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Selling Puts As A Substitute For Fixed Income

Recently I looked at the U.S. High Volatility Put Write (NYSEARCA:HVPW) ETF, attracted by an article that touted it as an investment for "prudent income investors." The prospectus is somewhat less inviting, describing it as a "speculative trading instrument." But it still raises the question, can selling cash-secured puts substitute for fixed income?

HVPW writes puts on the twenty large cap names with the highest volatility, 15% out of the money, with a two month duration. The puts are secured with treasury notes. The distribution rate is aspirational, at 9%. No estimate of maximum losses is provided, although the prospectus warns about possible complete loss of investment capital.

I looked at this idea several years ago from the point of view of a dividend-oriented investor, and studied the likely outcome of a portfolio that sold puts on dividend stalwarts 10% out of the money, with a three to six month duration. I estimated that such a portfolio would produce 4.5% annually, with very infrequent drawdowns maxing out around 18%. Of course a dividend-oriented investor would not be too upset, being forced to buy at a market bottom.

I also simulated the use of less than full cash security, resulting in proportionately higher returns and drawdowns.

Implications for Synthetic Dividend Growth Portfolio

The Synthetic DGI Portfolio has been working as expected, with one exception: the calls sold gave away the upside on a larger number of positions than I was looking for. Briefly, the results of the twenty names selected were more dispersed than I thought they would be.

Another issue, what to do with the cash reserve, was resolved by buying vertical calls spreads, both legs in the money, on stocks that were selected for a combination of volatility and margin of security. That's been working well, returning 12.8% while maintaining cash sufficient to support the exercise of all long calls. This is a cowardly way of selling puts, in that such positions are easier to deal with in declining markets.

Since the LEAPS which are the starting point for the Synthetic DGI Portfolio are at strikes averaging 80% of the share price, leverage starts at 5:1. Selling covered calls at strikes and expirations that provide income equal to the dividends, effective leverage to the upside is reduced because of the upside that is not realized.

After reviewing this, I plan to greatly reduce the sale of covered calls, and replace the income by either the sale of cash-secured puts or the vertical call spread strategy described above. Theoretically, the 5:1 leverage will replicate capital gains and losses on the underlying. Meanwhile, using a portion of the 80% remaining cash to secure the sale of out of the money puts (or the equivalent), the income received will replace the dividends forgone by using the LEAPS as substitutes for share ownership.

Incidentally, the 12.8% on the vertical call spread strategy includes stepping in the way of a sharp sell-off in Cisco (NASDAQ:CSCO), precipitated by horrendous guidance for the current quarter.

Under normal market conditions, this portfolio would replicate the results of owning the shares, other than the taxable nature of the income received. There are defensive advantages in a declining market, in that the LEAPS can be rolled down for less than the difference between the two strikes, resulting in a profit on the roll, or a reduced loss when compared to owning the shares.

The difference lies in the returns to be received from the cash held aside. In more normal markets the money could be placed in Treasuries or corporates at some reasonable rate of return. With rates where they are, using the money to support the sale of puts seems like a viable alternative.

Substituting Vertical Calls Spreads for the Sale of Puts

Please consider the following trade on Corning (NYSE:GLW).

This is effectively the sale of a put, in that I bear the risk that the stock will be below $17 at expiration. GLW has a very strong balance sheet and a history of increasing the dividend. I would most likely exercise the $13 call at expiration, for a net cost of $15.67 per share.

In the event something funky happens, if GLW gets down to the $13 area before expiration, time value will increase and cushion the loss. At that point, the position can be rolled down to pocket the time premium, or closed for proceeds of about 70 cents. Note the $9,100 I had available to exercise the call is intact, plus whatever salvage I get from closing the position. The downside is defined here, unlike with the sale of a put, where it theoretically extends to zero.

Leverage Rears Its Lovely Head

Note that the plan here is to have all puts (or equivalents) fully cash secured. The way I operate, it's not unlikely that at some point studied carelessness will result in positions that are less than fully cash secured, in the interest of improving returns.

I had hoped to make $100,000 behave like $250,000. As a practical matter, the way I'm doing it I need to use about $160,000.

What About All Those Covered Calls?

After concluding that the sale of covered calls hurt my situation last year, I don't intend to buy back those I have already sold that expire this year. The thinking is, now would not be a good time to correct the situation. First one thing works, then another.

As the situation stands, I'm controlling $270,000 worth of dividend paying shares, well-known names. Total account value is about $175,000, with $110,000 in cash. I expect to earn 9% on the cash, which is 3.9% of the value of shares controlled and exceeds the dividend income that the shares would generate if I owned them.

As such, the covered calls aren't necessary to achieving the income objective, and are interfering with the capital appreciation objective. With the market near record highs, and shuffling back and forth nervously so far in January, I plan to leave the calls out there, but will discontinue rolling them. In the even of a market sell-off, they can be bought back at a profit.

Disclosure: I am long GLW, CSCO, .

Additional disclosure: I'm a retail investor, and blog in order to expose my thinking to critical examination and comment from readers, and as a way of talking shop. I'm writing about what I do with my discretionary investments, and not giving advice of any kind.