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In a recent article, "Tempted by S&P 1600 but wary of a sharp correction" I commented on the seeming convergence of performance of previously diversifying asset classes such as stocks represented by SPY, and precious metals in the form of SLV and GLD, and how this, compounded with the negative real returns available from cash and US bonds (TLT) creates challenges for the effectiveness of asset allocations strategies to manage the downside risk of stocks as we enter a 5th year of price uptrend despite well-documented macroeconomic headwinds.

Identifying the need to explore alternative strategies, I presented the results of a back-testing simulation of a series of 12 month at the money put options to hedge a portion of the downside risk within the cost range of the expected dividend yield. The results indicated that the market is pretty efficient at pricing for the observed volatility, and that this strategy would have eroded value compared to a 'buy and hold' in the market strategy over a range of observation periods to 25 years.

You can read this article here.

A question was raised by one of the readers as to whether selling an out of the money call option would work better. The suggestion was for a 160 call, which is about 10% out of the money. I re-ran the backtest simulation using this strategy - making the same assumptions (consistent call pricing for 10% out of the money 12 month calls over the period.) For the sake of consistency, I assumed a 20% hedge of the portfolio, 1 call option for 500 units of stock.

As this is relatively close to the money in percentage terms, I also considered a 170 call, which is around 17% above today's price, and also close to the top end of the 2013 analysts' projections that I have seen published to date.

Selling a call option gives the obligation to the seller to sell the stock at the strike price if called, which involves significant risk. If the market price is higher than the strike price at expiration, the seller must absorb the difference. For this simulation, prices above the strike result in a loss of value equivalent to 20% of the difference between actual and strike price.

The challenge with this strategy is that the seller absorbs open-ended upside risk, with only the option price to offset.

The results were similar to the original put strategy. The 10% OTM call strategy underperformed an unhedged play by 18%, and the 17% OTM strategy by 11%, as represented by the results below.

145 Base

160 Call

10% OTM

170 Call

17% OTM

Hedge

No Hedge

Hedge

No Hedge

Jan

$1000

$1000

Delta

$1000

$1000

Delta

2013

603.4

710.0

118%

638.2

710.0

111%

2012

542.4

640.0

118%

574.5

640.0

111%

2011

519.2

615.0

118%

551.4

615.0

112%

2010

432.2

505.0

117%

455.1

505.0

111%

2009

334.5

380.0

114%

349.1

380.0

109%

2008

598.5

685.0

114%

627.8

685.0

109%

2007

622.0

715.0

115%

654.3

715.0

109%

2006

544.6

624.1

115%

570.5

624.1

109%

2005

526.6

606.0

115%

553.1

606.0

110%

2004

395.4

439.9

111%

411.6

439.9

107%

2003

610.0

683.0

112%

637.7

683.0

107%

2002

620.0

697.2

112%

650.1

697.2

107%

2001

650.5

734.6

113%

683.9

734.6

107%

2000

549.9

614.6

112%

573.4

614.6

107%

1999

443.1

485.2

110%

458.0

485.2

106%

1998

347.0

370.4

107%

355.6

370.4

104%

1997

291.9

308.0

106%

296.6

308.0

104%

1996

224.2

229.6

102%

225.8

229.6

102%

1995

226.7

233.2

103%

229.0

233.2

102%

1994

211.0

217.9

103%

213.6

217.9

102%

1993

201.2

208.5

104%

204.2

208.5

102%

1992

162.4

165.1

102%

163.5

165.1

101%

1991

173.1

176.7

102%

174.7

176.7

101%

1990

138.9

138.9

100%

139.0

138.9

100%

1989

123.5

123.5

1

123.5

123.5

1

The 10% OTM call was triggered in 12 out of the 25 years, and the 17% OTM call 10/25 years. Above the 17% OTM call level, the option demand and prices drop away to an immaterial level.

When tested, selling the call hedge generated a more negative result than buying the put hedge - the short strategy absorbs more tail risk than the long strategy, where the downside is limited to the option price, and in this 25-year SPY example, the market volatility exceeded the expectation built into the short price.

The bottom line - the parachute didn't open.

Option hedging strategies seem in this case to be undermined by the market efficiency, while consistent time in a rising market tends to act to compound out the annual volatility. If the market follows a generally growing economy, the long-term investor seems unlikely to outperform by using options to hedge the volatility.

This brings us back to other methods of outperforming the market:

1) Market timing.

2) Stock selection.

3) Return optimization using short term tactical options strategies.

4) Asset allocation.

In the near future, I will expand on the theme of seeking strategies for more effective asset allocation in the current environment which is distorted by monetary policy.

Source: Riding S&P 500 Up: Testing A Parachute