Buy And Hold SPY Vs. Selling SPY Put Options

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 |  About: SPDR S&P 500 Trust ETF (SPY)
by: Reel Ken

The last few years have seen rapid growth in the variety of investment vehicles available to the retail investor. We’ve seen the emergence of leveraged ETFs, reverse leveraged ETFs, ETNs, currency ETFs, hedge funds, funds of hedge funds and the list just keeps going on. It often seems that the average retail investor is inundated beyond their ability to act. Keep It Simple Stupid is out of style.

My articles have put forth various option strategies that run from very simplistic to extraordinarily complex. In an attempt to make them easier to follow I always start with a premise.That is, what is it that the investor trying to accomplish?

Investors are hungry for better ways to invest. They seek out better alternatives to "buy and hold". Since one of the most widely held securities is the SPDR S&P 500 ETF (NYSEARCA:SPY) it would seem that alternatives to SPY would meet with lots of interest.

Is it better to own SPY outright or sell cash secured Puts?

First, let’s deal with the tax issue. Under existing law, SPY and its dividends can benefit from favorable tax rates. Put sales, on the other hand, are considered ordinary income and denied this favorable tax treatment. In a taxable account, this factor alone tips the scale in favor of owning the stock. If the investment account is not taxable (such as an IRA) then a comparison of the two strategies can yield worthwhile results.

Second, let’s look at short term or day trading. Clearly selling puts does not have the same level of flexibility that accompanies direct stock ownership. Once again, this tips in favor of direct stock ownership.

Selling puts credits the investor with a premium in exchange for taking risk if the underlying stock moves down. Part of the analysis is intuitive. If SPY moves up sharply, the maximum gain the put seller can realize is the premium credit received. In contrast the stock owner has unlimited upside.

If SPY moves down, the Put Seller softens the loss by the amount of premium credited while the stock owner suffers the whole loss.

But what happens over a long term of many months or even many years? What about the BUY and HOLD of SPY?

Luckily, the CBOE has already done all the work. They have created the Put/Write Index (ticker PUT). This hypothetical index measures the performance of selling slightly out of the money puts each month on the S&P 500. I urge you to go to their web-site and read more (www.cboe.com/micro/put/).

All that is needed is to compare this hypothetical index to a real world stock. The SPDR S&P 500 (SPY) fits this perfectly.

Here’s a chart that compares SPY with PUT INDEX for the last Six Months:

Chart

Now a chart that goes back FIVE Years:

Chart

What we see is that PUT Index outperformed SPY during these two time frames.

But both represent down-trending markets. In the months that SPY rose dramatically it outperformed the PUT Index.

What about a longer time frame?

CBOE provides data going back to 1986 through 2008;

Average Annual Return Standard Deviation

PUT INDEX 10.32% 9.91%

SP 500 8.77% 15.39%


The outsized returns of the PUT Index strategy jumps out from this table. But it is the standard deviation that provides the most insight.

Standard deviation is one of the metrics used to calculate risk. The lower the standard deviation, the lower the risk. The standard deviation of the S&P ownership is over 50% greater than the PUT Index strategy. That means owning SPY incurs a 50% greater risk than selling the PUTS. This alone would be enough for me to sell put options over owning the SPY outright.

So all these charts and data can lead us to the following conclusions:

1) Over long periods of time, and down-trending markets, selling SPY Put Options may provide higher returns AND lower risk

2) During strong Bull markets, SPY ownership has an edge.

Let me make my own modifications to this:

1) The PUT INDEX is calculated selling MONTHLY puts. Selling WEEKLY puts on SPY should bring even better results. The effective cumulative premium received is greater and market swings are less exaggerated.

2) “High beta” stocks, such as AAPL, AMZN and GOOG probably don’t fit the PUT strategy as well (this is my sense, I have no empirical data to back this up)

3) “Low Beta” stocks, such as WMT, MCD, and XOM would also fit this very well.

In conclusion, selling weekly puts on SPY, slightly above the money, may turn out to be a preferable to actiually buying the shares. This strategy would appear to provide greater returns with lower risk. A hard combination to ignore.

Even more so when the market is flat, downward or modestly upward.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.