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Brendan O'Boyle
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Brendan, a Pennsylvanian by birth, completed his B.S. at Allegheny College and his Ph.D. at Stanford University in the field of organic synthesis. He has been employed by a major pharmaceutical company and a tiny biopharma startup, but is an avid investor as well. His writings focus on a variety... More
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  • An Options Strategy To Track The S&P500 With Less Downside Risk

    As we move into 2015 it is worth noting that the bull market which began in March 2009 is coming into its sixth year. Bull markets do not begin or end on a set schedule, however, there are a number of arguments that the current run may be long in the tooth, including:

    • A relatively high valuation for the S&P500 (NYSEARCA:SPY) in terms of price/sales, Shiller P/E, Tobin Q and TTM P/E.
    • A collapse in the price of oil (NYSEARCA:USO) and other commodities, which may indicate a weakening economy.
    • Investor sentiment, which is rather bullish.
    • An anemic global economy, with large segments of the world currently experiencing recessionary conditions.

    None of these considerations are determinative in isolation. Indeed, they are so widely discussed that the market has likely discounted them. However, the current investing landscape may suggest that discretion is warranted.

    With bond yields so low and cash yielding nothing options on the S&P 500 may create and interesting oppurtunity. The implied volatility of the S&P 500 is quite low and this is largely due to the current zero interest rate enviornment. Sellers of covered calls on the SPY are attempting to increase the yield of their investment. This options strategy will attempt to capitalize the current low implied volatility of the SPY to capture any remaining upside in the present bull market while limiting downside risk.

    This strategy is required to:

    • Capture any remaining upside for the S&P 500.
    • Accept a calculated amount of downside risk.
    • Hedge downside risk by keeping the majority of assets in shorter-duration high quality bonds or cash.

    This is a hypothetical strategy for a $500,000 portfolio and I would welcome criticism and comments from my readers.

    First Goal: Capture Any Remaining S&P 500 Upside

    The simplest way to accomplish this goal is through buying calls on the SPY. The S&P 500 index currently trades around 2000 and the corresponding price for the SPDR S&P 500 index is $200. A Dec-2017 $200 SPY Call gives a buyer all of the upside for the S&P 500 index at a price of $25.70. Purchasing 25 of these call options would give all the upside to the S&P 500 for the next three years at a price of $64,250 (25x100x25.70). The notional value of these options is equal to our $500,000 portfolio.

    Second Goal: Accept a Calculated Amount of Downside

    To accomplish the second goal a number of SPY puts will be sold to offset the cost of the SPY calls. We will choose puts that are of the same duration as the calls. An appropriate strike price would be the drawdown of an average bear market. From the S&P 500's recent high of nearly 2100 an average bear market would experience a 35% drawdown to a price of approximately 1350. This strategy will be a bit more aggressive and we shall sell puts that would lead to 1.5x leverage should the SPY expire below 135 in December 2017. Selling 56 Dec-2017 $135 SPY puts at a price of $8.50 would yield $47,600 (56x100x8.50). The notional value of these options is $756,000 or approximately 1.5x leverage should shares be assigned.

    Third Goal: Invest Remaining Cash in Short-Duration High Quality Bonds

    The cost for the first two legs of our strategy is $16,650 (the value of the calls minus the puts). Our remaining capital can now be deployed in Treasury notes in order to bring the cost of our strategy to zero over the next three years. Presently 3-Year notes yield 0.99%, while 5-year notes yield 1.47%. Splitting $483,350 evenly over the 3 and 5-year notes would yield on average 1.23% annually or 3.69% by the end of 2017, to net $17,835. There is a slight degree of interest rate risk, but in aggregate the strategy will be 50% in cash by 2018 and 50% in 2-year Treasury bonds.

    So in total our asset allocation will be as shown in Table 1.

    Table 1: Hedged Strategy Asset Allocation

    AssetContracts or ThousandsNet Proceeds
    Dec-2017 $200 SPY Callslong 25 contracts @ $25.70-$64,250
    Dec-2017 $135 SPY Putsshort 56 contracts @ $8.50$47,600
    Jan-2018 Treasury Noteslong $242k notes @ 0.99%$7,187
    Jan-2020 Treasury Noteslong $241k notes @ 1.48%$10,700
    Total $1,237

    To implement the strategy one must pay $16,650 up front. The Treasury notes will pay $17,835 by Jan-2018, slightly more than the cost of the strategy before taxes are considered.

    Summary: Advantages and Limitations of the Strategy

    To summarize here are the key advantages and limitations of the strategy.


    • If the S&P 500 falls into a bear market assignment on the puts we sold will only be a loss at 35% below the 52-week high for the S&P 500. This was chosen as it is the average drawdown for a bear market.
    • If the S&P 500 rises the calls will give upside equal to that enjoyed for the index.
    • Buying short duration Treasury bonds limits the interest rate risk of the strategy.
    • Timing the market is avoided, the overall approach is quite passive.


    • The bid-ask spread on each of the options described is fairly wide. Thus a trading strategy is not recommended as trading in and out will be costly.
    • The strategy is not advantageous from a tax perspective. It probably cannot be implemented in an IRA due to the sale of naked put options.
    • The strategy forfeits any income. It would be possible to buy higher yielding bonds to replicate the yield of the S&P 500, but not without risk (either credit risk or interest rate risk).
    • This is entirely a qualitative strategy. I do not have access to options data to backtest the strategy and because it is not hedged it could be more volatile than the S&P 500 on a day-to-day basis.

    Three years from now there are only three possible outcomes for the S&P 500:

    1. It may trade below 1350 in which case someone employing this strategy would be invested at 1.5x leverage with a cost basis of $135.
    2. It may trade between 1350 and 2000, in which case the strategy will breakeven. Essentially the portfolio at that time would be invested in 50% cash and 50% 2-year Treasury bonds.
    3. Finally, the S&P 500 may be higher and we could either exercise the call options or sell them. Exercising the call options would be advantageous from a tax perspective and we could choose to roll the strategy forward through buying puts at the new price of the index and selling puts 35% lower than its recent high.

    In summary, the above strategy attempts to capture any price appriciation in the S&P 500 index over the next three years, while limiting downside risk. The three pillars of this strategy could be optimized for different investors. For example, some investors might not be comfortable potentially being invested on leverage should the S&P 500 fall substantially. The leverage of the portfolio could easily be scaled to suit different levels of risk. Likewise the bonds in this portfolio could be optimized to suit different needs, buying longer-dated Treasury bonds (NYSEARCA:TLT) would hedge the options portion of the portfolio and raise the yield. Longer dated bonds tend to outperform when the S&P 500 underperforms, thus moving further out in duration should lessen the day to day volatility of the portfolio.

    Jan 06 6:35 PM | Link | Comment!
  • Buy Gundlach's New DoubleLine Fund For Excess Returns

    The Shiller CAPE® ratio is a tool that determines whether the market is expensive or cheap relative to its normalized earnings. To determine the Shiller P/E, or CAPE, one takes the price and then divides by the normalized earnings over a given period (most often ten years). The lower the ratio, the cheaper the market and conversely the higher the expected return over a long-term time horizon. A new DoubleLine fund aims to capitalize on sectors of the market that are judged to be cheap by this metric.

    The Shiller Enhanced CAPE® Fund

    The Shiller Enhanced CAPE® Fund (MUTF:DSEEX) is a no-load mutual fund with a management fee of 0.45% and a net expense ratio of 1.09% (See Summary Prospectus). The fund gives investors 100% exposure to the four sectors of the S&P500 (NYSEARCA:SPY) determined to be cheapest by the CAPE ratio (Figure 1). Out of ten sectors, the bottom five are selected based on CAPE ratio and then one sector with the lowest momentum is omitted. The portfolio is then rebalanced monthly.

    Figure 1: The Shiller Enhanced CAPE Fund - Selective Sector Exposure (click to enlarge)

    Source: DSEEX Fact Sheet

    However, the manner in which the fund achieves stock market exposure is somewhat unique. Instead of passively buying equity exposure the fund instead achieves 100% equity exposure through the use of futures and/or swaps (Figure 2). This then leaves an additional 100% cash balance that is invested in a managed fixed income allocation. Effectively the fund has a 100% weighting in stocks and bonds. Clearly, this enhances the overall return, but with the potential disadvantage of interest rate risk.

    Figure 2: The Shiller Enhanced CAPE Fund - Equity And Fixed Income Exposure (click to enlarge)

    Source:DSEEX Fact Sheet

    Over a long time horizon this fund should generate outperformance for two primary reasons:

    First, the fund has additional exposure to bonds in addition to its equity exposure. The easiest way to visualize this is to imagine buying 100% exposure to the equity market and then investing with a 100% exposure to the bond market through the use of leverage. The primary disadvantage is interest rate risk, whereby the bond portion may fall and create capital loss through a period of rising interest rates. However, the fund will generate excess return in the form of coupon payments on the portion of the fund that is invested in bonds.

    Second, the fund should generate outperformance by investing in the sectors of the S&P500 most likely to outperform over the longer term based on cyclically adjusted P/E. Out of the ten sectors shown in Figure 1 only four will be bought. Over the longer-term these should outperform the overall market, however, there is concentration risk if these sectors do not outperform.

    Summary and Conclusions

    Mr. Gundlach recently made an appearance on Barron's explaining the strategy of his new DoubleLine fund. The strategy of this fund is clearly a bet on interest rates remaining fairly low, rather than a normalization of interest rates in the near term. A rapid rise in interest rates is probably the largest risk to the fund's strategy as bonds would underperform cash and stocks would also likely fall in such a scenario. Mr. Gundlach has made very well-timed calls in the recent past and he clearly believes now is an oppurtune time to invest. With investors clearly concerned over the recent rise in interest rates now may be a the moment to take a contrarian stance.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Tags: SPY, long-ideas
    Dec 04 7:04 PM | Link | Comment!
  • What Does The Science Of Happiness Have To Teach Us About Owning Stocks?

    I just watched an outstanding TED talk by Daniel Gilbert, a professor of psychology at Harvard University, in which he discusses the science of happiness at some length. Watching this talk got me thinking about implications for investors in the stock market.

    First, it is necessary to define terms. Gilbert contrasts two forms of happiness in his talk; these are natural and synthetic happiness. Natural happiness comes from pursuing something that you desire and then getting it. For example, your goal could be to attend Harvard University and use your studies to pursue a coveted career. If this goal is within your power, then pursuing and accomplishing it will grant you natural happiness.

    Synthetic happiness, on the other hand, comes from being happy with what you get when you cannot control it. Perhaps your SAT scores and grades did not enable you to enroll at Harvard University, but you are willing to accept wherever you end up. Then you will experience synthetic happiness and this feeling of happiness could be just as real as the feeling of happiness from getting what you want. In general, we place far too many qualifications on things that must be accomplished in order to achieve happiness. Gilbert states that 90% of the time, achieving a major goal has little effect on our happiness only three months later.

    It must be noted that: Freedom is the friend of natural happiness, but it is the enemy of synthetic happiness. In other words, when you are in control you achieve natural happiness by pursuing what you want. However, when you are not in control you achieve synthetic happiness by accepting what you get. The resulting conclusion is that we must accept what we cannot change, while burdening ourselves only when it is within our power to accomplish something.

    Have you ever purchased something from a store and noticed that as long as you had the option to return it, you were never happy with what you had bought? For example, imagine you bought a video game, but you weren't sure if you wanted World of Warcraft or Donkey Kong. After reluctantly picking one at the store did you notice that as soon as you lost the option to return the game you stopped worrying about whether you had the right one, instead you were simply happy with what you had.

    In a similar fashion, investors in stocks can be in a constant state of nervous uncertainty. Perhaps an investment in Coca-Cola (NYSE:KO) isn't the best way to improve my long-term purchasing power; maybe I should invest in PepsiCo (NYSE:PEP) instead? Alternatively, maybe the whole market is overpriced or the economy is about to fall off a cliff. This uncertainty could lead to happiness if you were able to come to a certain conclusion about what to do. However, due to the uncertainty of the market, it is most often impossible to know what the correct action is, particularly over short time horizons.

    This leads to the conclusion that in order to maximize happiness investors should nearly always view the market as unpredictable and their investment decisions as unchangeable. It is only on rare occasions when asset prices are glaringly incorrect or the market is ignoring grave danger that an investor should take action by doing something.

    Consider Warren Buffett as an example. Amazingly, his great wealth is due in large part to a relatively small number of investment decisions. Importantly, these decisions were made at times when solid stocks such as Coca-Cola or American Express (NYSE:AXP) were so glaringly underpriced that he took action by buying them. The remaining time he viewed the market as unpredictable and as a result there was no reason to take any action at all.

    In a similar fashion, investors will achieve the maximum amount of happiness by viewing their past investment decisions as unchangeable for the vast majority of the time. Then they will simply be content and accept that the unpredictable nature of the market is not under their control. It is only on rare occasions that an investor needs to take any action at all.

    At this moment there are a reasonable number of modestly valued companies with good fundamentals that could be purchased immediately if an investor wishes to put money to work in the market. Companies such as: AFLAC (NYSE:AFL), Discover Financial Services (NYSE:DFS), International Business Machines (NYSE:IBM), Kinder Morgan Energy Partners (NYSE:KMP) and Exxon (NYSE:XOM) are all wonderful businesses trading at low valuations compared to what they have enjoyed historically.

    However, buying any one of these stocks today is not the only thing that must be done in order to be a successful investor. One must also hold the stocks until such a time when a rational decision would lead the investor to part with them. This decision could be due to valuation, business fundamentals or the macro economy, but it must be realized that many years could pass before the time to make this decision arrives. Until then the investor must be synthetically happy, realizing that the best kind of freedom is the freedom to do nothing at all.

    Disclosure: I am long AFL, DFS, IBM, KMP, XOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Additional disclosure: Some of the positions above consist of options derived from the underlying security.

    Jun 16 4:21 AM | Link | Comment!
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