This strategy is called a ‘strangle’, and is a combination of two other strategies that I analyzed earlier:
- Buying a 12-month Out of The Money (OTM) call as close to the SPY ETF price as possible to increase principle over the long term
- Buying a 12-month Out of The Money (OTM) put as close to 10% below the SPY ETF price as possible to protect principle during large market corrections
I will compare using a ‘strangle’ to just buying the SPY ETF over the period from 2006 – 2016.
A bit of a recap is in order. I was examining the annual payout and remaining principle balance of a strategy that consisted of investing all capital in the S&P 500, which currently can be approximated by buying an S&P 500 tracking Exchange Traded Fund (ETF). There are several S&P500 ETFs, I chose the SPY ETF for this analysis.
I then did two related studies to look into increasing / maintaining the investment principle.
The first consisted of using a portion of the principle each year to buy 12-month call options on the SPY. Historically, the S&P 500 has risen most years, so buying a 12-month call has the potential to increase returns and thus capital.
The second study consisted of using a portion of the principle each year to buy 12-month put options on the SPY. While the S&P 500 has historically risen most years, it has had several very large corrections (on the order of 50%), and recovering from those corrections has taken years. Buying a put option on SPY has the potential to alleviate some of the decline in the value of the underlying SPY holdings.
In the current study, I’m going to look at the result of:
- Investing 94% of capital into the SPY ETF
- Investing 3% of the capital each year into a SPY call option that is OTM, but as close to the current price of SPY as possible
- Investing 3% of the capital each year into a SPY put option that is OTM, but as close to 10% below the current price of SPY as possible
- Maintaining a constant payout each year, drawn first from dividends paid, and selling some of the SPY ETFs to make up for any payout the dividends don’t cover
The goals of this strategy are to minimize volatility due to sharp market corrections, and increase principle balance over the long run.
The annual payout will be held constant (examined for an annual payout of 3%, 4%, 5%, or 6% of the initial principle balance).
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, and another $3000 is taken out (per $100k invested) of the principle each year and invested in index call options. The proceeds from the index put and call 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).
Here is the chart of principle balance for each withdrawal rate leaving the entire principle balance in SPY, and not purchasing any options, for the same years of the study period:
I’ll focus on the 3% payout here. The other payout rates have similar relative results between buying a strangle and not buying any options.
The minimum principle balances were $59,109 for no options, and $70,328 for using a strangle. Using this option strategy did provide some protection during large market declines over the study period, though obviously there was still a significant decline.
The ending principle balance was $109,465 for no options, and $122,005 for using a strangle. The strangle did also provide a higher ending balance than not using any options over the study period.
This is an analysis of past performance, but past performance is not a guarantee of future performance.
Comments / Questions: joseph AT StockMarketMovement.com