One of the biggest challenges facing investors of retirement age, with typically heavily weighted bond portfolios, is the current low income yields that bond provide.
This strategy is designed to help enhance that income opportunistically, by selling put option insurance on equities, when the risk-reward ratio is acceptable.
We employ this strategy using only pre-qualified, dividend paying, value stocks that meet our strict risk-return criteria.
We will walk you through, step-by-step, how to evaluate the risk-reward and implement this strategy in your own account.
When implemented opportunistically, it has the potential to deliver attractive returns in excess of bond returns.
One of the biggest challenges facing investors of retirement age, with typically heavily weighted bond portfolios, is the current low income yields that bonds provide. In addition, bond portfolios are subject to significant risk in the event of a transition into a rising interest rate environment. While most people equate bonds with low risk, the sensitivity of bond prices to a change in rates – duration risk – is higher when rates are low, and as Bill Gross points out here, “today’s reward relative to risk – yield per unit of duration is more or less half of what it has been for the past 15-20 years.”
For investors who require yield or income from their portfolio, a strategy of selling put-option premium on equities can provide attractive yields, in excess of bond yields. While the put-option strategy may be more risky, when viewed in light of the lower reward to risk ratio of bonds at current low interest rates, it is worth considering substituting the put option strategy for a part of your bond portfolio – under certain conditions – to enhance your yield.
The concept – how it works
You begin by having a bond portfolio that would function in the normal way. However, if opportunities arise to write put option premium on stocks that we have pre-qualified, and where the risk return ratio meets our strict guidelines, then we will re-allocate the capital from bonds to the put option strategy for that opportunity, i.e. sell our bonds to invest in the put option strategy.
By selling put option insurance or premium, you are collecting a premium upfront, in exchange for agreeing to buy the stock at some agreed upon price, usually lower than the current price, in the future. If the stock does not go below the agreed price within the term agreed, you get to keep the premium and the trade is over. If the stock price goes below the agreed price, then you will be required to buy the stock from the person who bought the insurance from you. Your risk is that the stock price falls below the agreed strike price and end up having to buy the stock at a higher price than you could re-sell it for. For this reason you only want to sell insurance on stocks that you are willing to own and hold for the long term, because you may end up owning them, albeit at a lower price than they trade for today.
Existing solutions that are out there
There are a few ETF’s that offer a similar strategy of selling put option premium:
US Equity High Volatility Put Write ETF (NYSEARCA:HVPW) launched in February 2013, is an income generating fund, and creates income by selling 15% out-of-the-money put options every two months on a portfolio of forty stocks rolling every 2 months (i.e. 240 puts per year). The index focuses on securities with the highest volatility that also meet criteria on liquidity, market cap and sector concentration. HVPW has annual operating expenses of 0.95%.
ALPS Enhanced Put Write Strategy ETF (NYSEARCA:PUTX), just launched in July 2015, will sell one month at-the-money put options on the S&P 500 every month, or twelve times a year and investing the premium income received from selling such options in a portfolio of investment grade debt securities. PUTX has annual operating expenses of 0.75%.
How our strategy differs from these ETFs
Our strategy differs in two material respects:
- Always invested – both ETFs sell premium on a monthly/bi-monthly calendar basis regardless of the yield – they are always fully invested. Our approach is more opportunistic and we only sell premium when volatility spikes enough to give us a prospective return well in excess of current bond yields.
- Selecting stocks – PUTX sells puts only on the SPY ETF so it is diversified, with a lower volatility, but also a lower expected return. HVPW selects a basket of the 40 most volatile stocks trading above $20, regardless of quality – we carefully pre-screen all our stocks to ensure that we are willing to own them. In our case we are only working with value stocks which trade at a reasonable P/E ratio and which would provide a dividend yield at least equal to the iShares iBoxx $ Investment Grade Corporate Bond (NYSEARCA:LQD) ETF, if we were to end up owning them.
The basic idea of both ETFs is to generate income from selling premium on equities. Because they are fully invested at all times, we can benchmark them against a simple buy and hold strategy for the S&P500. For example, if you instead bought an S&P index ETF and matched the income distributions of the ETFs by collecting dividends, and selling shares if necessary, would the long term performance be any different than the two ETFs? Neither ETF proclaims, nor am I aware of, any theoretical basis for them to provide better risk adjusted returns than a buy and hold strategy over the long term. For this reason, we believe that allocating permanent capital to a put writing strategy is not an optimal solution.
Also, while forty stocks (HPVW) provides reasonable diversification, it seems more prudent to research each company you sell insurance on, to make sure you are willing to own it.
An opportunistic strategy of selling premium only on select pre-qualified stocks, when our return criteria are satisfied, seems more appropriate for a put writing strategy.
An example of how selling put premium works
If you have never sold put options before, it may look a bit complicated at first, but it’s really quite simple and I will explain exactly how it works. You can easily copy the worksheet – the formulas are shown in Column F. You need enter only the data shaded in grey – the rest is calculated for you. We show an example for Intel Corporation (NASDAQ:INTC) as at November 6, 2015.
The first section showing stock details come from Yahoo Finance when you pull up a quote for INTC. The yield for LQD which is our benchmark yield reference is similarly available on Yahoo Finance.
Next we need to insert the option details. You can find this under Options on Yahoo Finance, but I prefer the quote format most brokers provide. This screen is from TradeKing but most platforms have similar formats. Go to Quotes > Options >Options Chains. Type in the stock symbol and look for a suitable date; our strategy targets options that expires in 6 – 9 months, so we chose the option that expires on July 15, 2016. I have circled the key things to look for plus a red letter to correspond with Column “C” in the spreadsheet.
We have determined that we wish to leave some room for the price to go down before we are required to buy the stock – we choose a 10% discount or 90% of today’s price. In our spreadsheet you will see that 90% of today’s price is $30.46 but there is no strike price that exactly matches that, so we choose the closest strike price, which is $31.00.
Be sure to use the Puts from the right hand side – not the Calls on the left. One option contract represents 100 shares so be careful when placing your trades. The price of $1.64 is the midpoint of the bid and ask prices shown. Enter these into the spreadsheet and you’re done – the rest is calculated for you. The boxes highlighted in red in the spreadsheet are the three key metrics we are interested in. There are two possible outcomes after you enter the trade:
- The stock price remains above $31.00, the option in not exercised and we simply keep the premium. In this case our yield is 5.59% for the 253 days which equates to an annualized yield of 7.95%. This is 4.53% higher than the current yield on LQD bonds.
- The stock price is below $31.00 on July 15, 2016, in which case we need to buy it for $31.00. In this case we end up owning the stock for a net cost of $29.36. Based on a dividend of 0.96, that is a yield of 3.27% which is below the LQD yield of 0.15%.
Deciding on an acceptable return
You can decide on a suitable premium for your risk appetite, but my recommendation – shown by the green boxes in the spreadsheet – is as follows:
- If the trade goes against you at the time of expiration, you should end up owning the security at a minimum of a 15% discount from today’s price (Line” S” must be < 85%) and with a resultant yield which is at least as good as what you were receiving on your bond portfolio (Line “R” must be > zero);
- If the trade goes in your favor, you should earn at least an annualized 5% greater yield than you would have earned on the benchmark LQD bond portfolio (Line “P”).
Based on these criteria, the Intel opportunity above is slightly below our threshold, so we would not make the trade. I believe these criteria are conservative and further enhanced by managing the risk as described below.
Managing the risk
1. We must be comfortable owning the stocks we sell insurance on
Stocks have to be screened for quality, value, dividend yield and dividend sustainability. You can use a stock screening tool for this (Finviz has a good screener) or you can piggyback on someone else’s research to generate ideas, where they have already pre-screened stocks for certain criteria. For example, look at iShares Quality ETF (NYSEARCA:QUAL) and iShares core High Dividend ETF (NYSEARCA:HDV) as a starting point.
You still need to make sure that they trade at a P/E less than 15 and have the required dividend yield but it’s great to have this research available for free. You can download the holdings of both into an Excel sheet and see which names appear on both lists. That would be a pretty good starting point. I found fourteen names in both ETFs when I downloaded the data. Would you be comfortable owning these names?
2. The implied volatility of the stock you sell insurance on should be at least 20%-25% above its 12 month average historical volatility
TradeKing provides historical (white line) and implied volatility (yellow line) charts for stocks shown below. The key is to sell the premium when the implied volatility is at least 20%-25% above the 12 month average of its historical volatility, or something similar. Since volatility is typically mean reverting, this should work in your favor. Intel’s implied volatility is currently at about 25% and we would like it to be above 30% to make the trade.
3. Recession Risk
The biggest risk for put option writing strategies is the risk of a large decline in equity prices. Since you probably don’t have a model telling when a recession is coming, I will give you one simple chart you can keep an eye on which has historically been useful in predicting recessions. (click to enlarge)
If the slope of the yield curve is below or close to zero (most recessions have been preceded by an inverted yield curve), either do not use the strategy or increase the return threshold requirement. I realize this adds a subjective element, but just wanted to highlight the risk.
4. Lastly, you should not allocate more than 15% of your put option portfolio to any one stock
If you use 20% of your bond portfolio for this strategy, that 20% should be divided up amongst at least seven stocks, so you are diversified.
Summary of what you get from the strategy
As you can tell, the criteria are strict, the return hurdle rates are relatively high and it requires research and preparation. The strategy is opportunistic and you will need to be patient for opportunities to present themselves. It’s about being prepared to act when volatility spikes:
- If no opportunities present themselves, you get what you had before, which was your basic bond fund and yield.
- If opportunities present themselves, then you end up with either; 1) a higher return than you would have had of approximately 5%, or 2) if the trade goes against us, then you end up owning the stock at a discount from today’s price of approximately 15% and with a yield at least as good as you were receiving from the bonds. Or, you also have the option to exit the trade and buy back the insurance, and take your profit or loss at any time.
We think it is better to implement the put-write strategy with your government bond component rather than the corporate bond component. You are waiting for opportunities for volatility to spike and thus the market to decline – when that does happen corporate bonds will get hit harder than government bonds which normally move inversely to stocks when there is a volatility spike. So with government bonds, it functions effectively like a re-balancing mechanism, where you are selling them at high to allocate to put strategy at lows. This is better than selling corporate bonds at lows to allocate to the put strategy at lows.
How to do it in your own account
You are able to write a put if your account is approved for option trading. In a cash account, you will be required to hold sufficient cash to buy the underlying security at the strike price. You should be allowed to include the cash received from selling premium toward the total requirement, although this may differ at some brokers. Even if you have a margin account, do not attempt this strategy using margin; not only does it increase your risk, the costs of borrowing on margin at most brokers is so high – in the range of 8% – that it makes absolutely no sense.
Finally, we recommend having a separate account for this strategy, if possible, so that you can manage your exposure and easily assess your performance. You could start by transferring say 10% of your bond portfolio into the new account, until you get comfortable implementing the strategy. It’s a lot to absorb but feel free to leave comments or questions below.