Increasing Portfolio Returns For 2012 With SPY Options

| About: SPDR S&P (SPY)

It’s that time of the year where I start to seriously think about the upcoming year. Though I am always adjusting my portfolio as the year moves on, I like to have some basic premise for how I’m going to approach the New Year.

As I look forward there seems to be quite a few headwinds. Most of the discussion revolves around whether we are in a period of slow growth or closing in on a recession. The Europe situation certainly offers little help. Throw in the stalemate that is Congress, the propensity to “kick the can” and what will likely be a nasty Presidential election and I see little reason for a bullish case.

No matter which way the market goes, this all spells an extension of the “Headline Induced” volatility we’ve seen over the last year. Bi-directional moves of 5% to 10% in a week make it difficult for everyone but the day traders.

For those that try to hedge their portfolio these see-saw-like conditions require constant evaluation and tactical deployments. This is evident in the underperforming of the hedge fund industry. The more decisions you need to make, the greater the risk of making a wrong decision. The market has an uncanny way of punishing wrong decisions heavier than rewarding correct decisions.

First, I will stress that I continue to invest in those stocks and sectors that I think will perform well in the long run (long run nowadays is one to three years).

I have instituted 100% portfolio protection so a catastrophe, like 2008, is not my concern. Positioning a portfolio for minimal loss is very different than positioning it for gain. So, the focus must turn to ways to make gains, even as the market fights me.

My concern at this stage is how to generate income if the market stays flat for the year. This seems a likely scenario and a repeat of 2011. In less volatile times I could just sell weekly or monthly options. This is not so easy when big swings either way can come at any time. As a result, I’m looking for a better way, with less exposure to interim swings.

I’ve mentioned in previous articles that the SPDR S&P 500 ETF (NYSEARCA:SPY) is a wonderful surrogate for a balanced portfolio. SPY is very liquid and the bid/ask is reasonable. If I wanted to refine the surrogate I could mix in other ETFs, but at this juncture, I’m trying to keep it manageable.

Let's look at some strategies using SPY.

SPY is trading at $121.59. The first strategy is to sell the December 2012 at-the-money call with a strike at $122. This credits $11.73.

Now, the first thing I could do is just stop here and leave it as a simple naked call.

I won’t lose on this trade unless SPY moves above $133.73 ($122 strike plus $11.73 premium). That represents a move of about 10% and where I break-even. Assuming my actual portfolio replicates the SPY return, I make 10%, but no more. For instance, let’s say SPY moves up 6% for the year. My portfolio moved up 6% and I still make a residual 4% on the call. Any gains above the 10% threshold are “zeroed-out”.

I don’t want to understate the fact that I make this 10% even if SPY drops.

Assuming my portfolio is neutral, this is pretty attractive.

On the other hand, many don’t want to give up a potential big move. Sometimes, the market moves up the most in uncertain times. A positive resolution to some of the headwinds and the market might explode. So, I would like to increase my break-even point.

The standard method for dealing with this is to turn the naked call into a call spread. The typical Bear Call Spread would buy the December 2012 protective call with a strike of $134. This costs $6.34.

Taking the two trades together, the $122 call credits $11.73 and the $134 call debits $6.34 for a net credit of $5.39.The first thing I notice is that my potential downside gain is cut over 50% from $11.73 to $5.39. This is significant.

If SPY moves up by more than that $5.39 credit I start to lose and my maximum loss is at SPY $134. This loss would be the difference in the two strikes ($12) minus the net credit of $5.39 which equals $6.71. SPY would have to reach $140.71 for the protective call to earn back this $6.71. That’s up over 15% and I’m not willing to take that much of a gamble. I conclude that it doesn’t make sense to do this

Now, I’m willing to take some risk to increase my potential, but if I rule out the protective call spread then I must look elsewhere.

Let’s say I wanted to increase my break even from SPY=$133.73, to, say SPY= $140. Well, I could simply sell the December $134 call which credits $6.04. This gives me $6 in additional upside protection by trading $6 less in downside potential. I can pick other strikes and adjust the upside/downside in a similar fashion.

Though the simplistic approach of naked calls is inviting, I’ll look a little more. Not that the naked calls may not be the winning strategy, but it's best to look at alternatives and then choose the best fit. I will do this by adding a Bull Put Spread to the naked call. This adds two more legs.

I will sell the December 2012 ATM put with a strike of $122. This credits $14.02. I will then buy the December 2012 OTM put with a strike of $111. This cost $10.02. My net credit is $4.00.

This bull put spread adds this potential $4.00 to the upside. When I combine it to the $11.73 credit from the $122 naked call, my potential gain is $15.73. This increases my break-even to $137.73 instead of $133.73. If SPY ends up between $122 and $134, I make 15% instead of 10%. I make 10% or more if SPY falls but remains above $118.

However, if SPY falls to $111 the downside subtracts $7 (difference in strikes of $11 minus the $4 credit) from the otherwise $11.73 credit and results in a net gain of only $4.73. At least it is still a gain. No downside loss. That's a relief !

So it looks like I have upside through $137.73 and minimum downside gain of $4.73. A small move in the $122-$134 range nets me nearly 15%. This seems to meet my needs.

The upside break-even assumes a static strategy. That is, just let it unfold, come what may. There are always compensating moves. Let’s say SPY moves to $134 by June. I could “ratchet up” the $122 strike put, or decide to sell the $111 put, or “ratchet up” the complete put spread. I should get between $3 and $5 more for any of these moves. This effectively increases my break-even to $141-$143. I could “ratchet-up” the call,too. It all depends upon my outlook for the market over the ensuing six months. If I “ratchet-up” and SPY tumbles down, I made a mistake, but that is what investing is all about.

On the other hand, assuming your portfolio mimics the SPY, and SPY goes to $138, you may be happy with the 15% you’ve made and be willing to take some off the table by holding steady. I look forward to this type of quandary.

Summarizing, the naked call is the simplest strategy to understand and to implement. It works best if the market goes down or doesn’t go up more than your “break-even” point. In return, you forego larger gains. Adding a bull put spread gives a little more flexibility and lends itself to some adjustments.

Naturally, since all these strategies involve naked calls, they are not suited for IRA accounts. I'll try to deal with that in an upcoming article.

Margin requirements must be considered. They do vary by broker, but generally the requirement would be about 25% of the exposure. When selling a call and a put, only the larger leg of the two requirements is imposed.

One additional thought. I'd like this strategy better if SPY was at $126 or higher. I base this on my estimate that $125 is a fair value for SPY and the market seems at least a little oversold. No real science, just my best guess. This time of year usually experiences a seasonal bull market. I’d likely not implement this strategy until I get a better picture of “Santa Claus”. I would feel a whole lot better instituting this strategy if SPY was over $126 and I’d jump to do it if SPY was at $130. Maybe I’ll get my holiday wish.

Disclosure: I am long SPY.

Additional disclosure: I sell and buy calls and puts on SPY