Equity Index Put Writing for the Long Run
March 4, 2019
Equity Index Put Writing For The Long Run
One of my all-time favorite investing books is Jeremy Siegel’s Stocks For The Long Run, which is currently in its 5th edition. It’s a true classic that I refer to often. Professor Siegel lays out the compelling case for equities over extended time horizons such as 20 or 30 years.
Yet as compelling as equities may be over the long run, Professor Siegel notes that “fear has a greater grasp on human action than does the impressive weight of historical evidence.” We believe the attractive characteristics of collateralized put writing may give many investors the courage they need to indirectly participate in the equity markets for the long run.
An August 28, 2018 InvestmentNews article “Equity index put writing: A strategy for uncertain markets” is a great read to develop a better understanding of collateralized put writing. Using the historical data of the S&P 500 CBOE PutWrite Index (PUT), the author shows how writing cash secured puts produced similar returns as the underlying S&P 500 index, but with lower volatility and maximum drawdown. One particular chart in the article provided a great visual of how put writing tends to perform in different environments.
This next chart shows the total
performance of PUT (portfolio 1) vs. the S&P 500 (portfolio 2).
At Lorintine Capital, we believe we can make incremental improvements to further increase the attractiveness of a put write portfolio. For example:
- PUT holds winning trades until expiration. Writing puts limits profits to the premium collected. During rising markets, we believe we can capture more upside by rolling trades before expiration when the vast majority of profits have already been earned. Sitting on dead options for several days or even weeks doesn’t make much sense to us.
- PUT will also hold losing trades until expiration, which means during large market declines it will at times act like synthetic stock. We believe we can slightly reduce the downside by incorporating time series momentum into our strike selection process and by rolling losers prior to expiration. Both #1 and #2 are modest active management techniques, as we want to maintain the “beta” of put writing overall. In other words, the historical evidence is clear that PUT certainly isn’t broken, so we don’t want to spend too much time fixing it.
- PUT holds short term (1-3 month) US Treasury bills as collateral. We believe it’s sensible to replace T-bills with a small amount of term risk in the form of a low cost 3-7 year US Treasury ETF serving as our collateral. The term premium of 5-year Treasuries minus T-bills has been just under 2% per year over the last century with premiums often showing up when most needed (equity bear markets). Of course, this is not guaranteed to be the case in the future, so we consider this an expected risk premium.
- PUT is an index based on just one underlying; the S&P 500. Just as we believe in size and geographical diversification when owning equities directly, the same is true in designing a put write portfolio. In addition to the S&P 500, we add exposure to the Russell 2000 and the MSCI EAFE indices. CBOE also has an index for put writing on the Russell 2000 PUTR with historical data available for analysis since 2001.
- In addition to asset diversification, we believe we add incremental improvements to risk adjusted returns by adding time diversification. PUT holds all contracts in the same expiration at the same strike. The dynamics of option greeks mean that PUT will sometimes move dollar for dollar with the index and at other times only pennies on the dollar. Our strategy splits up its holdings into more than one expiration, and often times more than one strike, in order to produce more consistent exposure over time. We don’t necessarily believe this improves absolute returns, but is likely to improve risk-adjusted returns.
- Last, PUT is fully cash secured. Due to the above expected improvements, we believe it’s reasonable to use a modest amount of leverage to increase expected returns. Our strategy targets notional exposure of 125%. Just as owning more shares of the underlying index increases an expected return, so does selling more contracts. We understand that many have a binary view on leverage, as there certainly is a graveyard of options funds that no longer exist due to excessive leverage. Our very modest use of leverage is designed to make sure that we survive for the long run.
The evidence of owning equities is compelling, but many are too frightened to do so because of short term volatility. Cash is comfortable in the short term, and it is hard for many investors to let go of their cash. Collateralized put writing is one potential solution, allowing an individual to maintain their cash position and simply overlay a put selling strategy resulting in lower volatility and a higher success rate than owning equities outright. When implemented in a manner we’ve described in this article, put writing may even offer the opportunity for excess returns relative to indices. But as an advisor to clients for over a decade now, this isn’t what matters. Instead, it’s about simply staying in the game. This is what determines long-term real world outcomes. I’ll take above average patience and discipline over above average intellect every single time when it comes to investing.