I’m going to look at another strategy for principle maintenance. In an earlier article I looked at using a portion of the principle each year (3%) to buy a 12-month at the money (ATM) call on the SPY index. This strategy did, over the study period, end with a higher principle than just buying and holding the SPY exchange traded fund (ETF). However, it did not reduce volatility.
In this article I’m going to examine using 3% of the principle each year to buy a 12-month, 10% out of the money (OTM) put on the SPY index. The goals of this strategy would be:
- Reduce principle volatility
- Increase principle amount over the study period
As in the earlier analysis, the annual payout will be held constant, and a portion of the principle will be used to purchase a protective put.
Specifically, the analysis is for:
- Constant payout each year of 3%, 4%, 5%, or 6% of the initial principle balance
- 3% of the initial principle balance is used each year to purchase a 12-month SPY index put option
- The amounts shown assume an initial investment of $100k in 2016 dollars
For example, suppose a 4% withdrawal rate is used. This means $4000 is taken out each year as payout (per $100k invested). In addition, $3000 is taken out (per $100k invested) of the principle each year and invested in index put options. The proceeds from the index put options at expiration, if any, are put back into the principle balance for the next year.
This chart shows the principle balance for each withdrawal rate over the study period:
Since none of the withdrawal rates completely depleted the principle balance within the study period, each inflation-adjusted payout was constant for the entire study period ($3000, $4000, $5000, or $6000, depending on payout rate).
For reference, here is the chart of principle balance for each withdrawal rate investing in index call options instead of index put options:
I’ll focus the discussion on the 3% payout here. The other payout rates have similar relative results between buying protective puts vs. buying calls.
The minimum principle balance buying protective puts was $73,399 (per $100k invested), vs. $56,038 buying calls. This is a drop of 26.6% for protective puts, vs. a drop of 41.0% for calls. Over this study period, buying protective puts did decrease the downside volatility.
The ending principle balance buying protective puts was $115,098 (per $100k invested), vs. $116,371 buying calls. This is a gain of 15.1% for protective puts, vs. a gain of 16.4% for calls. Protective puts did not increase the principle balance over the study period vs. buying calls, but there was very little difference at the end of the period.
It’s interesting to note that buying 10% out of the money protective puts only had value left at the end of the year one time during the study period, which was the market crash in 2008. However, for that one year, it had a lot of value – $20,960 (per $100k invested), or 21.0%.
Obviously, the results from buying protective puts depends very heavily on how many major market corrections occur during the study period. Had there been no major market corrections, or two major market corrections instead of one, the relative results between these two strategies would have been very different.
This is an analysis of past performance, but past performance is not a guarantee of future performance.
Comments / Questions: joseph AT StockMarketMovement.com