Selling Calls To Hedge Your Long SPLV Position: An Extremely Powerful Combination

Updated: Nov 20, 2019

Houston, We've Got A Problem!


In search of the most aggressive stocks, investors hoping to get the highest returns will very likely underperform their benchmarks. Why is that? Well, first and foremost, stocks whipsaw every single day as does the economy. A while ago, Markovitz, who laid out the concept of beta which measures an equity's volatility against the entire market's, found that the more aggressive stocks (cyclicals, turnaround stocks) had a beta of roughly 1.25 whilst the more conservative and thus predictable companies enjoyed a much lower beta of 0.75.


One would expect the most aggressive stocks to outperform their low-beta rivals, but that's far from self-evident. Higher risk doesn't necessarily translate into higher long-term returns, though, most wealth managers become incentivized by possibly higher than market returns . In fact, during tough economic times and a complete melt-down, conservative stocks can withstand storms more easily than aggressive and fickle equities. So when investing in conservative stocks, we should see better returns during market corrections while lagging the normal index during bull markets. Let's take a look at the SPLV (S&P Low Volatility) and the S&P-500 to see how things have played out over the long run before digging deeper into the statistics that prove a low-risk strategy bears fruit:


(Source: Yahoo Finance)


The first thing that came to mind when examining the features of conservative, 'boring' stocks is that we expect them to underperform during bull markets. When looking at the chart above, the actual and thus realized performance over the past years is a far cry from that statement. But how does the index fare during downturns?

(Source: Invesco)


Based on the factsheet of Invesco, the SPLV's downcapture is 49%, indicating the SPLV suffers less than 50% of the S&P-500 losses. With more or less the same performance like the S&P-500 during the most hated bull market ever, that will inevitably lead to a substantially higher Sharpe ratio and Alpha. Since its inception, the SPLV returned an annualized 13.06% since May 5, 2011 while the S&P-500 was capable of generating an annualized return of 12.56%.This alone should persuade investors of turning to Low Volatility ETFs, but there's way more. The Sharpe Ratio, which is the average return earned in excess of the risk-free rate per unit of volatility or total risk, amounted to 1.36 for the SPLV and 1.01 for the S&P-500.


How come the SPLV has produced this kind of juicy returns while being less risky? Let's dig deeper into the holdings this ETF consists of.

(Source: Invesco)


As can be concluded from the chart above, the SPLV has a dynamic approach when it comes to industry diversification. Sectors that start to recover will be added quickly to the portfolio, to detriment of industries struggling to post durable earnings growth.


Breaking: Conservative, Boring Stocks Outperform The Most Aggressive Stocks During This Bull Market


Besides offering a Low Volatility ETF, Invesco also introduced one that tracks High-Beta stocks such as AMD or Applied Materials. It's quite funny to witness that the returns from highly volatile stocks have been inferior to the ones generated by predictable stocks during this massive bull run, namely an annualized 8.66% versus 13.06%. The Sharpe Ratio looks even more terrible: 0.78 vs. 1.36 for the SPLV.


Selling Naked Calls To Hedge Your Long SPLV Position

As the title of this article indicated, is there a way we can integrate option selling in ETF investing to improve our portfolio's risk/reward profile? According to a study by the Dutch fund manager Rob Stuiver and his team, buying the SPLV and selling calls against the SPY has resulted in exceptionally strong returns with the least amount of volatility. The strategy's framework functions as follows:

  • 50-70% of your funds allocated to the SPLV

  • 30-50% allocated to the SPY (short delta via selling naked calls)

  • Selling 6-month options on the SPY that are 4% out-of-the-money. Since we sell call options, we are obligated to sell the underlying security at the strike price at any time before/at the expiration date.

  • After one month, you must roll your 5-month options and depending on what the market is doing you will have to pay less or more to buyback the options.

Let me give you a real-life scenario of January, 2016 when the market started to contract. At the end of 2015, the S&P-500 was trading at 2,044 points. The June 2016 calls with a strike of 2,125 were sold for 47 points. The Implied Volatility, so the expected volatility that drives option prices, was then 15%.


At the end of January 2016, the S&P-500 sold off to 1,940 points or has declined by 5% since we sold the option. In wake of this downturn, the call option decreased in value precipitously and we decide to buyback the option for 12 points and sell the July 2016 calls with a strike price 4% higher than current market value. Our realized profit is 35 points or 1.7%.


As highlighted above, conservative stocks tend to fall less during market corrections and this statement once again demonstrated its veracity as the SPLV lost just 1.7%. Wrapping up, we've wiped out this loss by selling call options. Of course, when the markets rally, we are capped on the upside because we've agreed to sell our security at a maximum price that we determined.


But what's the benefit from setting up this strategy? The main reason why I like this tactic is because it reduces volatility to even lower levels than what the SPLV currently achieves (11% to 12%). According to the Dutch fund manager, this strategy's volatility stands at around 8% to 9%, which captures about 60% to 65% of the general market volatility. And the best part about it: this strategy was still capable of delivering far better returns than the normal index, but returned slightly less than just investing in the SPLV alone. The blue line represents the SPLV Total Return (TR); the red line the S&P-500 TR and the green line the SPY short calls TR with the SPLV TR.


(Source: VOC Beleggen)


Just to be fair, this strategy can also be reproduced utilizing the European and Emerging Markets Low Volatility trackers. And although ordinary investing offered poor returns, selling calls as a hedge against drawdowns while allowing for upside risk achieved remarkably better returns because of elevated volatility.


Conclusion

The purpose of this article really is to make everybody out there reading this article aware of the fact that although there's a bias of tracking a benchmark in order to not underperform the entire market can be improved while incurring less risk. The damage of the latest financial crisis and dotcom bubble that stock portfolios suffered could have been circumvented by investing in conservative stocks, that's for sure.


With a market cap of $11 billion, investors have faintly added low-beta stocks to their portfolios and with the market at all-time highs, it may be time to start instituting this low-risk option selling strategy to survive the next downturn. Especially since we're in the late economy cycle with the Federal Reserve starting to ease its monetary tightening because of the escalating and definitely devastating trade war between the US and China, it's worth considering the low-beta stocks as a substitute for your riskier assets. Those stocks represent not only the more economic insensitive businesses, but it gets as close to a perfect dividend growth portfolio as well, giving you a cushion when volatility spikes and markets correct.


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