Building A Core Portfolio With Options

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Includes: EEM, GLD, IWM, SPY, TLT, XLE, XLU
by: Novity Trading

Summary

How to build a Core Portfolio using Options.

Non-Correlated Diversified Core Portfolio.

Creating Lower Draw Down strategies with better returns then Buy and Hold.

Building a Core Portfolio with Options

Building a core portfolio is an essential part for diversification and staying active in the market. The benefits of building a core portfolio also helps the trader invest in non-correlated underlying, which in essence will mean there should be lower drawdowns and market risk, vrs investing into one product. Our idea is to build a portfolio that will throw off cash that we can then use, to continue to invest. Whilst dividends have their benefit, Options help add to this ability and enhance the returns.

With the core portfolio strategy model we are going to use options. Selling options helps the trader receive additional income and hence reducing the cost basis of each stock we are trading. Every time we reduce the cost basis of the stock purchase it will help us increase our probability of profit for the trade. Whilst selling calls on stock does limit upside profit potential, it does reduce the purchase price. For a trader, the lower we can accumulate the purchase price of the stock, the better chance we have of being successful over the long term.

For the work and analysis we have used Matlab®. As we don't have access to the use of real historical option data we have used theoretical option values based on 15% volatility across all instruments. The strategy is based on market pullbacks, and as we know volatility of options increase when the market pulls back. So based on that we think 15% is a fair value average for analysis.

The strategy buys ETF (Exchange Traded Fund) and at the same time sells a put and a call (covered strangle). The idea is to accumulated positions when the market is going down and exit positions by assigning stock to the call options which will happen when the stock rises.

What we are looking for, is a system that will reduce Drawdown risk via diversification of non-correlated underlying's. The strategy shown here is only the beginning of the conversation, and I look forward to improving on this train of thought. To begin with we are looking at building a simple system using the Moving average to determine the entry point. We are only using the Moving average due to the ease of use for development, and also to limit when we are buying stock, to only buying stock when the stock is theoretically trending upwards. We also use the highest high after the stock rose above (broker through) the Moving average as a reference point. When a stock pulls back a fixed amount from that high and as long as it is above the moving average it will trigger an entry signal. The entry signal is defined as buying the underlying instrument and selling a call against that stock, as well as selling a naked put.

For this exercise we are going to use weekly options and if the rules for entry are true, we will then buy the stock and sell both the call option and put option to the nearest Friday. On each Friday, which is the expiry date, if the stock is below the put option we will automatically assign the stock, and then write calls against all stock only when the stock is greater than the original purchase price.

To begin with we will look at the Correlation of various instruments. There are 2 things we need; the first is liquidity both for the stock and the option volume. Liquidity is paramount to ensure we can easily enter and exit at competitive pricing. The second is that we need to ensure the list of stocks we hold have a range of correlations both positive and negative, so our portfolio is not leaning to one underlying asset class and which in turn will lead to one outcome.

Correlation of Returns

The above image and information was taken from etfscreen.com

As the reader can see using these different instruments ensures a diversification of non-correlated underlying's. Whilst this list is not exhaustive and could be improved it does give us an idea for the basis of the strategy.

We have use yahoo data for our analysis. All the historical stock data was downloaded via yahoo data feed into Matlab®.

The inputs are;

  1. Volatility for the options 15%
  2. Delta: 30
  3. ETFs : SPDR S&P 500 Trust ETF (SPY), SPDR Gold Trust ETF (GLD), iShares 20+ Year Treasury Bond ETF (TLT), iShares Russell 2000 ETF (IWM), iShares MSCI Emerging Markets ETF (EEM), Energy Select Sector SPDR ETF (XLE), Utilities Select Sector SPDR ETF (XLU)
  4. Interest Rate: 1%
  5. Options: Weekly
  6. Buy and Hold reference stock is SPY

It is hard to quantify the value of the SPY quantity of shares, so we have taken a value that is roughly equivalent of the combination of the portfolio of stocks, bearing in mind that the combination strategy does accumulate more positions when the market moves lower and sells when the market moves higher, whereas the SPY buy and hold reference buys 400 stock and maintains that same amount of position throughout the years of research.

Chart Detailing

  • Blue Line (Combination Total Profit/Loss Accumulated) - is the value of the profits/loss of the ETFs plus the option profit/loss.
  • Orange Line (Combination Buy&Hold) - Is the value of buying 100 stocks for each of the inputs and holding these vrs holding the SPY.
  • Yellow Line (Combination Profit/Loss inc Interest) is the same as the blue line but this time we add in the value of investing into 1% interest rate when the strategy is not trading.
  • Purple Line (Combination Profit/Loss Open Position) - This shows the Drawdown historically and today of all the open positions of the combination strategy.

IMAGE 1

Image 1

We can see from the image that using this system the "Combination Total Profit/Loss Accumulated" outperformed the Buy and hold (SPY) by a solid margin. This outperformance is due to the use of options which generated extra flow. The trader is active in the market with this strategy and continually generating cash flow by selling premium through the put and call options. This shows the benefit of this strategy vs passive investing and waiting for the market to provide you the return.

The Orange (Combination Buy&Hold) show that just buying each of these stocks individually with no management is a great strategy to implement as the Drawdowns are less, and the overall returns are more stable. We can see that by just buying and holding the SPY, GLD, TLT, IWM, EEM, XLE, and XLU the returns were less than buying the SPY outright over the long term, but it has less volatility. This is why these 7 instruments were used as we were looking to reduce drawdown, but also use highly liquid ETFs both on the stock side and option side. This strategy along with selling calls only, could be a good strategy to implement just on its own.

You can see a DD of about $28,000 in 2008 in the credit crisis from the combination strategy, but if you look at the chart you can see that the SPY buy and hold had a similar drawdown of approx. $28,000. The reader can also note that the combination strategy came back into profit quicker than the buy and hold strategy.

What is most interesting is that the accumulated value of the combination strategy using options, kept growing at a steady pace and making profit, even though some of the stock positions were in negative/ drawdown territory for a period of time.

A takeaway from this information is that when we have diversification of underlying which is non-correlated it shows that even when in turbulent times in the markets the strategy will not implode and it will continue to throw off cash. This cash can then be invested further as the strategy buys stock when it is low and sells stock when it is high. If the ETF is not in a pullback of some sort, the strategy is invested into cash, and doesn't chase the market.

There is a lot more work that can be done in this area, but at least the fundamentals and ideas of building a diverse core portfolio has been contributed to. The way forward is to incorporate the use of options into the portfolio to help increase the probability of the profit per trade which in turn also lowers the breakeven price of the stock.

How to implement this strategy moving forward

A reader can easily implement the combination buy and hold strategy which is investing in SPY, GLD, TLT, IWM, EEM, XLE, and XLU and holding. To add to that the investor can then sell 30 delta options against these positions. Whilst this test results are not shown here, reducing the cost basis by selling options will help ensure a lower breakeven which will help increase profitability.

With the combination profit/loss accumulated strategy, we have used various entry criteria and moving average length to determine an entry period that is optimal for each different ETF. This was done as some ETFs in the list move faster than others and has greater/less volatility.

Whilst we have not optimized the individual ETF moving average and pullback amount we have come up with a list that decreases Drawdown risk and increases profit. Using a 200 Moving average with a 2% pull back the results are similar to image 1.

What this means moving forward is that every time the stock breaks above the 200MA we wait for a 2% pull back then buy the stock and sell both the put and call options at 30 delta. The pullback high is referenced from the highest high since the stock broke through the 200MA. Whilst this is a crude method it does provide some basic entry determination rule to help get involved in stocks that are theoretically moving up. If the stock is below the MA there are no trades.

If we change the MA setting to 100, we can see the results change as per below.

IMAGE 2

Image 2

We can see from this analysis that the combination total profit/loss accumulated increased significantly from about $70,000 odd dollars to roughly $82,000. The problem is that the Drawdown also increased from about $28,000 to approx. $45,000. The investor can work out if the added drawdown risk is worth the extra profit.

As noted, additional work can be completed to refine the strategy settings and also build it so only trading in stronger moving markets that are non-correlated on a historical data set.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SPY, GLD, TLT, IWM, EEM, XLE, XLU over the next 72 hours.

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.