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I have worked in the financial service industry for 40 years. My area of expertise is risk management and complex financial products. I have been a frequent speaker, on behalf of many financial firms, to financial professionals across the country. I have extensive experience in statistics and... More
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  • 2013...Up Or Down... Why Worry

    "Never make predictions, especially about the future."
    Casey Stengel

    This is the time of year that begs discussion about what's going to happen for 2013 and I was actually considering offering an opinion...until my senses returned.

    You see, what difference does it make what I think will happen? What matters is to position for all reasonable outcomes.

    My regular readers know that I'm concerned (some say obsessed) with two overriding principles .... 1) Portfolio Investing and 2) Portfolio Protection. So, instead of offering an opinion, this will be the first in a series of articles about Portfolio Positioning for uncertain times.

    With this nice start to 2013, all the major indices are near, or exceed all time highs. The VIX is at the lower range of its value. Add to this the uncertainty in macro factors and to many this screams SELL.

    First, I believe that, over time, the natural tendency of markets is upward. The disciplined, patient investor needs just to sit tight during bad times and wait for good times. Unfortunately the record shows us that this is just not what happens. Most investors are more influenced by fear and anxiety than discipline.

    Portfolio Protection is all about providing the "courage" to stay invested 24/7 and especially during bad times. For, if the investor is protected against loss they can remain fully invested and invest even more when the market drops.

    So, let's first tackle a strategy for the investor that has, say, a $300,000 portfolio of stocks they are perfectly happy with. The investor may add/subtract over time, but is comfortable with the challenge and their personal profile. Let's provide portfolio protection and "juice up" the returns in case the market is modest. I will use the SPDR S&P500 ETF (SPY) as a "surrogate" for a balanced portfolio.

    It involves a number of steps, so here goes:

    1) Purchase 20 far dated (December 31,2013) ATM PUTS on SPY, which is trading at $146. The $145 strike costs $10.72/option. This provides $290,000 of protection. Close enough.

    2) Purchase an "extra five" Dec $145 strike PUTS. This brings the total puts to 25 and the total cost to $26,800.

    3) The purpose of the "extra five" is to provide cover for selling five weekly PUTS to target a cost recovery of the purchase price. Breaking the $26,800 cost into 52 weeks, comes down to about $500/week. Selling five weekly ATM puts on SPY should average an extrinsic credit of about $300/week. A little short of the target, but we're not done yet.

    4) Purchase a Diagonal Calendar CALL Spread on SPY as follows... a) Buy 20 December 2014 (that's right the 2014) ATM CALLS with a $145 strike for $14.00 debit and, b) Sell 20 December 31, 2013 OTM CALLS with a strike of $155 for a $4.50 credit. Combined net debit is $9.50, total cost is $19,000.

    Now, if you're not totally lost, then you have to be asking yourself... "What's this all do? and how does it work?"

    First, let's examine the puts. Obviously the downside is covered. However, the targeted "cost recovery" isn't 100%. What I wanted to do is sell a deep OTM put, with a December expiry and a strike about $115. This would convert the put to a bear-put-spread and lowered the weekly cost recovery target to $300, or less. However, with the VIX so low, it's not time to sell options, it's time to buy options. So, this component is "on hold". When SPY drops and the VIX moves up, I'll enter this deferred leg, and maybe with an even lower strike, around $100, for the same or greater credit. In fact, if I want to take advantage of the drop (buy low) I might even sell the bottom leg with a higher strike. I just need to be patient and see what happens.

    When SPY starts to drop, plan on a little rebound and hold the weekly puts at a strike of $145. If SPY continues a down-spiral, then reluctantly lower the strike, but only as far as necessary to keep it at least 2% ITM. This is to avoid being "see-sawed" in an up/down market.

    If SPY moves up, follow it up in the same way as you would follow the SPY moving down, reluctantly and this time keeping it as much as 2% OTM.

    Now, let's turn our attention to the Diagonal Calendar Call Spread.

    The purpose of this is to provide a little "juice" if the market is flat or modestly up. How much "juice" it provides depends upon the volatility level when the December 2013 $155 short call expires. The long call is still a year to expiry (2014) and its price depends upon its IV.

    So let's examine two scenarios.... current lo-vol and a 20% greater vol (20% more, not 20%). The chart follows for Twenty Options:

    Dec 2013/2014 $155/$145 Diagonal Call Spread
    Strike Dec '13Current Vol 20%+Vol
    120-$15,313 -$ 2,160
    136-$ 7,489 $ 1,857
    1440 $12,833
    150$ 6,741 $25,374
    155$12,892 $28,640
    160$ 7,000 $25,301

    Some commentary is needed to fully appreciate this result.

    If, as of the December 2013 expiry the vol is still as low as it is now, we can expect the market has probably risen. That being the case, the left side of the chart is probably most predictive. If vol has risen, the market is probably down and the right side is more predictive.

    So, to the extent that this is true, we need to "merge the results". For strikes above $150, look left side, and for strikes $150 and below, look right side.

    What we find is that in a modest market (up to $155, about 7% from here) the strategy adds between $12,000 and $25,000 (right side of chart). This is a 4% to 7% "juice". Very nice little "pick-me-up" to your portfolio. If the market takes off and rises big, you add little, but you have made your money on your portfolio (actually, if SPY exceeds $180, this would lose a little).

    If the market falls, the increased volatility means that loss isn't suffered unless the drop is below $120. This is the benefit for buying at today's low volatility. And, if the fall is that drastic, aren't you glad you instituted the put strategy discussed earlier?

    Now, some housekeeping...

    Margin: Both the PUT and CALL strategies require only option authority and no margin. They do, however, use cash. With cash earning next to nothing, who cares?

    BETA Testing: Using SPY as a surrogate works well provided the portfolio mimics SPY. It is likely that any portfolio is either more conservative, defensive, income oriented or aggressive. If the portfolio outperforms SPY this adds relative value and if it underperforms loses relative value. This can provide a mismatch with either too much or not enough protection or "juice".

    The "perfectionist" should compute their personal portfolio BETA. This may take some work, but various brokers and web-sites can help.

    Then, simply adjust the number of options to reflect the comparative BETA. For instance a BETA of 1.2 is 20% more aggressive than SPY. In that case, purchase 30, not 25 put options, and 16 instead of 20 call spreads.

    If, on the other hand, your personal BETA is .90 (more conservative than SPY), purchase 22, not 25 puts and 22, not 20 call spreads.

    Calendar Spread Variations: I have chosen the December 2013 PUT as my far-dated long put. I am really considering the December 2014 PUT instead. It stretches everything out a bit, but should perform better. On the other hand, The December 2014 long call does work much, much better than a December 2013. I suggest readers that have the capability examine the choices. Those that don't, should truly try and gain this ability, even if by trial and error. It will do them a world of good in the long run.

    Conclusion: Rather than trying to position a portfolio based upon predicting what 2013 will bring, here's a dual strategy that will provide results for practically any and every contingency.

    One big word of warning, though. This is not a strategy to procrastinate over. It is very sensitive to the VIX and the VIX is probably headed up, even as you read this. In this case, the early bird may truly be the only one to get the worm.

    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.

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

    Tags: SPY, options
    Jan 06 4:56 PM | Link | 14 Comments
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