TMFTheDoctor (91.22)

Using 100 delta calls for portfolio protection, part 1

July 31, 2010 – Comments (3)

I'm here to talk to you today about leverage, and about portfolio protection. Now we all know that leverage can be a bad thing, and that buying portfolio protection in the form of puts can start to add up to the point of being almost self-defeating. Using leverage to make money faster tends to be a great way to lose money faster, and buying at the money puts is a really good way to steadily lose money on premiums in up, down, and flat markets. So what’s an investor to do? One answer is to use leverage to buy insurance. Sounds crazy, right? Hear me out.

Let’s say you started the year with a portfolio consisting of just 100 shares of SPY, the S&P 500 ETF. You feel the market has been good to you lately, and you want to protect this position, so you decide to buy at the money puts for June 2010, currently selling for $680 per contract (quoted as $6.80). $680 to protect $11,333 doesn’t sound too bad, right? Well, that’s about 1% of your portfolio’s value every month. Furthermore, the protection doesn’t become useful unless SPY falls more than the premium. That is, if SPY falls below $106.20, then you will start protecting your position. And unless SPY rises more than the premium, you’ll still be losing money on the wasted insurance as well. So anyway, you add that to the portfolio, and the total value of the positions is now $12,013 ($113.33 times 100 shares, plus $680).

By June expiration, SPY had fallen about $1.60, for a total loss of a $713. There are other ways to set up the protection, using puts that are more in the money, so the extrinsic value in the premium is less, or using longer dated puts so time value is cheaper, but the fundamental problem is that you are paying for the insurance, one way or another.

Now let’s say instead you had a portfolio consisting of 100 shares of SPY, and an equal value invested in AGG, the iShares aggregate bond fund. You’ve read about balanced portfolios and know that bonds and stocks are negatively correlated, meaning that as equities fall in value, bonds tend to go up. So that’s 100 shares of SPY, and about 110 shares of AGG (we’re rounding to the nearest share). So that’s a total portfolio value of $22,697.10. Going back to the June expiration, there’s no put protection but SPY still only fell $1.60, and this time the protection, AGG, actually rose $2.74, so the total portfolio had a gain of $141.30. But the main problem here is, you had to add another $11,364.10 for the shares of AGG, instead of $680 for the put. Even if it did make money, you’d need a whole lot of extra cash lying around.

So here’s where we get to using leverage to buy insurance. The reason that SPY put was so expensive is because option prices are based in part on volatility, and equities can be pretty dang volatile. However, the extrinsic value in the option tends to decrease as the option gets more in the money, until eventually there is almost no extrinsic value in the option. At that point, the option trades almost exactly the same as the stock and has a delta of 100. For something like SPY, the option needs to be very in the money to get to that point, due to the relatively high volatility. But when you’re dealing with something that has very low volatility, like a lot of bond funds, it doesn’t necessarily need to be deeply in the money at all. And that’s where our opportunity is.

At the beginning of the year, when you wanted to protect that 100 shares of SPY, instead of putting $680 on a SPY put or 11 grand on AGG shares, let’s say you put that $680 on AGG calls that were trading at parity. For about $662, you could have purchased two 100 strike AGG calls that would trade almost the same as AGG stock, effectively giving you 200 shares of AGG for a bare fraction of the cost of the shares. This would also require slightly less capital than the put. At June expiration, due to the leveraged calls, which had essentially zero time value in their price, the portfolio would have increased by $387.90.

What this comes down to is the fact that bond ETFs have extremely cheap options, such that an investor can leverage the heck out of them and get essentially free insurance. The risk here is that the bonds will decrease in value, either due to a rate hike or decreasing fear in the market or whatever. However, as we’ve seen in this example, the capital needed for one such call is much less than the put, so even if the protection does turn out to not be needed, less money will be lost. The protection of $11,000 or so of AGG shares can be had for $300 or so, and if bonds do fall a lot, sending AGG below the 100 strike price, your losses would end there, unlike with the AGG shares.

In my next post I will talk more about other ways to use 100 delta calls to reduce exposure and gain protection. Putting these methods together can significantly reduce not only the capital required for a full portfolio, but also the overall portfolio risk and volatility. Also, for anyone interested, here is a link to a spreadsheet with the numbers from this post: