Risk On? Risk Off? Have Your Cake And Eat It Too

Includes: SPY
by: Reel Ken

Establishing a Basic Market Understanding.

Failings of Traditional Investing Methodologies.

One way to Have Your Cake.

I've written scores of articles about the how and why of Portfolio Protection. Gauging by the number of SA messages I've recently received there is renewed interest in these techniques. I'm not too surprised ... whenever people start to get uneasy about the market and how to respond they start to wonder if it's time to be "in" or "out" of the market. Few ever think about how to be "in and out" at the same time. So, once again, it seems timely to discuss this topic.

Let me point out that what readers will see here is not especially new to my followers. In many ways it brings together concepts I've proffered in the past though I will be adding some new twists. I hope, in this article, to bring all these concepts together in one place.

Those that are not avid followers are likely to think I'm too much of a "maverick". No "been there, seen that" from me. So be prepared to hold onto your hat ... you are about to enter the realm of completely different approaches to investing.


When many investors hear the word "hedge" they roll their eyes. Frankly, I don't blame them. Many of the hedging techniques are overly complex and hard for the lay-person to understand. But investors might forgive that if "Hedgers" were value-added performers. Well, a picture being worth a 1000 words ...

Astonishingly these Hedge Funds are handled by some of the so-called brightest of the bright. Wow !

One could conclude by viewing this chart that investors would be successful switching into hedge funds just before a crash and switching back just after the crash. However, if an investor could accurately predict when crashes came and went maybe they should be running hedge funds not investing in them.

So, when one combines the complexity; the exotic nature; the lack of transparency; the high fees; and the under performance of many Hedge Funds it is no wonder typical investors stay away.

So, when it comes to my articles I try to avoid talking about hedging. Instead I prefer to call it Portfolio Protection. Yeah, I acknowledge calling hedges Portfolio Protection is a little bit deceptive ... but if doing so facilitates understanding; facilitates implementation and facilitates returns ... is this "deception" harmful?

Portfolio Protection Theory

Protecting a portfolio generally requires a willingness to accept somewhat lower returns in exchange for exposing oneself to less risk. There are myriad ways to accomplish this ... the simplest form is just taking something off the table ... up to and including exotic options and futures strategies. There is no shortage of ideas but most investors don't avail themselves of these techniques. I believe they aren't fully utilized because investors don't understand the underlying Theory.

You see, investing is just as much about the "why" we do something as it is about the "how" to do it. I suspect no one will argue that knowing "why" something is done makes it easier to evaluate "when" it should be done as well as "how" to do it most effectively.

So, to this end, let me start by explaining Portfolio Protection Theory. Don't be scared, it doesn't involve weird concepts or math skills ... in fact, I consider it almost intuitive. Most investors just don't "see the forest before the trees" as it applies to Portfolio Protection Theory.

The Theory is backed up by mounds of statistical proofs and observations and studies so numerous that it would be impractical to cite them all. But that is not necessary as the Theory is borne out of two separate but inter-related concepts … 1) Market Performance and 2) Investor Performance. Let’s take a look at these two elements:

Market Performance

A very basic statistical proof indicates that the market should have an inherently upward bias (or positive skew). Observations and data, collected over the last 100 years confirm this to be true. But one doesn’t need a statistics degree to confirm that the market has an upward bias … they need only look at any long term chart and they can easily see that the market is an ever-upward climb.

NYSE Composite - 1965-Present

Of course it has its “fits and spurts” but the upward bias is obvious to all that take the time to look. In years like 2008, investors driven by fear (real and imagined) often lose sight of this market tendency. When the sky is falling the gut reaction is to run for cover and not to start planting seeds.

There is discussion of exactly how significant this upward bias is and most studies indicate that the market is up 60% to 70% of the time. This seems to hold true whether viewed over decades, years, month, weeks and even days. So, the first step is to appreciate that there will be times ... maybe 1/3 or more of the time that at least "little pieces" of the sky break off. Less often ... big pieces. But anyone serious about investing needs to be able to step back and focus on the Big Picture.

Buy and Hold

This natural upward tendency (bias) is at the core of the success of buy and hold strategies. Those that invest utilizing buy and hold do so because they have faith that the market will tend upward in the future. Their faith has been consistently rewarded.

Despite the overwhelming evidence that buy and hold is a successful investing methodology many investors just can't seem to come to grips with a simple truth ... that, for most people, successful investing is as simple as going long and staying there.

Given that basic truth, let's now turn our attention to how most investors ... professionals and individuals ... take advantage of this natural bias while trying to "improve" upon it.

Investor Performance

There have been many studies of professional money managers and individual investors. Though the studies differ somewhat in their quantitative results they agree in the overall result … most investors (pros and DIY) under perform a simple buy and hold strategy of an index fund. Not only do they fail to "improve" upon indexed buy and hold results, they suffer for their efforts. Furthermore, this under performance is not small … in some studies it is as much as 5% per year in the short term, and even more in the long term.

Just in case someone misses the importance of this chart, it clearly demonstrates that investors under perform a simple buy and hold strategy by considerable margins. Furthermore, it seems that this under performance is in the range of about 4%-5% per year ... year after year after year for as long as 30 years.

Simply put: The very effective investment strategy of buy and hold is rarely accomplished. Though investors think they are, reality shows that they aren't doing it successfully. Let's look at some of the major causes for this under performance.

Emotional Investing

Simply stated, emotional investing is when the investor reacts to fear and greed. The average investor ... perhaps most all investors ... react to market movements “emotionally” not logically. Every seasoned investor has experienced going the wrong way because of fear or greed. No one … yes, no one … is immune. Here's a picture of the reality we all face.


This pattern degrades buy and hold from being properly executed in that investors wait too long to enter and exit when they should be buying. They let their emotions time the market instead of investment fundamentals.

This is compounded when investors fool themselves into thinking they are doing one thing when facts clearly indicate they are doing something else.

Asset Allocation

Actual investor returns don't even approach the emotionally deflated returns. Simply stated, most investors utilize asset allocations in the 60%-40% stock/cash-bond range ... or some other greater or lesser allocation dependent upon their "risk profile". In fact, if an investor was 100% equity invested most would consider them reckless.

So, under "standard theories" of investing, investors get a hit to portfolio returns from emotional investing and another hit from asset allocation ... allocating large portions of their portfolio to under performing asset classes. They too often make the wrong move and when they do make the right move the potential is not fully realized.

Let me drive this point home. If we took the Five Year results from the above chart, the average investor realizes a 10% equity return. But if one was, say 60% in stocks, the portfolio return is a little closer to 6%. So, on a portfolio basis they are not achieving anywhere near the 10% return. Now, if they just put 100% into an index fund and sat tight --- did nothing --- the portfolio return would have approached 15%. Do you need me to tell you how much more money a long term return of 15% will generate than a 6% return?

Of course, very few investors will accept putting 100% of their money into equities because of the risk of loss in down years (we all remember 2008). But, despite this, the logical path is clear … it is the emotional courage that is at issue.

Naturally, many investors will counter with the argument that by re-balancing after rises and falls they get to buy the dip and so on. That's true in theory ... except the data indicates that it doesn't pan out in practice. Consider: If most investors use some Asset Allocation to bonds/cash ... such as 60%/40% ... and most investor's equity performance under performs market returns ... maybe as much as 5%/year or worse ... then the theory behind Asset Allocation is at odds with the reality. Results either confirm or deny theory and in this case it denies theory.

One reason the theory doesn't mesh with the reality is that the theory doesn't fully take into account human nature and emotional investing's effect on decision making. Asset Allocation is a theory based upon a vacuum and not real world. Knowing what to do and doing it are different.

In a previous article I noted that portfolio rebalancing only seems to be accretive to returns provided there are big drops to rebalance towards equities. It may also fail because the market is up more than down and it systematically reduces equity allocations more than it increases them.

While investors have demonstrated a propensity to taking some off the table during rises they do not put it back on big drops. So, if one takes away from the good more often than one adds to the good ... what does common sense tell you will happen?

But people are people and we must take them as we find them ... having to accept less than optimal returns in exchange for a feeling of safety.

The real goal, as I see it, is to enable investors to take advantage of being 100% equity invested and also limit their downside loss potential.

Simple is as Simple Does

Investors can simplify everything and 1) buy an index fund with 100% of their funds, 2) Buy a far-dated put ... one with an expiry of two years or so. The cost varies depending on volatility when purchased, but usually about 4%-5% a year and 3) just hold and enjoy. Don't trade, don't do anything but ratchet the far-dated put upwards as appropriate. You see, the cost of the put is often less than the loss due to emotional investing. Not to mention the savings in worry and aggravation in not having to concern oneself with big draw downs.

Back in July 25 of last year, when the S&P 500 ETF (SPY) was trading at $247, I wrote an article recommending investors go "all in". But not really "all in" ... instead a cautious "all in". That is, simply take their dormant cash and bonds that were yielding next to nothing and put it 100% into SPY. Then, to provide peace of mind, buy a far-dated protective put. The cost would be nominal and the rewards potentially great.

Now, a little over a year later, the put has lost $15 but the SPY has gained almost $50 for a net gain of $35 ... or about 12%. A 10% net gain over letting idle cash earn less than 2%. That "extra" 10% increases their overall portfolio return by about 4%. This is not chump change.

Now, of course, SPY could have gone down, not up, and could have lost a little. But the inevitable market rebound would bring it back into the black. I wasn't prescient when I made this call ... I played the positive bias of the market and had a 70% chance of being right. If the market went down, I would have "doubled up" and done even more. When one is heavily favored to succeed one engages and doesn't ignore..

Funny, though. Once again, in December I wrote another article recommending to those that didn't go that route in July do it NOW. For those that went "all in" and bought a protective put the 8 month gains since December are about 8%. Quite a nice pop versus cash.

Of course, the far dated put detracts from returns, but the ability to be 100% equity invested plus the ability to have a cap on the downside (usually less than 5%/year) will enable the investor to outperform traditional asset allocations and … most importantly … enable them to avoid panic and emotional selling.

Let me repeat ... this is important: When an investor goes 100% in and buys a far-dated put that insures against big losses (losses in excess of about 5%/year) they can lose less on the put than they make on the extra allocation. One also must consider that they are insulated from emotional investing losses. Yes, they simply sit tight, forget about ups and downs and let the market come to them. Their losses are capped and their gains aren't.

Calendar Option Spreads

Now, you may ask ... what does all this have to do with Calendar Options Spreads?

The threat to a 100% all-in and buying a put strategy is that the market may not realize the magnitude of returns in the future as it has in the past. This low return prediction became a "mantra" for at least the last five years. Maybe we don't hear it much anymore as it seems to have died a silent death.

But, to me, modest growth is the single greatest threat. All in 100% covers big upside and the put covers big downside. So the risk is in moderate to flat markets.

Also many investors seem to be loathe about buy and hold do nothing enjoy the returns investing. They want to participate and do something. Oh well!

Calendar Spreads can be used to increase portfolio returns and provide protection. So, given their dual purpose and the uncertainties in today's market they command attention.

Those readers that are familiar with option spreads will find some very useful tools in the paragraphs that follow. Those that are unfamiliar may gain enough insight and curiosity to research and learn about them more fully. No matter what your level of expertise the CBOE web site has an excellent education section.

Without going into the level of detail that is necessary to fully understand Calendar Spreads let me give a simple explanation. A typical Calendar Spread consists of two option legs--- one long and one short --- expiring at different dates. The near-dated option is "short" and the far-dated option is "long". The strikes on the two options can be set at-the-money (ATM) and be essentially neutral. Or the strikes can be placed diagonally up or down to create a more bearish or bullish stance. Either way, the placement of the strikes will result in a "window" where gains will result. The closer the underlying lands to the near-dated strike that was chosen, the greater the potential profit. Movements above or below the "window" will result in losses.

It makes no difference whether one uses call or put spreads ... the results will be essentially the same (except for some minor adjustments) as long as the strikes on the two legs (the near-dated and far-dated) are placed at the same level. Most investors are more familiar with put calendars than call calendars, let me use put spreads as a proxy.

Here's an example of a neutral calendar spread where the near-dated option is set ATM. Notice that maximum profit is achieved if the underlying stays flat and profit is reduced as the underlying moves away from ATM ... in either direction.

Image result for calendar spread options

The reason for this is simple but often difficult to understand. There are two options ... one long and one short. So, their value will move in opposite directions depending upon the movement of the underlying. Since they have an offsetting effect on each other the gains or losses are limited. Gains generally result with small moves and losses with large moves. There are all sorts of sophisticated calculations such as Theta and Gamma that explain this but it's beyond the scope of this very general explanation.

Though somewhat subtle, a careful look at a slightly bearish calendar spread will reveal a profit window skewed towards a drop. In the illustration below, the underlying is at $50 and the near dated option is set at $45. Profit doesn't appear unless the underlying moves below $50 and increases as it approaches $45. If the underlying continues to fall ... move away from $45 ... the profit is eroded and if it drops enough will eventually turn into a small loss. The loss never gets too great because the far dated option acts as loss protection.

Image result for calendar spread options

As these two examples illustrate, the placement of the near-dated strike can mean the difference between profit and loss. Also, one can easily see that the profit window is a narrow range. That fits perfectly with a movement that is range bound, flat or modest. Big moves put it at a disadvantage.

Breaking this down further: inasmuch as the near-dated put is sold short it becomes a proxy for going long the underlying. The investor has the option of setting this near dated short put at any strike they wish to reflect their view of the market. They could set if out-of-the-money (OTM) or at-the-money (ATM) or in-the-money (ITM). The further they set it in one direction or another the more-or-less they duplicate having bought the underlying.

For instance, with SPY trading at $288, if one bought SPY outright, they get the full upside (I'm not worried about the downside as the far-dated long put protects that). Now, if they sell a put OTM at, say, $285, they insulate themselves somewhat against a drop but limit their gains on a rise. On the other side, if they sell a put ITM at $290, they get more on a rise but won't realize the full potential on a rise above $290.

Let me be clear: I'm not suggesting this strategy as a "one-off" or occasional strategy. It is designed to be implemented continuously as an alternative to funds that would otherwise be allocated towards buying the underlying. At each expiration of the short put the investor rolls it forward ... at whatever strike they feel appropriate (OTM,ATM,ITM). They keep doing this for years. So it isn't without effort and complexity.

In the end what we have is a mechanism that allows us to maneuver around a flat or modest market and pick up extrinsic value along the way ... extrinsic that can partially or completely offset the cost of the far dated protective put. Of course, if the market rip-roars up, we regret using a put instead of buying the underlying.

In my opinion, a big drawback is that it requires the investor to try to figure out where to place the strikes of the short put and what expiration to choose. The more accurate the better the results and the less accurate the worse the results. Not as easy a task as one might assume.

Now, with this behind us, let’s look at a calendar spread methodology that tries to reduce these complex issues to more common sense and easier to follow guidelines.


First, the ideal time to employ a calendar spread is when volatility is average or lower. This is common sense. The far-dated long put wants to be bought at the most economical price and the lower volatility lowers the cost. Not rocket science.

Exposure: How many options to use? Well, let's say one has a portfolio value of $250,000 that is 60%/40%. They have $100,000 in cash/bonds to target to go "all in". SPY trades around $288 so 4 options represents $115,000 in exposure ($288*4*100). So, set a calendar with 4 options.

A two year far-dated ATM put (June 2020 with a $285 strike) costs only around $8,000. The total margin requirement will only be about $10,000 so you really still preserve almost 90% of your cash. So "all in" isn't even really "all in". I consider levels above 4 options to be a form of leverage and for experienced traders. And I certainly wouldn't use all $100,000 to buy options. OUCH !

Now, one might want to go with more than 4 and cut back on their 60%. Personally, that's what I do. I cut back to zero underlying. In the example of $250,000 in portfolio value ... if one wanted no underlying exposure ... all calendar ... then slightly more than full exposure should be used. I'd go with 12 options representing some slight leverage ($288*12*100= $345,000). This increases your upside and downside .. but assuming upward bias ... it's how I go. Even in 100% calendar, one is using only about 10%-15% of their cash. So there's plenty of safety.

Next, and the more difficult part, is the setting of the near-dated put-write. This is complicated because one needs to consider the strike; the expiry; and when to roll. So let me give some guidelines.

Strike: One can “play around” and try to guess the market and go ITM, ATM or OTM as they please. My personal experience and the rather dismal track record for “market timers” would discourage this in favor of a more systematic approach.

A systematic approach should be based upon the concept that the market has upward skew. It won't work 100% of the time, but 60%-70% is enough to be a winner. And remember ... 60%-70% win ratio is outstanding when compared to emotional investing. Plus, systematic investing for an upward bias is aided by the fact that the downside is limited and protected by virtue of the long, far dated put.

That being the case, the put-write strike should be as deep ITM as practical. Simply stated, it replaces a long equity position. The further ITM it is placed, the closer it comes to mimicking a long equity position.

Remember: One sells a near-dated put instead of an outright buy of the underlying to try to capture extrinsic with the hopes that it will offset the cost of the far-dated.

There aren’t a lot of studies that would indicate exactly how DITM it should be set, but if done as a monthly strike, 2% seems to be confirmed in at least one study. But before someone hops on that, we need to look at what is the best expiry.

Expiry: When one sells a DITM put, it favors selling shorter durations provided the move --- in the direction of the strike --- does not exceed TWICE the premium collected. This is true whether one is comparing a weekly to a two-week; a weekly to a monthly; or a monthly to a quarterly; or even a weekly to a leap.

Using SPY as an example: SPY is trading around $288 and let's say one sold a weekly put at a strike of $290. They would receive about $2.80 in premium. As long as SPY doesn't move up more than twice the $2.80 (2x$2.80=$5.60) … the weekly is favored over any far-dated, provided the SPY doesn’t go up more than 1.95% that week ($5.60/$288=1.95%).

Strike and Expiry: Unfortunately, this is sort of a balancing act and there is no definitive study that helps us out. Combining the two elements, my experience is that selling a weekly 1% ITM is the right level. However, that holds only on an underlying with a Beta of 1 (NYSEARCA:SPY). If the underlying Beta is, say, 1.5, then the strike should be 1.5% ITM … and so on.

The 1% ITM shows gains in and of itself and compared to a further-dated as long as the weekly move is less than 2% up. Now, there will be times that the move is greater than 2% up. This will happen, on average, 4 times a year. But the frequency of large up moves may be offset by “Holding the Strike”.

Holding the Strike: This is the most important part of selling puts (calendar spreads or naked puts). If there is a drop, do not lower the strike and try to capture more extrinsic. Always be willing to sacrifice extrinsic on a down move in order to be prepared for the inevitable bounce back up. It may come in a week; a month; or a year. But the market, historically and scientifically has always (yes, always) rebounded.

The real danger to a calendar spread is losing short term value on a big move down and then not fully regaining it on a bounce (the “whip-saw”) Always keep in mind that the far-dated protects the downside … “holding the strike” protects against the “whip-saw”.

Many times a big up move follows a down move. So, holding the strike will reduce the frequency of being over-run which is the real danger to a calendar.

Strike and Expiry Summary: Combining these three ingredients, one should sell the short put on a weekly basis; the greater of 1% ITM or the previous strike.

Picking the Underlying: I hope that I've adequately conveyed the message that calendar spreads work best on underlying that don't exhibit wide swings. Though one could utilize them on high beta stocks it isn't within the spirit of 100% all in ... but more speculative in nature.

I suggest that calendars utilize broad indices or their surrogate ETFs as their underlying. SPY and SPX are perfect and I've authored an article previously that compares these two. One could also use options on indices or ETFs representing the Dow or the NASDAQ ... but I prefer the S&P 500.

Rolling the Put: As long as the PUT is ITM, it is best to hold till expiry to maximize theta decay.

However there will be times when one sets the strike 1% ITM on Friday and on Monday the market moves up 1%. What to do? Will the market drop by week’s end? Or, will it continue up?

There is no answer. The market will do what the market will do. History tells us that it is 60-40 going to go up. That may be sufficient reason to raise the strike. Let's say you raise the strike and the underlying doesn't go up any further. Well you would have raised it another 1% on expiry under a normal roll, so at worst, you’re doing it a little early. Rolling up ½% now would be a cautious minimum.

A greater dilemma occurs if there is an over-run resultant from a move greater than 1% early in the week and you’re now OTM. If a strike is over-run and then rolled up, you incur a permanent loss of some amount. I seem to always pray that it goes back down within my strike but that's a 40-60 bet. So, one can pray or consider rolling up on the basis that even if there is a drop down, the previous level will be regained.

Knee-Jerk or Fundamental: It is worthwhile to evaluate the character of any big move. Is it knee-jerk or fundamental? Has something changed or is it concern over the possibility that something may change? Every investor needs to consider these factors. If there is a fundamental deterioration in the economy, then one might want to be somewhat more defensive on the near-term put-write. My best advice is to make any such determination carefully and don’t be afraid of getting there a little late. The far-dated put protects. So it is never an issue of suffering large losses, it is more about possibly making money during the bear, while others lose money.


Stock market theory and observation both suggest that the market has an upward bias that favors buy and hold.

Unfortunately, most buy and hold investors don't realize market returns. Though they see themselves as buy and hold, the reality is they do move in and out and emotional investing takes a very big toll on them.

In addition to emotional investing loss, investors willingly accept Asset Allocation loss. A double-whammy.

Perhaps the best way to invest is just go 100% into equities and buy a protective put to limit downside exposure. Studies indicate that such a strategy would have easily out performed the typical investor.

It is worth noting that portfolio insurance is actually cheaper than the mistakes investors make darting in and out of the market.

Imagine this: No more worries about the market. No more obsession with what will or will not happen in tomorrow's news. No more listening to Cramer or all the other Pundits. Just invest all your available cash in an index fund and buy a put. Can it be that simple?

Well, if you insist on making it more complicated there are calendar spreads.

Calendar Spreads can be very effective method to go "all in" when one suspects a flat to modest market but they bring with them their own unique set of problems … where to set the strikes and expiration as as well as what to do as time passes. The guidelines presented here can help resolve some of the complexities in setting strikes and expiry for calendar spreads.

Investors need to acknowledge to themselves that they give up significant levels of return because of emotional investing and asset allocation towards cash/bonds. Once they accept this of themselves they can move to an investing program that is 100% invested and 100% protected.

Sure, there is a cost of the protection. But, as they say ..."Pay me now or pay me later".


This article did not address tax issues that play a part in any investing regimen. It's a complicated area and requires discussion but there's a limit on how much one article should cover. I've written previous articles on this topic and probably will write more.

For all those experienced option traders ... I know that buying an underlying and a far dated put is equivalent to buying a call and I could have illustrated that. However I was moving towards a spread and for purpose of "building blocks" chose the path that more logically led there.

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