You’re a goose chaser. Admit it. It’s the gold you seek. And that’s okay. You’re in good company. Most of us round these parts have been searching for the big bird for ages. Some have even tagged one.
Of what do I speak? Well alright then, let’s cut to the chase.
Stock owners hate bear markets. They’d prefer returns without the risk. Riskless returns as they say. And we’re not talking the peanuts you get in a savings account. We’re talking stock market returns coupled with bond market volatility; maximum participation in bull markets with minimal exposure to bear markets. Like Veruca Salt from Charlie and the Chocolate Factory some investors want their Golden Goose and THEY WANT IT NOW!
Unlucky for Veruca, Willy wasn’t the sharing type. No, he kept his golden geese to himself thank you very much. But me. Well, I’m the anti-Willy. I’ll part with a golden goose or two. So gather round, friends. I’m about to unveil all you need to know about how investors can attempt to capture stock returns with little downside. But, be forewarned, all is not as it seems. Tagging the golden goose can be fraught with peril. It’s both harder than it looks, and sometimes more costly than you might think.
To begin our goose chase we begin with a bit of education. To help you best decide your fate consider the ever-growing stable of choices faced by stock investors in the age of derivatives.
The first and undoubtedly most popular approach is an oldie but a goody (or so I’m told): Buy and hold, baby.
The second approach entails adding covered calls to the mix in an attempt to score superior risk-adjusted returns.
The third approach is where the goose seeking adventure begins in earnest. It involves coupling our investments with protection. Put protection to be exact. At first the idea of buying insurance glitters like gold. It can be spun to be so appealing it becomes a no-brainer addition to a portfolio. But, alas, it comes with some serious baggage.
The fourth and final approach attempts to fix a few of the systemic issues of the third, to build a better mouse trap if you will. I shall keep the details under wraps until later. The suspense must build before I unleash the gambit in all its glory.
Let’s take each in succession to ensure you fully grasp their characteristics. As you’ll quickly discover there isn’t one right way. It really comes down to which tradeoffs you find most enticing. In the end your decision will stem from a variety of factors including your personality, risk tolerance, and skillset.
We begin with the conventional route traveled by the masses. ‘Tis a well-trod path followed by ignoramuses of all stripes failed by an education system that teaches little about investing. The few intelligent ones in the buy-n-hold camp build a diversified portfolio, maintain a long-term focus, and rebalance along the way. Before eviscerating this prominent approach let’s give it its due. Such a venture guarantees you get whatever the global markets are willing to give. You’ll never miss out when raging bulls stampede on the Street bringing fame and glory to asset holders. In decades like the ‘90s or bull runs like the past six years you get to sit back and bask in the profits arriving to your doorstep month after month. Sitting on your hands was never more profitable.
And yet, you’ll also nakedly face every vicious bear with nary a pittance of protection. Worse yet, if you lack the emotional fortitude to stomach the occasional 30% downturn your panic prone digits will reach for the sell button at the worst possible time.
Perhaps the most damning statement about buy-and-holders is that they are destined for mediocrity. And maybe that’s okay for some. For everyone else, the hunt for the golden goose is far too tempting to ignore. Superior returns beckon and we’re willing to expend a little time and effort in the stretch for excellence.
Cover Them Calls
One of the first strategies greeting buy-n-holders converted to goose chasing is the covered call. I’ve trumpeted the virtues of covered calls already (see here and especially here) and see little need to repeat myself. Rest assured covered calls offer a smoother ride than outright stock ownership, shining in times of market distress.
Insurance? Yes, Please.
The principle issue facing buy-n-holders and covered call writers are these pesky, yet inevitable, bear markets. Only a masochist enjoys the pain inflicted during selling raids. Your embedded aversion to bears generates instant excitement at the thought of evading the next market downturn. That right there is the golden goose of which we seek – the ability to ride the bull until the bitter end while exiting gracefully with profits in tow just as the bear begins ravaging the Street. Or, if we don’t exit altogether we at least seek the ability to retain the bulk of our bull market gains during the bears’ romp.
The options market beckons to golden goose seekers. See, derivatives offer just such a chance to protect your hard-earned gains during the next market swoon. The usual strategy involves buying a put option to protect your portfolio. It’s akin to buying insurance on your residence. If your house blows up (while you’re away, of course. If you were inside you wouldn’t much care about insurance at that point now would you?) you can submit a claim to your insurance company to compensate you for the loss. Intelligent asset holders the world over use insurance to transfer risk to a third party. In the stock market we can do the same thing by buying puts on our portfolio.
Suppose we have $100K invested in the S&P 500. I’ll use the S&P 500 ETF (SPY) for illustration purposes. At the time of this writing SPY is perched at $193.50, so $100K would buy you about 500 shares. Rather than simply ride the shares come hell or high water, you could buy a long-term put option (aka a LEAPS put). Specifically, we’ll buy one put for every 100 shares we own, so five in total. To minimize the effect of time decay we’re buying a LEAPS put and to make the cost more manageable we’ll buy 10% out-of-the-money.
Let’s say we buy five Jan 2017 175 strike puts for $10.00 apiece (that’s per share). The 175 strike is roughly 10% OTM while the Jan 2017 expiration is one year away. All told, five contracts would cost us a cool $5,000. Think about that for a second. We have a $100,000 position and we’re paying 5% for one year worth of protection. And it’s not comprehensive protection, mind you. Since the puts sit 10% OTM we would eat the first 10% loss at expiration before the puts kick-in. But, hey, on the bright side I suppose you did cut your risk from $100,000 to $15,000 ($10K risk in stock plus $5K cost for the puts).
In theory the idea of buying protective puts is fantastic. In reality, the cost is often too burdensome. Especially if you want to always own the protection. You simply can’t afford to sacrifice 5% of the upside in stocks every year for the peace of mind that you’ll sidestep the temporary 30% declines that strike during bear markets. Bottom line: I’m not a fan of the always-on approach with protective puts.
The next logical step then is to consider using protective puts from a more tactical perspective. Ideally we would only buy the protection during the latter stages of a bull market while exiting the protection and returning to a straight long portfolio during the latter stages of a bear. While the tactical approach would drastically reduce the overall cost of protection, it runs the risk that your timing sucks. I mean, what if every time the market goes down 10% (like now) you scramble and buy protection only to see the market recover before a full-fledged bear market materializes? Now you’ve subjected yourself to whipsaw which poses its own difficulties.
Here we sit, squarely between the proverbial rock and a hard place. Either own LEAPS puts at all times and see your gains swallowed by the annual cost of protection, or buy puts tactically only when you think you need them and run the risk that the whipsaw monster wreaks havoc on your portfolio. But, perhaps I’m being too pessimistic. If your timing is stellar you certainly can buy protective puts to success. I’m aware of a few students I’ve mentored that used LEAPS puts quite successfully during the 2016 swoon.
The REALLY Golden Goose
So let’s review. First, we can embrace mediocrity in all its dingy sub-par glory and ride the stock roller coaster both up and down. Second, we can sell covered calls along the way to generate greater returns; outperforming in every market except extremely bullish ones. Third, we can buck up and buy protection, suffering its carrying cost all along the way.
Those opting for door number three may be wondering if there’s a way to partially finance the cost of insurance.
Indeed. Time to unveil approach number four – the REALLY Golden Goose. Which is actually a combination of approach two and three: sell covered calls along the way to pay, at least in part, for the LEAPS put option. Consider the prior example of the $100K invested in the SPY (currently at $193.50). The Jan 2017 75 strike put cost $10. To partially finance the $5,000 required to buy five contracts each year suppose we sold two month, far out-of-the-money calls along the way. For example, with SPY at $193.50 we could sell five (one for each LEAPS put purchased) of the March 203 calls which have a 20 delta for $1.50. If every two months we could pocket $1.50 from covered calls we would bring in around $9 by year end ($4,500 total).
Obviously you can vary the call strikes you sell to achieve the right balance between premium received and how much the upside is limited. In my example we sold calls about $10 or 5% out-of-the-money. That would allow for full participation in 5% of upside in stocks every two months. Not a bad trade-off considering the premium received along the way all but pays for the puts. The 20 delta implies 80% of the time the options would end up expiring worthless allowing you to pocket the $1.50. The other 20% of the time you would be limiting your participation in the bull run slightly, but in the long run it may well be worth the sacrifice.
If selling calls along the way doesn’t do it for you I’ve got another idea. Stay tuned for a future post where I’ll divulge the details.
Financial freedom is a journey
The Tales of a Technician series is brought to you by Tackle Trading.
Sign up now and gain unfettered access to all of the quality content and powerful Scouting Reports that our Pro Members enjoy for 15-days absolutely free with no strings attached and let us show you what your trading has been missing.
Tackle Trading LLC (“Tackle Trading”) is providing this website and any related materials, including newsletters, blog posts, videos, social media postings and any other communications (collectively, the “Materials”) on an “as-is” basis. This means that although Tackle Trading strives to make the information accurate, thorough and current, neither Tackle Trading nor the author(s) of the Materials or the moderators guarantee or warrant the Materials or accept liability for any damage, loss or expense arising from the use of the Materials, whether based in tort, contract, or otherwise. Tackle Trading is providing the Materials for educational purposes only. We are not providing legal, accounting, or financial advisory services, and this is not a solicitation or recommendation to buy or sell any stocks, options, or other financial instruments or investments. Examples that address specific assets, stocks, options or other financial instrument transactions are for illustrative purposes only and are not intended to represent specific trades or transactions that we have conducted. In fact, for the purpose of illustration, we may use examples that are different from or contrary to transactions we have conducted or positions we hold. Furthermore, this website and any information or training herein are not intended as a solicitation for any future relationship, business or otherwise, between the users and the moderators. No express or implied warranties are being made with respect to these services and products. By using the Materials, each user agrees to indemnify and hold Tackle Trading harmless from all losses, expenses and costs, including reasonable attorneys’ fees, arising out of or resulting from user’s use of the Materials. In no event shall Tackle Trading or the author(s) or moderators be liable for any direct, special, consequential or incidental damages arising out of or related to the Materials. If this limitation on damages is not enforceable in some states, the total amount of Tackle Trading’s liability to the user or others shall not exceed the amount paid by the user for such Materials.
All investing and trading in the securities market involves a high degree of risk. Any decisions to place trades in the financial markets, including trading in stocks, options or other financial instruments, is a personal decision that should only be made after conducting thorough independent research, including a personal risk and financial assessment, and prior consultation with the user’s investment, legal, tax and accounting advisers, to determine whether such trading or investment is appropriate for that user.