Buying Puts: Waste of Your Money or Crucial To Survive? (1/2)

Updated: May 5

Introduction

The VIX is difficult product to read, especially during uncertain times like we witness right now . Many investors, including professionals and non-commercials, who have been shorting the volatility index got squeezed out by the Covid-19 meltdown. Let's try to read the contradicting signals the VIX and investor positioning send out over and over again.


1) Shorting The Vix When It's Near Record Lows: A Spike Is Coming

When expected volatility is near its lows (clustering around 11-13), be ready for a turmoil if news starts to provoke changing risk-positioning (risk parity, long gamma positioning, short covering in the VIX...).

(Source: CTFC)


A possible future spike can be predicted by looking at positive divergence in the daily MACD. If the inclination is pronounced, short covering in the VIX may suddenly take place. What level it's going to reach cannot be forecast, but the chart below shows you that despite decent returns in 2019, the VIX was not as stable as one might have guessed. Also, the frequency of these spikes has been increasing over the past 3 years despite favorable returns for the US stock market. When the VIX spikes, short speculators turn heavily long in an attempt to reduce risk. Unfortunately, that's when the **** has already hit the fan.


Simulating Long Put Returns

Given the Covid19 crisis, isn't it worthwhile exploring the opportunities of adding long volatility exposure (via long puts) to our covered call portfolios?


I have simulated a long put strategy on the Eurostoxx-50 index for 2017, 2018 and 2019 - May 2020. Let's take a look at the input:

  • 5-year puts being bought in a 250k portfolio; 10% of the portfolio value. In reality, we can easily finance this insurance with covered call premiums.

  • Strike price is 10% below starting price (at 1/1)

  • Renewing the number of contracts, strike price and expiration period each year. Wait for renewal until the VIX is within the 12-13 range, which was the case in March 2019.

  • No rebalancing

  • No other strategies implemented (no portfolio overwriting)

  • Please note that simulations are not 100% accurate but point to a fairly realistic performance based on long-term implied volatility

Goal of the simulation: looking for a volatility hedge, taking profits on puts when possible and re-investing them portfolio overwriting. By taking profits on your long puts, you automatically re-invest these gains when a correction has occurred.

For defensive investors looking to add to their equity exposure only during meltdowns, this strategy bears fruit as they capture juicy covered call premia on new portfolio overwriting positions. In the meantime, you can keep the covered call premia on the sidelines and utilize them during retirement. I steadfastly believe that this approach is far more attractive than rebalancing a 50-50 portfolio (bonds and equities). The outcomes were surprisingly favorable, even in a low-volatility market environment like 2017.


2017

In 2017, our overall return was slightly negative despite seeing an outperformance in April because of rising volatility.

(Source: Option Generator Calculations)


2018

2018 was an excellent year for the long put holders with spiking volatility in February and December. As expected, putting a tenth of your portfolio in permanent insurance provides a real cushion during turmoils. Throughout the whole year, the combination of 10% puts and 90% Eurostoxx-50 outperformed a simple buy and hold strategy. Profit-taking should start when the entire put value exceeds €55,000, or resulting in a net gain of €30,000 as it's almost impossible to sell the puts at their peak value.

(Source: Option Generator Calculations)


2019 - May 2020

The coronavirus pandemic caused on an unprecedented crash on the stock market and pushed the VIX far above 80% at some point. What would have happened to our long put strategy that started on March 18th, 2019? On March 20th, 2020 the spike in the VIX and the roaring bear market led to a monster profit of €230,000 on the put side.

Even after some cooling in the volatility index, the profit on the put side still stands at €100,000. Re-investing that money in the stock market - without risking the other covered call premia accumulated over the past year(s) - should be a no-brainer.

(Source: Option Generator Calculations)

Conclusion

Hedging your portfolio by utilizing long puts on the Eurostoxx-50 turns out to be a successful strategy in conjunction with traditional buy and hold investing, not to mention the covered call premiums we can collect on our long-term leaders. I wouldn't do this on the S&P-500 given its strong outperformance relative to foreign indices, which would destroy the value of the long puts. Also, there are no 5-year options available on the SPY tracker.


Finance your permanent insurance with portfolio overwriting income and you'll be able to absorb future VIX shocks. This is especially true for those who have garnered sizable long-term capital gains and want to reduce drawdown risks. Right now, the VIX is elevated and a lot of VIX speculators turned heavily long, indicating further cooling in the VIX to the sub-20's is likely. We're going to examine the yearly performance of this strategy prior to 2017 and share the results on this blog page.

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