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Combining Momentum and Put Selling (Updated)


In February of 2017, I wrote an article about combining together the concepts of momentum and put selling. You can find that article here as prerequisite reading. With this post, we'll look at how the strategy presented has done since then, along with some additional implementation ideas.

Selling puts on the S&P 500 has been a good strategy since the mid 1980's, based on CBOE's Put Write Index (PUT). In the referenced article, I showed how adding a time series momentum filter to PUT further improved risk-adjusted results, while also mentioning that creative investors could use assets other than T-bills/money market as the underlying source of collateral. We'll also look at that here.

 

First: Replicating the strategy in the article, how has it done out of sample the last 23 months?

 

Notes... 

Equal Weight Portfolio = PUT 

Timing Portfolio = Times series momentum applied to PUT

Vanguard 500 Index Investor = VFINX

 

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Given that the S&P 500 has been up so strongly during the last 23 months, it's no surprise that PUT underperformed the index. This is expected during strong bull markets where put selling has gains limited to the amount of monthly premium collected. The time series momentum overlay stayed invested the entire time, thereby doing its job since there were no major drawdowns along the way to avoid.

 

Next, we can look at two examples of ways to enhance the returns of our momentum approach. First, instead of holding bonds only when momentum is negative, we'll hold bonds (instead of T-bills) all the time (via VBMFX) in addition to our put selling. This further improves results, but it should be noted that this could only be done in a non-retirement margin account. All the brokers I'm aware of would prohibit this type of portfolio in an IRA. 

 

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The risk-adjusted results here are impressive for such a simple strategy. So what are the drawbacks? Here are a few to consider:

 

1.  We saw in the last 23 months that put selling can underperform in a raging bull market. Investors could consider substituting part of their traditional equity exposure with put selling for this reason. 

 

2. Future returns may be lower. As more market participants become aware of the strong historical risk-adjusted returns offered to those willing to sell options, more supply can impact premiums.

 

3. Risk-adjusted bond returns have been extraordinary since 1990 due to falling rates, with VBMFX producing a Sharpe Ratio of 0.78. This is unlikely going forward. 

 

4. Time-series momentum can and will occasionally create whipsaw trades. Again, the solution to this is continuing to maintain a healthy portion of your equity portfolio with traditional index funds and/or ETF's.

 

5. The returns shown are pre-tax, and option selling is tax inefficient due to the high turnover, even after considering the special 60/40 treatment that cash settled index options receive. All of the bond income would be taxable as well (although substituting VBMFX with VWITX gives similar results). The ability to defer capital gains until sold and forever when bequeathed is one of many reasons why index funds are so attractive. 

 

One more example: Instead of collateralizing 100% of our put selling with bonds, we'll do it with 20% equities and 80% bonds. Since PUT is based on large caps, we'll add factor diversification by allocating half of the equities to a US small cap value index, and the other half to an International small cap value and emerging market value index.

 

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Adding cash equities to the portfolio further improves results, and would also improve tax efficiency. Even though this type of portfolio may be simple, its creativity makes it quite unconventional. But for someone willing to succeed unconventionally, the data suggests the minimal effort involved is worth it. And for those lacking the time, interest, or confidence to do it themselves, we run portfolios similar to this for clients if you'd like to have a discussion about it with us. Thanks for reading. 

 

Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse is managing the LC Diversified portfolio and forum, the LC Diversified Fund, as well as contributes to the Steady Condors newsletter. 

 

 

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@Jesse  Love these articles 

I get how PUT (CBOE) and PUTW (Wisdom Tree) should underperform SPY in a low-vol - up trending market.   When the market changed this year and has had huge pull backs and is down about 10% from the peaks shouldn't PUT and PUTW be outperforming SPY?   


Here is a quick YTD chart of SPY/PUTW and it looks like PUTW is still underperforming ......even in this market? 

 

I was speaking with a finance professor here who writes papers on options and he was saying how most of the CBOE indexes have underperformed since they became mainstream.  Is it possible the premium we used to get for selling puts has been arbitraged down to the point where we can't expect these simple indexes to outperform SPY in the future?

 

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Q: I get how PUT (CBOE) and PUTW (Wisdom Tree) should underperform SPY in a low-vol - up trending market.   When the market changed this year and has had huge pull backs and is down about 10% from the peaks shouldn't PUT and PUTW be outperforming SPY? 

 

A: Since the September 21st all time high, stockcharts.com shows SPY performance as -9.75% and PUTW -6.75%. PUT is about -6.5%. The same was true from peak to trough in the Jan/Feb decline. YTD the returns are similar. The path traveled matters for put selling...for example, 2015 was also a flat market and PUT returned 6.4%.

 

Q: I was speaking with a finance professor here who writes papers on options and he was saying how most of the CBOE indexes have underperformed since they became mainstream.  Is it possible the premium we used to get for selling puts has been arbitraged down to the point where we can't expect these simple indexes to outperform SPY in the future?

 

A: I talked about this in my article. "Future returns may be lower. As more market participants become aware of the strong historical risk-adjusted returns offered to those willing to sell options, more supply can impact premiums." The risk premium built into options is rational in an efficient market (meaning, it's rational to expect to be profitable systematically selling puts...otherwise insurance would be free for buyers), but theory suggests risk-adjusted returns should be similar for risk assets. That's exactly what we've seen in PUT since 2007 when it was launched in real-time where PUT has a Sharpe of 0.54 and VFIAX 0.55. Also, there are ways to improve the risk-adjusted returns of PUT in real time implementation vs. the simple index without introducing active management decisions. Research I've read from Larry Swedroe, Parametric, and AQR have written about how it may be rational for slightly better risk-adjusted returns from volatility selling type strategies to persist due to the distaste for negatively skewed return profiles by market participants in general. 

 

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