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"The moment a person forms a theory, his imagination sees in every object only the traits which favor that theory." Thomas Jefferson

In my last article, I put forth the theory that most investors (and even money managers) would be better off abandoning traditional stock selection in favor of targeted selling of puts and calls. The theory is based upon combining the historic results of two CBOE indices, the BXY and the PUT.

Let's first review the recipe as given….

1) Sell monthly naked calls on the S&P 500, precisely 2% OTM. Now we all know that there is always a strike at which a call can be sold most profitably. What the BXY index illustrates, and what I have found experience to validate, is if we avoid any specific timing module or a specific market bias, 2% OTM works better than other strikes such as 3% OTM, 1% OTM, ATM or ITM.

2) Sell monthly puts on the S&P 500, ATM. The number of puts sold is adjusted in a manner very similar to "Dollar Cost Averaging" [DCA]. That is, as the market goes up/down, then the number of puts sold on each successive monthly expiry would go, inversely, down or up. Market goes up---sell less puts; market goes down---sell more puts. The "exposure" or amount at risk remains constant. This provides a gradual reduction of exposure in an up market, and more exposure in a down market than would be provided selling the same number of puts each month. Just good old common sense.

3) The historic outperformance of this strategy is significant. In range-bound and down markets it shows gains relative to the S&P 500 but underperforms the S&P 500 in rapidly rising markets.

Here's a chart showing the performance versus the S&P 500 of this two pronged strategy, from January 2000 through July 2012:

(click to enlarge)

Now, let's keep in mind that this is a theoretical outcome, as it is based mostly on historical observation and back-testing. I doubt anyone actually implemented this. There is nothing inherent that mandates any result. Left without modification, I believe it will be hard to achieve for several reasons:

1) The theory is based upon the hypothetical results of an index. The mechanics of just managing position size in options becomes an obstacle. Just a single SPX option represents $140,000 in exposure and the inability to deal with fractional shares is a deal breaker. Using mini-SPX or SPY lowers the exposure to $14,000, but still makes "fine tuning" very difficult. It would be nearly impossible to match the monthly put sales precisely with the actual up/down of the market. A plan that can't be implemented is no plan at all.

2) Human nature runs counter to the plan. Most investors "pile on" in up markets and "run scared" in down markets. Will they stick to the plan and cut back the number of puts sold in up markets and sell more as the market falls? In this, history tells us no.

3) Wealth is not created by simply losing less than your neighbor in down markets. Return of your money is just as important as return on your money. There is a difference between risk management, hunches and gambling.

4) Successful investors don't choose investments based solely upon the past. We must replace back-testing with "forward-testing."

So, it's time to look at adding "dessert and coffee" to the recipe. The menu now calls for protecting against downside risk making significant gains in a rising market.

First, portfolio protection: This is pretty easy to accomplish, just buy an ATM put, about one year ahead. The objective is to protect against loss, but more so, to provide the "courage" to keep invested when the market falls. The obstacle to portfolio protection has always been the cost. Buying puts, even when volatility is low, diminishes returns.

Here's a solution. With SPY trading around $138.40, the January 2014 $138 put costs $12.93. If we break the cost of the puts down to a monthly cost, it comes out to a little less than $1.00 per month.

So, instead of selling a varying number of puts each month, sell a constant number of puts each month, as deep ITM as possible, so as to generate $1.00 per month of extrinsic value. By example, the December 2012, $144 strike put credits around $6.80. That breaks down into $5.50 intrinsic and $1.30 extrinsic. So, if the market headed straight down over the year, the total extrinsic received will offset the cost of the put debits of $12.93. So, instead of losing relatively less than the S&P 500, the absolute loss is zero. But most importantly, it allows the investor to "stay in the game" when things look bleak.

Here's the beauty of targeting a fixed extrinsic value ($1.00 per month) rather than a fixed strike…. When the market rises, volatility usually drops, and the strike will need to be set closer to SPY's price to reach the target amount of extrinsic. When the market drops, volatility usually rises and the strike can be set further ITM and still meet the target. For example, when the initial strike is set at $144 it represents $4.50 ITM or about 2.8% of SPY. If the market rises and volatility lowers, the strike may be set only $2 or $3 ITM, representing 1.5% or 2% of SPY. When the market falls, and if VIX increases, the strike may be 4% or 5% or more ITM. So, the result is very similar to selling more/less puts each month as required in the CBOE PUT Index.

I guess what I'm saying, is, keeping a fixed number of options sold each month, but adjusting the strike to fit the extrinsic available, can have a similar outcome as keeping the strike ATM and adjusting the number of options.

Now, the actual results can't be predicted with precision, because the market is never uni-directional. Even if the market shoots up immediately, the $6.80 made on the first month's put covers over one-half the cost of the far-dated put with many more months of $1.00 extrinsic to some.

This method works perfectly as long as SPY, at the monthly expiry, hasn't over-run the pre-set strike. For instance, if SPY climbs to $150 when the strike is set at $144, setting the next month's strike at, say, $153 to target $1.02 of extrinsic can be problematic. It would take too much to explain the reasons, but if there is an substantial over-run of the strike, start looking for more extrinsic and less intrinsic. Just make sure the target is at least $1.00 extrinsic. Another option would be to "re-set" the far dated put ATM= $150 strike and continue to lead with ITM puts.

Second, selling the OTM naked call: The BXY index anticipates selling monthly calls 2% OTM. This needs to be modified into selling weekly calls. The reasoning is simple; by selling monthly calls, it provides more premium credits, and therefore, more protection in a down market. The trade-off is more risk exposure in an up market. However, with the purchase of the far-dated puts, the down market isn't much of a hazard. Therefore, we need not "trade-off" downside protection for upside risk.

So, with SPY at $138, instead of selling a monthly 2% OTM for a credit of $1.30, sell the $142 weekly put for 28 cents. Here's a very important point: regardless of what the market does, continue to sell the naked call at $142 strike until the next month's expiry. Then re-adjust your strikes on the puts to garner $1.00 extrinsic per month, and the call at 2% OTM weekly. Repeat the process.

I'll leave the math to each of you to figure out, but in a rising market, the cumulative weekly premium credits received for the naked calls will exceed the one-time credit of a monthly naked call. So, in a rising market, the weekly will outperform the BXY index. An added bonus to maintaining the strike is protecting against a drop back and "locking in" gains on the $144 strike put that was sold.

Summary: The long-term investing recipe starts with a first course of selling 2% OTM calls to lower volatility and increase returns. In the next course, we served selling ATM puts (DCA technique). The problem with the basic menu is that it is incomplete, as it doesn't account for human nature and the problems of implementation.

The "dessert and coffee" adds portfolio protection and offsets the cost by raising the strike on the puts and selling the naked calls weekly.

Instead of back-testing, let's look at a "forward-test" these variations:

If the market goes straight down, the near term and far-dated puts provide significant protection. The naked calls are profit. No one can predict the actual results, but if the "puts" ended up in a wash, the calls would have made 28 cents times 52 weeks or about $14.50. This alone represents a 10% or greater return on SPY.

What if the market goes up? Each week it exceeds 2% there is a loss on the calls, but the puts show a gain. It is more than reasonable to predict that the net gains on the puts will exceed the net losses on the call, but only "Mr. Market" knows by how much.

Conclusion: Presented for your enjoyment is a complete full course menu, appetizer through dessert. It is not a trading strategy; it is a long-term alternative to buy and hold or whatever the average investor is doing. It has as its core three basic objectives: 1) protect against loss 2) lower volatility and 3) look for outsized gains. This is a pretty tall order.

For those looking for a "take out" meal, I would suggest selling 2% OTM naked calls as a standalone adjunct to their portfolio. Or, if they want lighter fare, selling puts, initially ATM, but lowering strikes on the way up and increasing strikes on the way down can be satisfying.

One thing to consider is that this strategy does not require the investor to try to guess or time market direction. Though it has several pieces and requires effort, it is devoid of judgmental decisions. Each investor can "juggle" the strikes as they see fit and make modifications (such as using a bear put spread instead of a put, for protection).

I won't go so far as to say this is an easy recipe, but when compared to managing individual stocks, it has much less risk, much less decision making and much lower volatility.

Disclosure: I buy and sell options on SPY. I have no positions in any other stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Selling Puts And Calls: Dessert And Coffee