Following the Global Financial Crisis, central banks across the world aggressively loosened monetary policy. Rates were cut across the board and quantitative easing was implemented on a massive scale by the Fed, the ECB, the BoJ, and a number of other major central banks. This state of highly accommodative monetary policy drove equities higher almost without interruption as volatility was constantly contained.
We recognised that actions of central banks and the markets response had created a Global Central Bank Put, which meant that investors had protection against any downside movements in equity markets. At the start this year we published an article that discussed how one could take advantage of this by selling downside equity protection to enhance the performance of their portfolio.
Here we will look to explain how one could have implemented the strategy over recent months and analyse if it can be successfully used in the coming year, given the changes in the monetary policy environment.
Selling Downside Equity Protection
We believe one of the most effective ways to sell downside protection on equities is by selling longer dated out of the money vertical put spreads on SPY, the ETF that tracks the S&P 500. This strategy has a number of advantages that makes it more attractive than the alternatives.
We recently closed two short vertical put spreads on SPY, so will use these to demonstrate. On March 16th this year we sold December '15 dated vertical put spreads with $195/$190 strikes for a net credit of $1.08. On the same day SPY closed at $205.58, which we will use as the equivalent entry price for a long trade.
The payoff diagram below illustrates how each position, the short put spread and the SPY long, would have performed relative to the SPY level upon expiration. This shows that the SPY long would have made a minimal profit even if equities had rallied to new all-time highs, whereas the short put spread would have gained the maximum possible profit of 27.55%. This means that SPY would have had to rally above $261.65 to begin to outperform the short put spread trade.
We respect that the put spread will show greater losses much faster on a pullback. At a SPY level of $190 the maximum loss of 100% would be reached for our put spread, while the SPY long would only be down 7.58%. At face value this may indicate that the SPY long is the better trade, as the downside risks are shown much more slowly, thus allowing one to exit the trade at a more favourable level if the market situation changes.
However, taking a closer look reveals a much more detailed picture. For our vertical put spread position to take the maximum loss SPY would have to be at or below $190 on expiration, which translates to approximately 1900 in the S&P. While the S&P did trade this low, the rebound was swift and powerful with equities having their best month since 2009 very soon after the correction.
The reason for this is the highly accommodative stance of central banks globally, which has ensured that equity markets are protected to the downside. Investors knew that, if necessary, the Fed would take whatever action needed to ensure that the slowdown in China (the trigger of the correction) did not cause another recession. This meant that soon after the correction had found its bottom, equities were able to rapidly rally back to their previous levels.
Our view that stocks would rebound quickly after a correction has now been proven correct. This view made the chances of the S&P being below 1900 at expiration extremely small. Therefore, although the maximum loss of our put spreads would be reached much faster than those of an outright long, the risk reward dynamics were much more favourable for the put spread as the expected losses were far smaller than the expected gains.
Time Premium Turns a Loser into a Winner
Suppose that one bought the underlying asset, SPY, to gain direct long exposure to equities. This trade would only perform profitably if the S&P 500 moved higher, regardless of how long it was held. However, a short vertical put spread on SPY actioned at the same time would make a profit if the S&P simply did not fall, as the positive theta component would ensure the time premium of the sold puts would decay to leave the position worthless at expiration. This means one could potentially bank the maximum profit without the S&P rallying at all, or even if it fell.
We had opened a second vertical put spread trade using the same expiry and strikes as the previous, but for a smaller net credit of $1.04 on April 8th, when SPY closed at $205.90. We took profits on both trades simultaneously on December 15th when SPY finished at $205.03.
This means that had one entered and exited a SPY long on the same days that we had traded our vertical put spreads, they would have lost money both times. This is in stark contrast to the 26.28% and 25% profits that we banked.
The reason for this difference is time premium. A long ETF trade neither accumulates nor loses time premium while it is open (although does earn dividends), the profit and loss depend purely on the current price level. However, options involve a theta component. When one is long a put or call this decays as expiration is approached, because there is less time for the option to move or stay in the money. Conversely, if one is short an out of the money put, then they are effectively paid the time premium as expiration approaches.
Shorting a put outright is an unlimited risk trade, so to avoid this we sold a vertical put spread. These trades are limited risk, but have the same attractive quality of negative theta. This means that the longer we were short vertical put spreads while they were out of the money, the more likely they were to expire worthless, the more time premium decayed, and the more likely we were to collect the maximum profit available.
Selling Downside Protection to Beat the Benchmark
In our article earlier this year we discussed how one could sell downside protection to enhance portfolio performance we considered how one could use these strategies to outperform the index as a benchmark. Here we considered a portfolio allocation of 20% to vertical put spreads on SPY, and the remaining 80% directly invested in SPY. The payoff diagram below illustrates the performance of such a portfolio, with 10% allocated to each of the vertical put spreads we sold.
This shows that allocating just 20% away from directly long stocks and towards vertical put spreads dramatically reduces the breakeven point. Rather holding SPY until the S&P rallied above 2050, one's portfolio would show a profit 100 points lower at approximately 1950. Also, once the S&P moved above 1935, an SPY level of approximately $193.50, then the new portfolio would be outperforming a direct long. This outperformance would continue until the S&P reached approximately 2600.
This means equities would have to rally more than 25% before a direct long performed better. We believe the chances of this happening in the current market situation are limited enough to ensure that an 80% SPY long to 20% short SPY vertical put spread portfolio easily outperforms the direct long on a risk reward basis. If one had weighted their portfolio in this way with the trades we recommended to our subscribers, they would have outperformed the losing SPY long by 5.18%.
Will This Strategy Retain Positive Risk/Reward Dynamics in 2016?
Along with most we held the view that the first rate hike would come at this week's meeting. Now that this hike has come, the Fed appears to moderately hawkish looking forward. Dot projections indicated rates will rise by another 100 basis points in 2016. The beginning of this tightening cycle means that the risk reward dynamics of selling downside equity protection is changing. With this in mind we exited both trades just before the Fed released their statement for the December FOMC meeting.
The phenomenon of the Global Central Bank Put was a result of highly accommodative monetary policy. With the Fed now tightening the effect of the Central Bank Put will very likely be reduced. This means that selling downside equity protection is less attractive in terms of risk reward dynamics, as the probability of selloffs being higher or prolonged has increased, which increases the expected losses.
However, monetary policy is not being aggressively or rapidly tightened in the US and most other central banks are still easing. This means that there are still potentially profitable trades to be made selling downside equity protection. ECB QE will likely be the key determinant of this.
The ECB failed to increase their current easing measures at their most recent meeting, despite market expectations. As a result it is likely the ECB will now have to expand their current easing program in early 2016. This fresh batch of QE is likely to support equity markets in the same way that QE3 did, but the effects are likely to be more concentrated on European stocks, particularly with the Fed tightening.
Therefore it is likely that European equity markets will be much more protected to the downside. This means that selling downside protection on European stocks likely has better risk reward dynamics than on US stocks going forward.
Disclosure: I am/we are long EQUITIES VIA VARIOUS OPTIONS STRATEGIES.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.