My firm has been posting mostly about using collars to build a hedged portfolio for the last three years -- just like our book recommends. But our book also talks about how to use "in the money" (ITM) calls to build a hedged portfolio. Today, we want to introduce the Buy-and-Hedge Retirement Portfolio that uses ITM calls.
Using ITM calls as stock/ETF replacements makes a lot of sense – but because the calls eventually expire, using them creates a tax consequence earlier than would be the case if the ETF were in a collar. This is where the retirement
part of the strategy name comes in. My firm recommends this strategy for qualified accounts like IRAs and 401ks. You can have short-term gains or regular turnover in the portfolio and not have any tax consequences.
As part of this strategy, our firm suggests buying the call in the money – and clients determine how far in the money based on the maximum loss they are willing to incur. We suggest buying right "at
the money" (ATM), or just 1-2% in the money. Our rationale is the following: The cost to hedge is still hovering near historic lows.
Let's look at an example: You can purchase an ATM call on the SPDR S&P 500
(NYSEARCA:SPY) that expires in January 2015 for about $9.40 with the SPY trading at $184.75 (the ATM call is the $184 strike in this case). That has an extrinsic value of roughly $8.65, or 5.1% annualized.
That annualized rate is reasonably low -- but not so low that you'd look back on the year and think that paying 5% cost of protection was an acceptable drag on your portfolio. You are left with a lot of cash in your portfolio when you buy this ATM call, however, and if that cash can be invested in a protected-income device, you might be able to reduce the cost of hedging. Let's explore.
If you bought 10 contracts of the January 2015 expiration, it would cost $9,400. You'd be controlling an implied portfolio value of 1,000 shares times the SPY price of $184.75 -- or a $184,750 portfolio. We don't recommend having a notional value greater than your portfolio value, so we recommend this portfolio strategy for a portfolio of $185,000 at minimum.
After buying the call, you would still have roughly $175,000 in cash remaining. If you can invest that in a fixed income ETF with around a 3% to 5% return, you could generate a lot of the return needed to pay that 5% cost of hedging.
In the past, my firm has purchased the SPDR Barclays Capital High-Yield Bond ETF
(NYSEARCA:JNK) and collected around a 6% to 7% dividend, then we reinvested half of the dividend in protective puts that were out of the money. We netted to a 3%+ return from that strategy, and the puts provided crisis protection in case there was a credit event in the markets.
So, in effect, we transferred our risk from the equity markets (because we own ATM returns) to risk in the credit markets (the fixed income ETFs). This strategy worked very well through the last couple years as interest rates were on the decline and the ETF in JNK was increasing.
But now we face a rising interest rate environment, and fixed income prices are declining. The hedge we built on JNK would not save you from the slow decline that accompanies a slowly rising interest rate environment.
This is why we are interested in the new product from ProShares High-Yield Interest Rate Hedged
(BATS:HYHG). It owns similar investments in high-yield corporate bonds and it shorts Treasuries. In effect, you are interest-rate-hedged, but not credit-crisis-hedged. You capture the spread between interest rates on high-yield bonds and Treasuries at a matching duration of around 4.5 years. The net interest after the cost of the Treasury hedge is around 3.5%.
What have you done here? You have traded equity risk for bond risk, but not the usual bond risk. You are taking credit-crisis risk, so not really interest-rate risk.
At this point, you are making a 3.5% return on 95% of the portfolio. That leaves you with around 1.5% as the cost of hedging. That is getting closer to what we can stomach, especially for ATM protection.
Fortunately, we can still cut a chunk out of that cost. We can sell an OTM call against the long call we bought at the money. We generally like to look at about a one standard deviation stock move in the underlying implied by the options pricing. In our case study, that would mean selling the $210 strike in the January 2015 expiration to match your long call. You can sell that for about $0.85, or exactly 0.5% annualized.
In general, if we cannot get at least three-quarters of 1% for our short call a full year away, we don't take it. It's not enough to entice us to give up the upside. So, we may settle on the 1.5% cost for hedging -- but for at-the-money protection, we like that setup.
We have back-tested this strategy by buying one year out in a two-step ladder, meaning we were always buying on the June and December expirations. The chart of the returns from December 2007 to December 2013 are included. The returns are attractive -- especially given the protection it provided through the 2008-09 crisis. The primary benchmark is the S&P 500
Click to enlarge
No positions in stocks mentioned.
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