The Money Train's Next Stop: Risk Village

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Includes: DIA, IWM, QQQ, SPY
by: Reel Ken

Summary

Exactly Which Risk Are We Protecting Against?

The Risk We Need to Protect Against.

A Low Risk Solution.

One of my favorite reads on SA is Jeff Miller's column. He provides a great deal of information, seems to be pretty level headed and right more often than wrong. Practically every article he writes includes something along the lines of: "I have a rule for my investment clients. Think first about your risk. Only then should you consider returns."The problem is that each investor faces multiple risks. General Market Risk seems to be what everyone, including Jeff, focuses on when it comes to risk. But as we'll see shortly, that is not as great a risk as most investors think. There are other risks that are much greater and generally are left un-mitigated ... risks such as emotional risk associated with impulse, fear and execution. Then there's what I consider the biggest risk of all ... the risk that Portfolio Returns will not be sufficient for the investor to realize their goals ... particularly retirement goals.

In my last article I laid out a strategy to realize greater Portfolio returns by re-allocating low yielding cash assets for gains with low defined risk. I considered that strategy a conservative "safe" investment and useful as a cash replacement. I promised that I would switch over to how I handle my riskier investments. But before I get into how I handle the "risk" portion of my Portfolio, we need to lay some foundation regarding risk assessments. So bear with me.

Let's start with a chart of the last 50 years returns on the S&P 500

What this chart shows us is that over the last 50 years, the market experienced only 10 down years ... and one-half of them less than 10%.

Furthermore, there was not a single drop or consecutive drops --- no matter how severe -- that didn't fully recover, and then some, within two years.

But, most importantly, the market was up 80% of the time gaining, on average, over 12% in an up year.

Let's see how this fares if we look at a more recent market ... 2000 through the end of 2017:

What we see is very similar to the 50 year chart. The market is up about 80% of the time; down years are fully recovered within 2 years. Where we see difference is that the "Great Recession" isn't spread out over as many years and the average loss is somewhat greater.

Real Risk

So while the vast majority of investors are worried about a practically non-existent risk ... I concentrate on a completely different risk ... insufficiency of return. Over the last 16 years the average return on stocks has been 7.66%. Take away trading fees, inflation and taxes and the average investor has next to no real return. Now, consider the loss resultant from asset allocation into lower yielding bonds and cash (typical 60%/40% mix) then subtract out the emotional risk loss and "mistakes" cost and the average investor is steadily losing ground.

Then consider the low overall savings rate which has been on a steady decline and is now under 4%. How does this balance with the obsession with Market Risk?

Here's the really scary part: If we're looking at single digit stock returns ... before inflation and taxes .... a 100% allocation to stocks may not even be enough.

Now I must admit disagreeing with Jeff Miller carries its own risk. But I have to say he has it completely backwards. One must think about returns first, then, and only then, think about how to minimize risk. Sorry Jeff !

Real Problem

"The fault, dear Brutus, is not in our stars,but in ourselves, that we are underlings."Julius Caesar (I, ii, 140-141)

There are a myriad of good ideas out there but most people just don't avail themselves of them. People are mostly interested in confirming that they are doing the right thing than actually doing the right thing. But this is human nature and to think people will change is unrealistic. Instead, any successful plan most consider the shortcomings, not only of the plan, but of the investor.

My Real Solution

Well, after all this, I'm finally getting to actionable advice. My solution is really pretty simple and has as it's objectives the following:

1) Increase yields in slow moving markets

2) Reduce risk sufficiently that the investor has "staying power"

3) Allow the investor to benefit from market drops

4) Establish a defined risk of loss

The method I use to meet this is not new ... I've written about it many times and will keep writing about it. There are many "moving parts" and I'll cover the main ones here and the minor ones, as needed, in subsequent articles or in the comment section. So here goes:

Risk Assumptions:

In order to suggest an action plan one must first reveal the underlying assumptions. It is the underlying assumptions that really define the risk.

Assumption 1: The market has an upward bias and will expand over time. The longer the time period the greater the likelihood of new highs.

Assumption 2: Every new high will be re-visited on a drop. Maybe not the next day or week or month or year, but within a reasonable time period thereafter.

Assumption 3: The investor, if given specifics and the rationale, can execute reasonably within defined parameters. That specificity and knowledge can overcome fear and impulse.

Action Plan:

Let's assume a $500,00 Portfolio invested $200,000 in cash equivalents and $300,000 in stocks, commodities, "whatever" (classic 60%/40%)

A) I've already suggested how to deal with the $200,000 in cash equivalents in my previous article. Let me just add that I used a two-year far dated put because, as illustrated, herein, it should provide enough time for a market recovery in the event of a drop.

B) "Lever-Up" the $300,000 in risk assets, but do so with limited risk ... here's one of many methods (later articles will detail more) .....

1) Supplement your risk assets. Buy far-dated calls on SPDR S&P500 (SPY). Buy it At-The-Money with an expiry no sooner than December 2019. Once again, two years out ... for the same reason.

2) The number of calls purchased should be based upon the value of your risk assets ... in this case with $300,000 in risk assets, buy 11 SPY calls at a strike of $270 (11*$270*100=$297,000 strike exposure). The cost is about $22.30

3) Look to amortize the cost over the two years. Simple division: $22.30/104 weeks= about 21 cents per week.

4) Sell a weekly Out-of the-Money (OTM) call on SPY that will provide 21 cents extrinsic. The objective is to recover the cost of the far-dated call over the two year period. Now, as SPY moves up and down the OTM strike will vary. But in calm markets it should average about 1% OTM. In more volatile markets, when volatility is higher, the OTM strike might be as much as 2% or more OTM.

So far, if this sounds remarkably similar to my suggestion for cash equivalents, you are correct. It is simply a diagonal call calendar spread. Let me continue:

5) If the market goes up and over-runs the strike ... roll the next week's call In-The-Money at the same strike as the previous week as long as the new strike earns at least 21 cents extrinsic. If you have to walk the strike up a little higher to get 21 cents, then do so. But this type of "walk-up" won't happen unless SPY moves up more than 2% in a week ... a rare occurrence.

6) If SPY did over-run the strike, if it drops back down to the now ITM strike you can safely raise the next weeks strike OTM for 21 cents extrinsic.

7) Most of the time, SPY will behave and rise up less than the strike, but over-runs can be expected as much as 25% of the time, or more. So be prepared.

Let's pause a second and evaluate what happens in an up market.

1) There will be times that the market will over-run the strike and the weekly short call will lose money. However the far-dated will show gains on up moves. SPY would have to rise about 2% in a week for the combination of the losing weekly and the winning far-dated to net a loss for the week.

2) There will be times when the market, after over-running the strike, will drop back down. Some, or all, of what was lost on the way up will be recovered on the way down. Unless the drop is severe, the gain on the weekly will be more than the loss on the far dated. Patience is needed. But the market never goes straight up.

3) The 21 cents extrinsic is earned in either case and the cost of the call is fully amortized. Overall gain will equal the amount by which SPY ends up exceeding the initial strike of the far-dated. For instance, if SPY is up 5%, you will make 5% on this "leverage". Added to the 5% on your own investments and you've hit 10%. In fact, If your investments mimic a broad diversified portfolio, this "lever up" will double your upside.

Never Never Land

In the event that the market just keeps going up and up and up and you have to continually sell the weekly call ITM you will eventually break even and not make any money. But if the market keeps going up 1% each week for two years ... are you going to complain that this little piece didn't do anything. Remember, the "cash equivalent" strategy in my previous article is integral to this strategy and will make bundles and bundles in such a scenario. Not too mention your basic risk assets.

Let's now move on to a market that moves down.

1) The building blocks of this strategy is that the market will end up higher than it started and that any high will eventually be revisited. The down market presents the greatest challenge. When the market drops ---- and it most surely will --- in order to earn the 21cents extrinsic, one would need to walk the weekly strike down as well. This increases the risk of an over-run on the inevitable bounce and should NOT be done. Instead, it is imperative to hold the strike and lose some extrinsic.

2) However, to ignore the buying opportunity afforded in a drop would be a mistake. A tactic I employ tries to take advantage of the drop while providing some downside protection. It is somewhat tedious to explain and you won't find it anywhere else. So here's as good as place as any to go into it.

Butterfly Protected Put-Write

Let's say the market just dropped 1% or so. We'd like to take advantage of a potential buying opportunity, but do have some fear (misplaced) and want to exercise some caution. Here's what I do:

STEP 1: Sell weekly "just OTM" naked put for 1/2 the number of calls. So, in the example above, let's say SPY dropped 1% and to $266.86, I'd sell 5 puts just OTM at a strike of $266.5 for a credit of 96 cents.

STEP 2: I'm worried about a bigger move down, so I provide contingent protection via a long put butterfly spread. I've written about this in a previous article. Those unfamiliar should study that article. The particulars here would have three legs, as follows:

Leg 1: Buy 5 weekly OTM puts with a strike of $265.5 for 68 cents.

Leg 2: Sell 10 weekly DOTM puts with a strike of $263.5 for 37 cents each (total credit 74 cents)

Leg 3: Buy 5 more DOTM puts with a strike of $261.5 for 22 cents

The net cost of the Butterfly is 68cents minus 75cents plus 22cents = 15 cents.

So, where does this get us?

1) If SPY closes above $266.5 I gain 96 cents on the naked put but lose 15cents on the Butterfly. Net gain is 81 cents which more than compensates me for any extrinsic I sacrifice on the weekly call because I set it high awaiting a bounce

2) If SPY drops below $266.5, I give-back some of the 81 cents. If it drops to $265.70 ( a 1/2% drop) I gain nothing.

3) If it drops to $263.50 (the upper leg of the Butterfly) I've lost 19cents.

4) If SPY continues to drop, the upper leg of the Butterfly goes ITM and protects form further loss unless the drop continues past the second leg of the Butterfly. But, since the middle leg is at $263.5, SPY would have to drop from $266.86 to below $263.5 (1.4% drop) before my "contingent protection starts to dissipate.

5) The most I stand to lose is the amount of the drop less the 81cents net extrinsic. So, If SPY dropped $6 (2.25%) I would lose slightly less, at $5.19.

6) If this happens, I just continue to roll the 5 puts each week at the original strike and continue with the Butterfly 1% further OTM. I keep doing this waiting for a bounce. In theory, the longer it takes, the more I stand to make on the bounce. It won't be fun, but when it's all over, it will be money.

This is predicated on several calculated risks:

1) It is employed after a 1% drop.

2) SPY would have to drop two consecutive weeks of more than 1% before it suffers loss. It would have to drop 1% before the put plan is instituted and then 1.4% afterwards for loss to occur. Additionally, loss is permanent only if there is never a recovery after these back-to-back drops. The odds?

Butterfly Protected Put Write Results:

I've been keeping weekly records since October 2014 (3 years). During that period (169 weeks) SPY dropped 63 times. Of those 63 drops, 23 drops exceeded 1% and were bought. Only once did it incur back-to-back drops of more than 1% and fully recovered within the next week.

So the market risk just doesn't seem to be present enough to NOT do this.

Calendar Call Risk Evaluation:

This article presented a method that holds the potential to double upside gains. So what are the risks:

1) Risk #1. Failure to execute properly

2) Risk of loss. This is hard to get one's hands around. The maximum risk is the cost of the call which is less than 8% over two years. But that risk is diminished by each weekly extrinsic captured. In a way it's like asking what the risk of buying rental property is. Well, as long as one receives rents, the cost is diminished. In the end, the rents may actually equal or exceed the property value.

3) My Risk Assessment: As close to zero as it gets ... caveat ... provided one "holds the strike" and has patience.

Tweaks

1) This article illustrated using SPY for the "lever up". One could just as easily use the SPDR DowJones ETF (DIA), Powershares QQQ (NASDAQ:QQQ), IShares Russell (IWM) or any that the reader has greater familiarity with. I choose SPY because I have years experience in it, the bid/ask is favorable, there are tight incremental strikes, and the greatest selection of expiry dates.

2) For the daring, this strategy could be employed on individual stocks ... such as AAPL, TSLA or (help me lord) BitCoin. However, non-diversified holdings have some special problems that I'll cover in subsequent articles and should only represent a small portion, if any, of this type of "lever-up"

3) I illustrated a "lever-up" equal to the Portfolio Risk Portion. One could go 3:1, 4:1 or more. I have done this for very short periods of time. The problem isn't the "math", it's the emotions. If there's a big over-run or a big drop, fear steps in and distorts judgment. Fear often travels with greed. I only recommend it for the very, very disciplined investor

4) I've illustrated SPY. However, there are some tax and other issues that may favor the S&P500 Index SPX, or SPX Minis and worth considering as an alternative to an ETF. I'll be detailing this in an upcoming article.

Summary:

This article was longer and more extensive than my typical article. I tried to get as much useful information as possible in circulation. My congratulations to all the readers that have stayed this long.

What I've tried to do is point out that Market Risk is less of an issue than most people think. On the other hand, return risk is greater than most people acknowledge.

As a result, I try to beef up returns as much as prudent. But I also understand that human emotions will counter logical plans. So, instead of just "diving in" I use a call calendar spread to beef up returns in a slow market environment and also minimize the risk in doing so. It's a strategy that takes advantage of what the market gives while mitigating the emotional risks ever-present in traditional leveraging.

Conclusion: Everyone talks about managing risk but they rarely define it. To me, the biggest risk is investor inability to achieve long term, meaningful returns after taxes, inflation, costs and "mistakes". I can't stress enough that Portfolio Returns and Portfolio Management is the heart of solid investing.

What I've detailed here are two option strategies designed as an adjunct to one's portfolio. They are not one-'n-done or hit-'n-miss "option trades", but deliberate, long term portfolio enhancement strategies.

I have employed option strategies for decades and have made about every mistake one can make. I'd like to believe that I've also learned what works and how to work it.

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 buy and sell options on SPY and SPX