis as of June 1, 2018 prices. You can see below that selling an “insurance policy” (called “put contracts”) at then-current levels (called “at the money”) for one week at a time for a whole year provides about a 28% return, and one for 4 weeks at a time pays a yearly equivalent of about 16%, and if we go out to about half a year, the 29 week contract pays an annualized total of about 7% (not much of an advantage any more this far out). The shorter the contract time period, the more it pays:

 

 

The focus on weekly time frames has an extra benefit in that it allows us to better adapt to the curvature of the market, resulting in potentially higher returns and lower risk. When you’re allowed to adjust to road conditions every 100 feet instead of every mile, you are able to position yourself more advantageously just as markets are gathering steam or just as conditions are beginning to deteriorate. Going back to the previous analogy of trying to approximate a circle, you have far better results with 52 points than with 4:

 

 

Since I usually sell these insurance contracts at more conservative levels that are 1%-2% below the market before our guarantee to own it kicks in, I have found that portfolios are on average avoiding about 75% of the downside when markets fall. In exchange for that greater protection, we have a more modest expected rate of return of about 5-7% per year. And if the market looks like it wants to fall further, I can cancel the contract and go even lower to protect ourselves even more, or get paid a higher insurance premium for potentially higher returns. On the other hand, if the market looks like it wants to go higher, we can write the contracts closer to current price levels to get closer to that 20+% annualized return shown in the above example.

The returns for the Short Put strategy have tended to be much smoother than the stock market because of the safe distance we tend to keep before our guarantee to buy takes effect. In addition, the very short expiration dates for the weekly insurance premiums we collect often means that the contracts have ended well before any sustained decline in the market can develop. Therefore, downside volatility is dampened significantly because the market has to fall a lot within a week before we even begin to experience a loss.

I calculated the return vs. risk ratio (the Sharpe Ratio) for the brief time period I’ve been using this strategy, and the results have so far been very promising. A typical Sharpe ratio is maybe around 0.40 (from 1971-2015, it has been 0.34), and anything over 1.0 is considered good. As for this strategy, its Sharpe ratio so far is an impressive 2-3. This is an extraordinary number, but I have to caution that the time frame is still very short (anything less than a year is not yet significant) and its execution has coincided with a cooperative stock market, where most strategies will also have elevated Sharpe ratios. In addition, since shorting puts is inherently a bet against volatility (since options pricing takes volatility into account), large spikes in volatility can result in losses even if the put option remains out of the money. Put options also have an asymmetrical payoff profile (small capped gains can be offset by uncapped losses to the downside), so a stop loss strategy should be implemented to keep the payoff profile more symmetrical.

To conclude, selling puts on a weekly basis and capturing their high annualized premiums seems to be an approach that is able to significantly bend the relationship between risk and reward in our favor, subject to the above risks and caveats, and provided a stop-loss methodology is simultaneously implemented to control for its asymmetrical risk profile. It is an approach that has a lot of potential to capture higher returns while limiting risk.

 

Rainier Trinidad, CFA
San Diego and Coronado’s Fiduciary Financial Advisor
Parabolic Asset Management
206 J Avenue
Coronado, CA 92118
rainier@parabolic.us
(619) 888-4070

 

INVESTMENT RISK DISCLAIMERS
(i) Investments involve risk and are not guaranteed to appreciate, and (ii) Past performance is no guarantee of future results. (iii) My writings may contain statements and projections that are forward-looking in nature, and therefore are subject to numerous risks, uncertainties and assumptions. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.