In “A Simple Way To Approach The Markets In 2012,” I discuss a 2012 investment strategy using ETFs ideal for the long-only, passive investor who is tired of sitting in cash or would like to diversify away from individual stocks. The strategy involves entering only one order for the entire year by selling put options expiring at year-end. The examples in my previous article offer the potential for more than 9% returns in 2012 while also providing double-digit percentage point hedges should the ETF selected decline in value. For those investors interested in a variety of risk profiles and asset classes, I offer the following additional ideas for executing a passive investment strategy in 2012.
For the fixed income investor, one possibility would be to consider selling puts on the iShares Barclays 20+ Year Treasury Bond Fund (TLT). The mere suggestion of such a possibility is likely maddening to many investors, as Treasuries remain one of the investments retail investors, analysts, and many fund managers seem to love to openly mock, even as prices keep going higher and higher. Perhaps this will finally be the year the Treasury bears can make a little bit back on the massive losses they’ve accumulated while trying to short an uptrend (in prices) and fight the Fed. Even if Treasury prices do decline in 2012, given the way this investment will be structured, the put seller will still have an opportunity to make a reasonable return over the next 12 months relative to other fixed income investments. Here is one of many possibilities for executing this strategy on the TLT.
By selling the January 19, 2013 (there are presently no December 2012 options) $97 puts in a cash account at the current bid of $2.75, an investor will collect an annualized yield of approximately 2.73% (total return of 2.835%) should the puts expire out-of-the-money. If the puts expire in-the-money and an assignment of shares occurs, the downside protection from the TLT’s current level of $121.25 would be 22.27% ($121.25 minus $94.25 cost basis ex-commissions divided by $121.25). This means the investor will only be forced to get long Treasuries at approximately 4.20% on the 30-year. Using this strategy, losses ex-commissions would only begin to accumulate for the put seller at levels under $94.25 on the TLT, approximately equivalent to 4.34% on the 30-year Treasury bond. At the time this article was written, the 30-year U.S. Treasury bond was yielding 2.90%.
Another possibility for the fixed income investor is to sell puts on the SPDR Barclays Capital High Yield Bond ETF (JNK). However, it should first be noted that the option chain for the JNK does not appear very liquid, and therefore an investor is more likely to overpay (receive a smaller premium) than he or she otherwise would if the options were more liquid. Also, various options for the JNK have undergone adjustments to the strike prices. If you are interested in selling puts on the JNK, it would be wise to spend some time on the OCC’s website looking through the various “infomemos” on JNK to learn about the reasons for and frequency of the adjustments on the option strike prices. You could also consider contacting your broker for more information.
Nevertheless, as things stand today, by selling the January 19, 2013 $34.13 puts for $1.75 in a cash account, an investor would collect an annualized yield of approximately 4.94% (total return of 5.13%) and only begin to experience losses on the investment should the JNK close more than 15.78% lower than its current price of $38.45. This would be at levels below the lows of July 2009 and below the lows of 2010 and 2011. One could also consider selling puts on other fixed income ETFs like the LQD or HYG, but at the time this article was written, the furthest out an investor can go on their option chains is to June 2012.
The investor seeking exposure to commodities also has a number of possibilities when it comes to selling puts in 2012. The out-of-the-money December 22, 2012 $150 puts on the GLD are currently bidding $14.20. In a cash account, if the puts expire out-of-the-money, this investment would yield a 9.47% return ex-commissions. If the puts expire in-the-money and an assignment of shares occurs, the downside protection from the GLD’s current level of $151.99 would be 10.65% ($151.99 minus $135.80 cost basis ex-commissions divided by $151.99). For those gold investors who would never dream of missing out on gold’s potential upside in the event of an explicit or implicit return to the gold standard, one possibility would be to take a part of the premium collected from the puts and buy out-of-the-money calls with it. This would reduce the hedge in the event gold falls, but it would also increase the upside potential in the event of an explosive move higher in the precious metal.
Commodity investors seeking a bit more diversification might explore the PowerShares DB Commodity Index Tracking Fund (DBC). Currently trading at $26.84, the January 19, 2013 (there are presently no December 2012 options) $25 puts are currently bidding $1.65. Given the current 40 cent spread between the bid and ask prices, if I were to enter a sell-to-open order on this option, I would not accept a price at the bid. Instead, to search for hidden liquidity, I would enter an order with a limit price of $1.75. In a cash account, a fill at $1.75 on the option would translate into roughly a 7.00% return on the upside with losses ex-commissions only beginning to accumulate once the DBC traded below $23.25, 13.38% lower than where it sits today. One word of caution: the option chain on the DBC is fairly illiquid. However, when this article was written, the strike price in question did have the largest open interest of any put option beyond the front month options.
The iShares MSCI Emerging Markets Index Fund (EEM) provides an opportunity for the investor seeking diversified exposure to emerging market stocks to sell puts expiring on December 22, 2012. By selling the out-of-the-money December 22, 2012 $34 puts in a cash account at the current bid of $3.35, this investment would return 9.85% if the puts expire worthless. If the puts expire in-the-money and an assignment of shares occurs, the downside protection from the EEM’s current level of $37.94 would be 19.21% ($37.94 minus $30.65 cost basis ex-commissions divided by $37.94).
Finally, the iShares MSCI EAFE Index Fund (EFA) provides exposure to European and Australian companies as well as companies from the Far East (Japan, Hong Kong, etc.). An investor selling the December 22, 2012 $45 puts at $4.25 in a cash account would realize a 9.44% return if the puts expire worthless. If the puts expire in-the-money and an assignment of shares occurs, the downside protection from the EFA’s current level of $49.53 would be 17.73% ($49.53 minus $40.75 cost basis ex-commissions divided by $49.53).
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 sharp rallies since the October 2011 lows, or Treasury yields that have hardly rebounded from the large drop beginning last July, 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.