A Simple Strategy for Limiting Risk

February 16, 2020


Create your own "structured products" using long-dated options to manage your investment risk


The bull market in the U.S. stocks has lasted more than a decade resulting in valuations that are on many metrics at the very high-end of historical levels. Naturally, it is hard to buy stocks at these prices. To be in a position to take advantage of the wonderful compounding affect the stock market can produce, the entry price is very important. The chart below shows how long it took the S&P 500 to recover after major declines. A surprising number of years to wait. Only the youngest investors are in a position to take advantage of these bear markets because they can continue to invest at cheap prices. For everyone else, these periods are a real problem - especially those nearing retirement before they began. (Note these numbers are adjusted for inflation, but the nominal data shows similar results.)


Of course, the best solution for this problem is to buy low and sell high. As we all know, this is easier said than done. In this post, I will present a basic option strategy that can help deal with this problem. It will recreate do-it-yourself versions of what are commonly referred to as "structured products". Structured products are custom investments created by Wall Street designed to limit losses on certain investments in exchange for a reduction in the potential upside over a certain timeframe.


A theoretical example of a simple structured product might have the following traits:


  • Based on the performance of the S&P 500 over the next one year.

  • If the S&P 500 ends up lower after a year, the first 10% of losses are covered and beyond that would accumulate to the investor.

  • If the market ends up higher, the investor earns up to the first 8% and anything beyond that is sacrificed.


This type of deal can be attractive for certain risk-averse investors anytime but might appeal to most any investors during times like now when the market is expensive and the odds of a large correction or bear market seem high.


These structured products are usually created internally by brokerage firms but investors with comfort trading options can create many versions of these strategies themselves. Here is a theoretical example of the do-it-yourself type using prices for the S&P 500 ETF (symbol: SPY) referenced from end-of-day prices from January 31st, 2020. To create about a year's timeframe, the options expiring on January 15th, 2021 will be used. (Note this is not a trade suggestion but only an example to explain the strategy). Here are the details:


  • SPY entry price of 322.0

  • Sell the 355 strike (covered) call for credit of 4.4

  • Dividends are assumed to be 5.6 for the year (same as 2019)

  • Buy the 322 put and sell the 289 put (a long put spread) for a net cost of 9.9


There is no cash outlay for the options, the covered call premium of 4.4 plus the dividends of 5.6 = 10.00 - 9.90 cost of the put spread = 0.10 credit (which should cover commissions). If SPY ends up closing on January 15th of 2021 at 355 or higher, the maximum gain is 10.2%. If SPY ends up below the entry price, the first 10.2% is covered by the puts and below that would accrue. If the market has a bad year and the SPY is down 20%, the loss would only be 10%. Alternatively, if the SPY was up 20% after a year, the gain would be reduced to 10%.


The "window" of downside protection can be moved around by using different put spreads. For example, using the same call strategy that limited the upside to 10% but this time accepting the first 5% of the downside risk before the window of protection kicks in. Here are the theoretical numbers:


  • SPY entry price: 322.0

  • Sell the 355 strike (covered) call for credit of 4.4

  • Dividends are assumed to be 5.6 for the year (same as 2019)

  • Buy the 305 put and sell the 255 put for a net cost of 9.8


This scenario would again limit the annual return to 10% on the upside, but the downside would have about a 15% window of protection between down 5% and down 20%. In this case, if the market is down 20% for the year, the investor only loses 5% and the other 15% is covered by the put spread.


Anther variation protects less initially but more if there is a really big drop.


  • SPY entry price: 322.0

  • Sell the 355 strike (covered) call for credit of 4.4

  • Dividends are assumed to be 5.6 for the year (same as 2019)

  • Buy the 287 put for 10.0


Again, the upside return is limited to the first 10%. If the market is lower, the first 9.8% must be absorbed, but beyond that would be fully covered no matter how low the market goes.


At first glance, these strategies might seem like a great deal. But an investor should still consider the maximum gain possible versus the adjusted downside risk and judge if makes sense in today's investing environment.


Wall Street has offered for sale canned versions of these strategies of all different types and sizes for many years. The fees for putting these together and selling them come at a cost that usually reduces the gain potential and loss coverage a bit. One advantage of the do-it-yourself option method has over the canned Wall Street ones is liquidity. Under normal market conditions, one could most likely exit the option and stock combination anytime at market prices. A brokerage product must be repurchased by the same broker at usually a discount.


A relatively new ETF issuer called Innovator is trying to bring this strategy to the masses with various canned strategies packaged in tradeable ETF's. This is a welcome new choice compared with the private broker variety. They do not appear to be very liquid, but they do trade on exchanges. The company’s website is worth taking a look at since it presents a lot of educational materials.


Building these strategies directly has a lot of advantages. There is a lot of flexibility, they are usually liquid and the cost is probably less than a canned brokerage product. Because these strategies have a very clearly defined risk that can be less than the underlying investment itself, they can be a valuable addition to a portfolio.




Please keep in mind, this blog article nor my advisory entity is not making any recommendations, only pointing out interesting strategies for consideration. Investors should to do their own research and/or consult their advisor before making any investment decisions. Options should only be traded by those who fully understand the implications and risks (some of which are outlined in this disclosure downloadable: here). Unless you have experience with options, it is best to get some professional help to establish these types of positions.


Disclosures

Notaro Wealth Advisory is a registered investment advisor. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. The views and opinions expressed in this blog post are as of the date of the posting, are subject to change based on market and other conditions. This blog contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Please note that nothing in this blog post should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and you should not consider anything to be, investment, accounting, tax or legal advice. If you would like accounting, tax or legal advice, you should consult with your own accountants or attorneys regarding your individual circumstances and needs. No advice may be rendered by Notaro Wealth Advisory unless a client service agreement is in place.