Enhance Portfolio Performance by Selling Downside Equity Protection

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 of the buttons below.

Subscribe for 6 months- $499

Subscribe for 12 months- $799