Updated: Sep 21, 2019
Option sellers have carved themselves out a niche in generating reliable monthly cash flows to meet their living expenses, but why is conservative option selling - if done properly - such a powerful tool towards financial independence? Before I started writing options, I was analyzing dozens of companies which I believed were worth trusting my money to. Diving into annual reports, reading through the cash flow statement and elaborating on their fair values... I love it! But as the old adage of Keynes goes: "The market can stay irrational longer than you can stay solvent.” To put another way, a stock which I felt was too cheap to ignore could remain dead money for quite some time before the mechanism of mean-reverting to intrinsic value comes into play. Since the well-known mantra of most retail investors is to only focus on the long run, we simply stick to these stocks regardless of whether they underperform the benchmark or not, especially since beating the markets has been a very though challenge for good part of the past decade. So, why should holding onto a stock which is underperforming its benchmark bother investors? In the investing world, there's one golden rule to sleep well at night: picking investments which have produced massive returns, but also with the least amount of volatility. As I've stated in my article about the S&P-500 Low Volatility, most investors chasing the highest possible returns pick the most aggressive and heavily fluctuating stocks assuming they present the best risk/reward ratio. Though, not only did the SPLV outperform these stocks, they also outperformed the entire benchmark.
So, why would investors prefer the whole market over the best-of-breed but boring stocks? This is especially true if you recall that Self-Storage REITs, a very attractive asset class, have proven themselves capable of not only delivering steadily growing income, but also market-crushing returns with a considerably lower portion of volatility and appealing Sharpe Ratio (return per unit of risk). Yet, very few fund managers and retail investors have seen the light and realized they are going nowhere with just tracking the entire benchmark which consists of the good, the bad and the ugly. Let's take a look at the following image which ranked the Sharpe Ratios of every singly REIT sector compared to the ones of Russell 3000 from 2008 to 2018.
(Source: The Economist)
Despite the fact that REITs suffered significant losses through the latest Financial Crisis, investment portfolios consisting of these relatively safe securities have posted far better returns than the overall markets while experiencing less volatility. But that doesn't imply that each REIT sector has brought forward consistently attractive or positive Sharpe Ratios. In other words, depending on which REITs your portfolio was exposed to, the risk/reward profiles differ heavily and don't create substantial alpha. Over the long run, one would have produced returns about quadruple that of the whole market. Nonetheless, there are times when you have to stick to your investment principles and stay in the kitchen when you have to stand the heat in order to ride out the corrections like a market stoic. Another issue relates to your entry point since most investors buy high and sell low. Just like with cherrypicking conservative stocks, we have to figure out what the impact of an imminent market crash on our portfolios will be as equity valuations turn pricey and other alternatives are yielding next to nothing these days. Nearly every investor I have spoken to doesn't pay that much attention to the Sharpe metric as they just want to get the sweetest returns available on the market. As long as markets don't correct radically, there's nothing wrong with that. Nonetheless, since timing the markets is a very tough exercise they are eventually incurring inordinate risk.
This is where my favorite option selling strategies kick in and will help us answer the following question. How do you generate consistently positive returns with an optimal risk/reward ratio? Most people will automatically link this type of investing to bond investing, however with global interest rates standing at rock-bottom levels these investments will very likely produce poor returns and carry risks of capital losses if rates increase. As most pension funds must - by law - allocate a considerable portion of their funds to bonds, the idea of generating sufficient income to live your income streams during your golden years is in jeopardy. On the other hand, Modern Portfolio Theory suggests investing in stocks alone is way too risky, which seems - at first glance - quite understandable given the fact that you depend on irrational investor behavior and relatively low equity risk premia. Adding the impact of a human being's emotional and irrational behavior (buy high, sell low), investing in the stock market is too intimidating for most people and those who embark on their mission towards financial freedom underperform their benchmark while facing the same or even higher risks. Let's investigate the performance of several portfolios being made up of bonds, cash-equivalents and stocks and see whether it possible to improve our Sharpe Ratio while not missing out on reasonably high returns. Again, this statement might seem too good to be true at first sight but that's the purpose of this article to make you aware of the alternatives that so few incorporate into their investment portfolios. In this research article I'd like to cover the past performance of different asset allocations from 1987 to 2016.
If you invested every dollar of your portfolio in equities, your annualized return would have been a very nice 10.77% along with 15.15% standard deviation/volatility/risk. Your Sharpe Ratio would have amounted to 0.49, not significant in my humble opinion. As can be deducted from the table provided above, the best bond/equities allocation in terms of risk/reward would definitely have been 20% equities and 80% bonds/cash equivalents providing a Sharpe Ratio of 0.85, though, the realized annualized return would have stood at 7.50%.
Now, let me stop here for a second to explain the following graph. As stocks and bonds whipsaw, as do their Sharpe Ratios. Consequently, there are times when investing in bonds generated a negative Sharpe Ratio, calling the effectiveness of e.g. a 60% equities - 40% bonds portfolio into question. In addition to that, can we conclude that despite the fact that stocks, which have produced returns far exceeding those of bonds and the inflation rate, have posted consistently attractive Sharpe Ratios?
No, we can't and the well-defended 60/40 portfolio mix did also suffer significant drawdowns when the dotcom bubble bursted and the latest Financial Crisis saddled many risk-averse investors with huge losses. If one invested in this portfolio back in 1999, you would have suffered not only a 30% drawdown over the next 4 years, but more importantly it would have taken 5 years to recover from this calamity.
(Source: Research Gate)
At this point, it's getting increasingly interesting to see how the average investor fared through multiple economic shocks and melt-downs. Over the past two decades, the average retail investor achieved an annualized return of 2.6% barely beating the inflation rate of 2.1%, while the S&P-500 was capable of posting triple that return, though, it still lagged the whole REIT industry. If you recall that the S&P-500 had 15.2% volatility over a 30-year time frame (from 1987 to 2016), can we post a similar return with a considerably lower portion of volatility and thus risk? Let me draw your attention to the next graph utilizing that same 30-year time period before we go into great detail on demystifying the options concept behind it.
(Source: Parametric, 2016)
As I've mentioned earlier, return and risk are the metrics you have to keep a keen eye in order to make relevant investment decisions. With stock markets at all-time highs and - in my opinion - an egregiously overvalued bond market, minimizing the drawdowns is of key importance to achieving market-beating returns as smaller losses will make it easier for you to ride out the steep melt-downs. Let me first define the following simulated portfolios.
The Dedicated VRP Portfolio has 50% S&P 500 Index exposure, consists of 50% Treasury Bills, and a short strangle consisting of shorting S&P 500 Index puts and calls layered on top of the base assets. Both short positions of put and call options are explicitly and fully collateralized by the underlying S&P 500 Index and Treasury Bills. Transaction costs have been factored in to objectively measure the returns (35 basispoints)
The Overlay VRP Portfolio - a short strangle based on shorting S&P 500 Index options with equal notional, i.e. 100% S&P 500 Index puts and 100% S&P 500 Index calls, plus 100% Treasury Bills. Transaction costs have been factored in to objectively measure the returns (35 basispoints).
When we set up a short strangle, we sell an out-of-the-money put and an out-of-the-money call simultaneously. As a result of these transactions, we now have a delta-neutral strategy unless the market starts moving into one particular direction, either way down or way up. Let me give you an easy-to-grasp example of how this strategy can be formed. In the backtest, they've used one-month options that have a delta of 20%, meaning there's a 20% chance that either the call or the put will expire in-the-money. Taking the SPY tracker as example, you simply deposit $29,193 worth of cash into your brokerage account and sell an OTM put and an OTM call. In return for undertaking this contract obligation of either buying the SPY at the put strike or selling the SPY at the call strike, we get paid a two cash premiums which are generated into our brokerage account immediately. For the sake of context, a delta of 20% now corresponds to a $278 put strike and a $301 call strike both expiring on September 11, 2019. These options take into account an implied, thus expected volatility of 15.4%.
(Source: Interactive Brokers)
The $301 call strike can be sold for $118 for 100 units of the SPY tracker in order to be fully collateralized
The $278 put strike can be sold for $213 for 100 shares of the SPY tracker
So, we've now generated $33.1 in cash premiums (excluding commissions) ours to keep no matter what happens. Because of selling the options, time is on our side, which is important since the time value component of an option (OTM options only have time value attached to them) evaporates every day. Let's have a look at the our breakeven points:
Infinite loss on the upside if the SPY moves up to $301 + $3.31 = $304.31
Infinite loss on the downside if the SPY drops below $278 - $3.31 = $274.69
Difference between call break-even and put break-even from current market value = (304.31 - 274.69)/291.93 which is a wide range of 10.15%. As long as the SPY doesn't increase by more than 4.24% or decline by more 5.91%, this constructed short strangle trade will trade profitably. Stated differently, when we set up this kind of short-term option selling strategy, we are not in the least concerned about how the markets will fare over the next one month. As long as we don't see huge rallies or melt-downs, we don't face general market risks.
As pratical research has demonstrated, about 8 months out of 12, we fully earn the premiums. About 2 months out of 12, we will make note of small gain or negligible loss or maybe we post no gains or losses at all. And in the other 2 months, either the calls or the puts would have expired (deeper) in-the-money.
Why has this relatively simple option construction been capable of posting such an incredible Sharpe Ratio and thus providing a remarkably better risk/reward structure than the entire market which nearly every investor has been underperforming for a very long period of time? Before we go any further into why short strangles may be a good diversification tool to survive the next market correction, I want you to notice that short strangles underperformed the S&P-500 significantly during market rallies. Though, with indicies standing at all-time highs, it may be worth considering allocating some of your funds to short strangles since ordinary stock investments make it extremely painful for retail investors to ride out the next storm.
(Source: Parametric, 2016)
When the S&P-500 bottomed out in mid-2009, it has posted an annualized return of roughly 18.8% over the following 6.5 years while the Overlay Portfolio enjoyed an annualized return of just 7.6%. As a matter of fact, one would benefit from the short strangle when markets whipsaw sideways or decline/increase at a modest pace. Still, from 2002 to 2007 when markets peaked, the S&P-500 would have created enormous wealth courtesy of an annualized return of 15.9%, thereby easily outpacing the examined approach to selling short strangles which would have produced an annualized return of roughly 10.4%.
The main reason why the short strangle strategy has proven itself capable of providing a favorable and asymmetric Sharpe Ratio is because of overvalued option prices caused by the VRP, representing the variance risk premium. This phenomenon can be interpreted as the premium a market participant is willing to pay to hedge against variation in future realized volatilities. It is expected to be positive because of the intuition that risk-averse investors dislike large swings in volatility, especially in bad times. When looking at the VIX index, which measures the expected or implied volatility, there's a noticeable discrepancy between realized volatility and what the market feared it was likely going to be.
As option sellers, we succeed in turning this recurring situation to our favor when one executes trades he feels very comfortable with without taking on too much risk/margin. Selling covered options creates a substantial alpha as we face less downside risk than ordinary investors while benefiting from a broad range wherein trades remain profitable. As such, we can keep drawdowns to a minimum while enjoying double-digit returns during bull markets. And as the short strangle theory has shown, a very favorable and rather surprisingly high Sharpe Ratio did produce not only market-conform returns but also face less drawdowns.
In a pricey stock market environment, an increasingly threatening trade war dispute, expensive bond market and the Goldman Sachs risk indicator which currently doesn't favor bullish sentiment, staying in the game but managing downside risk puts investors in a tricky and seemingly unreachable situation.
Utilizing short strangles in conjunction with several other low-risk strategies should make it a lot easier for you and your family to resist to panic-selling through thick and thin while earning market-conform returns which most retail investors don't achieve. Going forward, it's highly unlikely that you will see the same returns the market has generated over the past decades owing to the fact that interest have since tanked. That's especially true for European investors thinking about whether bonds will continue provide a material cushion during steep market corrections since bonds' Sharpe Ratio could quickly turn gloomy. I believe it's high time to rethink our traditional investment methodology as it relates to just owning bonds, cash-equivalents and stocks. Short strangles can replace the bond feature of your portfolio as they are relatively uncorrelated with the stock market