Are you a long-only investor with a passive investment style? Are you nervous about the current state of the world’s financial system and financial markets? Are you sick of earning almost nothing on your cash in your money market or bank account? Did you partake in the buy high-yielding dividend stock craze of 2011? Do you have money you plan to allocate in 2012 but are unsure in what manner to allocate it? If this describes you, here is a passive investment idea to consider.
This strategy is structured to provide reasonable upside potential over the course of 2012 relative to the asset class selected, should the asset targeted go up in value or not decline by any significant amount. It is also structured to provide at least reasonable downside protection should the asset targeted decline in value and involves placing only one order per security chosen.
What is this strategy of which I speak? It is to sell longer-term (approximately 12 months) put options on one or more exchange-traded funds (ETFs) tracking a variety of financial market indices across one or more asset classes. Although this may sound like a mouthful, the strategy is incredibly easy to execute. Simply choose the market index or the asset you wish to have exposure to from the long side, choose a corresponding well-established, liquid ETF, and enter a sell-to-open order on put options at a strike price and month of your choosing. For the purpose of this article, I will use options expiring in December 2012 as examples.
The long-only equity investor might be interested in executing this strategy on the SPDR S&P 500 ETF (SPY). Its December 31, 2012 slightly out-of-the-money $125 puts are currently bidding $12.68. With an indicated forward dividend yield of 2.22%, all things being equal, during 2012 the SPY would pay out approximately $2.79 in dividends at today’s price of $125.50. By selling the puts, if the puts expire worthless, the entire position would be subject to capital gains at the ordinary income tax rate, versus the $2.79 that could have been received in dividends at the qualified dividend rate of 15% (or 0% for some investors).
However, in 2012, it will take more than $128,000 in taxable income to get a joint Federal tax return to have an effective tax rate of more than 15% (assuming application of the standard deduction and two personal exemptions, i.e. no children). Given how few Federal returns show taxable income greater than $128,000, perhaps I should actually calculate a benefit to the put seller, rather than assume the qualified dividend would have been better.
Since we now know that many put sellers are not losing any tax benefit with regard to the dividend by selling puts expiring on December 31, 2012, versus buying the SPY and selling the shares on December 31, 2012, let’s get back to calculating the return on the investment. In a cash account, if the SPY stays anywhere below $135.39 (current price of $125.50 plus $12.68 put premium minus $2.79 dividend received for owning the shares outright), the put seller will make out better than the investor buying shares of the SPY. This would roughly equate to a level of 1353.90 on the S&P 500, or 7.66% above current levels.
When adding in the $2.79 of indicated dividends we pulled out to equalize capital appreciation possibilities between the put seller and the shareholder, and comparing it to the cash secured money held by the broker, the total possible return for the put seller in 2012 is 10.14% (ex-commissions). If the SPY goes lower over the course of the year, and the put seller is assigned shares, the cost basis will be $112.32 (ex-commissions), or 10.50% below current levels.
To summarize, buy placing one order, a sell-to-open the December 31, 2012 $125 puts on the SPY, a long-only investor who is more concerned about the next 12 months than the next 12 years can sit back and do nothing for the rest of the year, while hedging downside risks by 10.50% and gaining up to 10.14% on the upside. If the S&P 500 closes anywhere below 1353.90 at the end of 2012, the put seller will have outperformed the shareholder. In fact, the put seller has the added possibility of actually being able to make money even if the S&P 500 declines on the year because of the $12.68 put premium collected.
Naturally, the S&P 500 is not the only index or financial instrument on which this passive investment strategy could be executed. Using the same strategy on the SPDR Dow Jones Industrial Average ETF (DIA), in a cash account, an investor could sell the out-of-the-money December 31, 2012 $120 puts and collect $11.30 (ex-commissions). If the puts expire out-of-the-money at the end of the year, this investment would yield a 9.42% return. If the puts expire in-the-money and an assignment of shares occurs, the downside protection from the DIA’s current level of $121.85 would be 10.79% ($121.85 minus $108.70 cost basis ex-commissions divided by $121.85).
The PowerShares QQQ Trust (QQQ) out-of-the-money December 31, 2012 $55 puts are currently bidding $5.45. For the investor choosing to sell these options in a cash account, if the puts expire out-of-the-money at the end of the year, this investment would yield a 9.91% return. If the puts expire in-the-money and an assignment of shares occurs, the downside protection from the QQQ’s current level of $55.83 would be 11.25% ($55.83 minus $49.55 cost basis ex-commissions divided by $55.83).
Before executing this strategy on any security, keep in mind that volatility levels market-wide have declined dramatically over the past few months. Also, particularly when it comes to those “risk” assets experiencing double-digit returns since the October 2011 lows, it may be possible to enter any short put position at better prices than those being offered today.
Naturally, the strategy discussed in this article can be modified in any number of ways to best suit individual investment needs. For instance, if you are interested in another ETF for the S&P 500, you might choose the IVV. However, please keep in mind that all option chains are not uniform. The IVV, for example, only has options going out to June 2012, and its options are much less liquid than those of the SPY.
If you are interested in this type of passive investment strategy, but would prefer other types of risk exposure, such as fixed income, emerging markets, gold, or other commodities, please read my next article, “Selling Puts: A Passive Investment Strategy For 2012.”
Disclosure: I am long various underlying securities of the ETFs mentioned in this article.