S&P500 Plus Index Options

Recall that in the constant payout strategy, a constant amount of inflation-adjusted capital is withdrawn each year.  If it can be fulfilled entirely from dividends it is, if it can’t be fulfilled entirely from dividends then underlying shares are sold to make up the difference.

The strategy considered here is a twist on the constant payout strategy.  The same amount is withdrawn every year, but instead of the entire amount being used for spending, some percentage is used to buy 2% In The Money (ITM) 1 year S&P500 index call options (SPY).  The value of the options at expiration, if any, is then available for spending.  The amount I plugged in to buy options for this analysis was 0.5% of the underlying principle.

E.g., suppose SPY is trading at $100, there is $100k in principle, and $3k is taken out each year.  In this case $2.5k is available for spending, and $0.5k is used to buy 1 year call options on SPY with a strike price of $98.  If at the end of the year the call option is in the money, the option would be sold and the proceeds available for spending.  If at the end of the year the call option is out of the money, the option is worthless and the $0.5k invested in it is lost.

I again looked at four annual withdrawal rates: 3%, 4%, 5%, and 6%.  Based on availability of SPY option prices, the analysis covers years 2006 – 2016.

The graph below shows the resulting payout each year:

Looking at the 3% draw rate as an example, you’ll see that the ultimate payout each year varied from a low of $2.5k (when the index options expired worthless) to a high of $4.6k, with an average of $3.15k.  Four years had payouts below $3k, one year had a payout of about $3k, and 6 years had payouts above $3k.

With the constant payout strategy, the ultimate payout was $3k each year.

So using 0.5% of the principle each year to buy an index option, instead of using it directly for spending, increased the average annual payout by 5% ($3.15k / $3k = 1.05).  However, this came at the cost of introducing significant fluctuations in annual payout.

The graph below shows the remaining inflation-adjusted principle balance each year:

The principle balance isn’t affected by whether or not a percentage of the payout is used to buy index options.  It does show, however, that over this time period, stock value growth was enough to offset annual withdrawals of up to about 4%.

This is an analysis of past performance, but past performance is not a guarantee of future performance.

Comments / Questions: joseph AT StockMarketMovement.com