This represents the third episode in my series on Portfolio Enhancement. In a sense, it probably should have been my first episode, for a very simple reason - the earlier episodes took for granted that the reader understood the problem that Portfolio Enhancement was designed to solve.
Let me clearly state the problem.
Most investors have some reasonable asset allocation. The typical diversified allocation is around 60% Stocks, 40% Cash/Bonds (60/40). If one includes savings accounts, not just investment accounts, the asset allocation could be getting closer to 50/50.
By example, 2016 was a good year for stocks, up about 12.5%. However, a 60/40 allocation in 2016 would have an overall Portfolio return around 7%. It could be a little higher or a little lower if more or less was in bonds, cash or stocks and whether one under-performed or over-performed.
If we look at historic returns, stocks return around 8% and bonds/cash around 4%. That means the historic 60/40 allocation returns are closer to 6.5%. So, though the stock portion exceeded historic returns, the cash/bonds were less. So 2016, if viewed on a portfolio return basis, was about average.
But that doesn't tell the real story, the net gain after taxes and inflation. If one subtracts as little as 15% in taxes the net return is closer to 5.5%.
The real inflation rate is a moving target, but most think it's at least 2.5%. Given that very conservative estimate, after tax and inflation, a 60/40 portfolio returns only around 3%.
Now I won't get into the Retirement Merry-Go-Round, with all sorts of calculations and assumptions, none of which will probably play out. Instead, let me just say that a net-net 3% return won't make it easy to save or live comfortably in retirement.
Add in higher tax rates and higher inflation, "oh my, oh my", not to mention slower growth rates.
Long-term portfolio returns are reduced because asset allocation does NOT increase returns, it reduces volatility and risk.
If one wants to increase returns solely through asset allocation, then they have to undertake more volatility or risk, or both. They're likely to do better in the long run, but factor in the costs of valium and sleepless nights.
At the heart of Portfolio Enhancement is acknowledgement that reduced volatility and reduced risk through Asset Allocation are favorable characteristics. We don't want to sacrifice them, just find ways to increase returns without sacrificing favorable components.
My two previous articles, here and here, were building blocks and this article will build even further. Subsequent articles will add more building blocks as I progress through the simple to the more complex techniques. We will progress from strategies that work in bull markets or bear markets to the most complex, those that work either way.
I started with the Bull-Call-Ratio because of its simplicity.
I recommend readers look over my earlier article for foundation and variances, but I'll summarize it as follows:
1) Take an existing position
2) Buy an ATM (at-the-money) call option with an expiry as much as one year out
3) Sell (write) TWICE as many OTM (out-of-the-money) calls at such a strike to receive (credit) approximately the cost of the ATM call from step (2)
I like to use the SPDR S&P500 ETF (NYSEARCA:SPY) as a surrogate for a portfolio. Here's how it would be implemented, assuming a portfolio with about $113,000 in SPY equivalent equities.
1) Establish the lower leg with a Buy of FIVE January 2018 ATM calls at a strike of $226 for a cost (debit) of $13.85, or a total cost of $6,925
2) Establish the upper leg through a sale of TEN (twice) as many OTM calls at a strike of $240 for a credit of $6.90 each; total credit of $13.80, or $6,900
3) The net cost of the two legs ends up at just $25, plus trading costs
Now, here's what happens: As SPY advances above the lower leg at $226, the leg will "enhance" dollar for dollar on the move towards $240 where the gain is maximized at $14 or about 6.2%.
The $14 made on the way to $240 starts to give back if SPY rises above $240 since the short calls start to go ITM (in-the-money). At SPY = $254, the loss on the short calls wipes out the entire $14 earned on the way to $240. However, the gains from the basic portfolio remain intact and the overall gain is 13% (from the underlying SPY). If SPY continues to climb, no further gains will result from the options or the underlying SPY.
Summarizing: Returns are enhanced when SPY rises only modestly. This comes at a cost of limiting gains from the stock portfolio to 13%, no matter how high SPY goes.
It's probably easiest to see in chart form.
SPY vs. "Enhanced SPY"
Assumes $113,000 as SPY moves from $225 up to $260
This is the scenario that I presented in the original article. The problem with this simple ratio strategy is that it can cut off very large gains. Let's face it, there will be times when the market gains much more than 13%.
No one likes to miss the BIG UP MOVE, so we turn our attention to mitigating this loss. This can be done by trading some of the "enhanced" gains in exchange for more upside potential.
There are several ways to accomplish this but my favored choice is adding another leg. This converts the ratio spread to a Butterfly Spread. Don't get hung up on the name (Butterfly). Think instead of it as an opportunity cost in case there's a big move up.
So, start with the initial buying of FIVE $226 calls and sale of TEN $240 calls. BUT add a buy of FIVE $255 calls.
We have now created a $255/$240/$226 Butterfly.
The FIVE $255 calls (the uppermost leg) cost $2.45 each or $1,225. This is the opportunity cost allowing for the big run up.
The opportunity cost is $1,225 and if SPY doesn't move that's lost. If SPY moves up, the cost lowers the overall profit potential.
Let's look at the Butterfly without regard to the underlying SPY portfolio holding.
As one can see, the Butterfly adds significant value from about SPY = $228 through SPY = $252. In essence, enhancing mid-range returns.
Let's see how this enhances the SPY "Vanilla" Portfolio. (by "vanilla" I mean SPY and only SPY, no enhancements)
So, for an "opportunity cost" of $1,225, mid-range returns are substantially increased and the "drag" is just the $1,225.
This may not seem important but consider that in years when there are outsized gains to be made, when one can make 15%, 20% or more, the opportunity cost is minimal compared to the potential of the big move up. However, the main objective, increasing yields in modest markets, remains essentially intact, although not quite as much.
O.K., time to show one chart that encompasses it all:
Conclusion: Everyone's a HERO when the market's up 20%, 30% or more. When that happens, it's hard to make a mistake (other than being short). It would be nice if that's the way it always was, but the truth is the market is fickle. In fact, many believe that we're headed into decades of below average returns.
Option strategies can be very useful when viewed as a method to trade off a little when gains are robust to enhance returns when returns are less robust.
In my previous article, I explored the Bull-Call-Ratio as a method to enhance an individual stock by giving up the possibility of huge gains. On a portfolio level that just doesn't make sense.
The essence of the Butterfly, as described here, is accepting a little less ($1,225) if the market goes up 13% or more. In exchange, the investor can enhance the sub-par years, when every extra dollar means much more.
Oh, and you can impress all your friends with a fancy name, Butterfly.
Addendum: The butterfly has no margin requirements but does require some cash outlay for the long calls. That means that some cash, which is currently earning next to nothing, will go this way and ultimately returned through the short-call-credits.
There are many variations in strikes that can skew the returns in favor of larger run-ups or even flat to modestly down markets. I have and will touch on them in various articles (as in my prior articles) but they exceed the scope of this article.
Disclosure: I am/we are long SPY.
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 have long and short option positions in SPY. I use ratios and Butterfly option strategies.