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Recent years have seen strong performance by global equity markets, with
stock prices being fuelled higher by accommodative central bank policy and
quantitative easing. The question is whether stellar performance in the stock
market will continue this year, with the Fed looking at moving towards
tightening monetary policy, having tapered all their quantitative easing, and
the ECB and BOJ potentially running low on easing ammunition. We believe that
the stock market will struggle to top the performance of recent years in
2015, and therefore there is a strong argument to be made for a change in
strategy for professional investors in order to outperform.
Overweight long positions in equities is the right trade in an environment
where monetary policy is in an aggressive easing stance aimed at inflating
asset prices. However, when the easing of policy is no longer as aggressive,
or at least not accelerating at the same pace, equity performance is likely
to be less than in prior years. Nonetheless, the stance of central banks
globally is still one that, on balance, has an accommodative bias. Therefore,
whilst equities may not power higher this year to the same extent they did in
prior years, they are likely to still be well supported as central banks
still firmly defend any risk of deflation, resulting in drops in asset prices
being shallow and short. Thus, in 2015 selling downside protection on the
stock market appears to be the optimal way to outperform and offers
attractive risk reward dynamics.
We will explore this concept through an example where the investor is
attempting to outperform the S&P 500. In the last 5 years the index has
gained an average of 13%, with a high return of 29.6% in 2013 and a low of 0%
in 2011. In order to outperform the index, the investor must allocate capital
away from the S&P 500 and into another trade. The capital in the new
trade must return more than the index in order for outperformance to be
achieved. We would allocate capital to sell downside protection on the index.
One of the ways to execute this is to enter a Bull Put Spread, where one
sells an out of the money put option and purchases another put option that is
further out of the money in order to limit the overall risk, with the aim of
collecting the difference in premium should the underlying price remain above
the strike of the put that has been sold.
SPY is currently around $206, a 10% decline from these levels would take
it to $185.40. It is our view that a 10% fall in equites over the next year
is highly unlikely, with equities likely to post a moderately positive
return. Therefore we would be sellers of protection against a 10% drop in
order to outperform the S&P 500. For example, selling a January 2016 put
on SPY with a strike of $185 and buying a put with strike of $175 (in order
not open exposure to unlimited downside) would result in a $2.00 net credit.
In other words, the seller of this protection will make $2.00 if SPY is above
$185 on expiration. The simple expiration payoff diagram is shown below.
 
Essentially this trade is risking $8.00 to make $2.00, speculating that
SPY will be above $185 on expiration. So for every $8.00 of capital one
allocates to this trade, the return could be $2.00, or 25%, which is
significantly higher that the returns we expect on the equities market this
year, given the average of the last 5 years was 13%.
Clearly the risk of capital allocated to the bull put spread is higher
than capital invested in equities. The chance of losing 100% of the capital
invested in the bull spread is much higher than the same losses occurring in
the purchase of SPY outright. Therefore we are not suggesting a reckless
attempt at outperformance by selling all equities and placing all capital in
such strategies. However, it is our view that a shift of a minority portion
of capital into such a strategy will lead to a subtle outperformance over the
next year.
For example instead of being 100% long SPY, one could be 80% long SPY and
allocate 20% of the remaining capital to selling downside protection with the
goal to outperform the index. The graph below illustrates how this portfolio
performance might compare.
Now different investors will look at this in different ways. The bears
will note that our idea performs very poorly should SPY fall significantly
this year. This is true. This strategy is not about protecting the downside
in a long equity portfolio, it is about optimising returns in a mildly
bullish market. If one is bearish on equities then one should not be long at
all, or one should be moving capital away from equities into more defensive
trades.
The bulls will be less deterred by this chart. Although it is not shown on
the scale, the 80:20 portfolio continues to outperform SPY until $256, when
SPY begins to return more than 25%. Even if SPY soared all the way to $300,
the 80:20 portfolio would only underperform by 4.27%, still returning a solid
42.07%.
From our view we are encouraged by the risk reward dynamics at play here,
especially given our macro view and outlook for equities over the next year.
This strategy performs best in a “muddle through” scenario, where equities
have a mediocre year, where SPY maybe loses 5%, or maybe rallies 5%, but does
not explode in either direction. Whilst we are still bullish on equities in
general, we see a significant risk of a “muddle through” year in in 2015 as
the market digests the first bout of Fed tightening.
At SK Option Trader we do not run a benchmarked portfolio, we are focused
on absolute return. However this article is more of a discussion point for
either those that are looking to outperform a benchmark, or as a look into
the analysis we do prior to a trade when we calculate the most efficient way
for us to allocate capital to match our view. Options are not for every
investor and contain a high level of risk, so are best suited to those with
an understanding of how they work and experience in markets. When properly
utilized they can offer tools for traders and investors to maximise portfolio
return and tailor trades to match one’s view. This is one such example of
this, to find out more about what trades we are making please subscribe via either
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