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Enhancing 60/40 With a Short Strangle Overlay


The classic 60/40 stock/bond portfolio has stood the test of time in both hypothetical and live fund results from multiple fund sponsors such as Vanguard, Fidelity, and American Funds. 60/40 balances enough in equities (60%) to generate long-term growth with enough in high quality bonds (40%) to manage downside risk.

Many alternative portfolios have been devised to beat the 60/40 portfolio on a risk-adjusted basis, but few have succeeded over the long-term. The death of the 60/40 portfolio is often proclaimed by many in the industry, yet it’s often by those with competing products. In this article, I’ll present a simple idea for active option traders to enhance the 60/40 portfolio instead of compete against it.

 

Short Strangles

Short strangles are a multi-leg option strategy typically written around one month from expiration by combining an out of the money (OTM) put with an OTM call. This creates a profit zone at expiration where the goal is for the underlying asset to finish in between the strike prices so that the entire option premium collected is retained as profit. What’s unique about selling options is how no cash outlay is required, only a collateral requirement known as margin. This presents opportunities for creativity. With a 60/40 allocation as the underlying portfolio, the short puts can be collateralized by bonds and the short calls can be collateralized or “covered” by stocks.60/40 with a short strangle overlay effectively combines covered calls with cash secured puts.

 

Portfolio Example

A specific example could be using a fund like Vanguard’s balanced index fund (VBIAX) as the underlying 60/40 portfolio. This fund maintains a US based 60/40 asset allocation all in one low-cost fund with a track record of 8.6% annualized average return since 1992. An active trader could then enhance this base portfolio in an options approved margin account by writing SPX, XSP, or SPY strangles on top of a portion of the VBIAX position. If a trader targeted a 30% notional allocation for the strangles, the short calls would be fully covered by the underlying equities and the short puts would be fully collateralized by the underlying bonds. Short strangles have a historical risk profile that exhibits low beta to both stocks and bonds during most market conditions, which adds diversification to the portfolio. Although a strangle overlay increases total portfolio risk it’s likely to increase returns by a greater degree that should result in a higher expected Sharpe Ratio.

 

Stay Tuned

In a follow up article, I’ll present historical data that illustrates the concept in more detail. I personally find this portfolio compelling as it’s simple to manage and relatively tax efficient due to the buy and hold nature of the underlying 60/40 portfolio and the 1256 contract treatment of the option strangles when using a cash settled index like XSP. The portfolio blends together three distinct sources of returns in stocks, bonds, and option selling. It also blends passive investing with active trading in a well thought out manner. Like a good recipe, the ingredients taste the best when combined together.

 

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™ professional. 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.

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