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Market thoughts and Anchor update

It's been a while since I wrote just a pure column for members, and I think it is about time to update everyone on where my firm is, how the Anchor strategy is performing, and my general thoughts on the markets before the end of the year. Since most people care more about the markets, I'll give my general thoughts on those, and I'll save the professional updates to the end.

As always, note these are my opinions only, I am not able to predict the future, and you should form your own opinions before making any investment decisions. If anyone has any questions, I welcome your posts, emails, and even calls.


Market Thoughts


To me, there is only one investment rule currently in play -- do not bet against the Federal Reserve. Whether you want to call it a Bernanke put or the Yellen floor, the markets are being controlled by the Fed right now. In the last eighteen months, I personally have had this made very clear to me. While of course fundamentals of a business still matter, market trends as a whole are governed by the Fed and will continue to until the Fed stops. Interest rates, bond markets, gold prices, oil prices – are all tied to current Fed policy. In a way that is unfortunate, as it makes it impossible for efficient markets. However, it certainly is a great wave to be on while it lasts.


So just how long is it going to last? Well according to Yellen, at least for a few more months (and thus the most recent run up in the market this week). Until the Fed starts hinting at taking their foot off the gas pedal, I do not think we’ll see a major market draw down. Now Fed policy cannot guarantee that markets will keep going up at a rate of twenty percent per year, but it should provide a floor and prevent a major sharp drawdown. But does the Fed keep its current policies in place through Summer 2014? Your guess is as good as mine.


Not knowing when the rug is going to be yanked out from investors should keep everyone on their toes. If you’re not in a place to make significant adjustments once governmental policy changes, you certainly need to have some sort of protections in place – whether it is stops, puts, or owning inverse positions (such as a long/short fund). This past summer gave us a hint of how fast prices can move when the Fed even hints at changing prices. Bond prices cratered, very quickly, just on the hint of changing rates. Once it becomes official policy to increase rates and slow down bond purchases, it very well could be too late to save your bond portfolio. (Of course this also depends on what your bond portfolio is and the purpose of it – if you own physical bonds for yield and not growth, you likely will not be affected near to the extent as the individual who owns three major bond funds.)


I realize that a prediction that (i) the market will stay somewhere between up and flat and (ii) until the Fed moves then bad things may happen is not much of a prediction and may seem obvious. However, that is the problem with large governmental intervention – it interferes with normal market movements and patterns. Because of this, I structure my personal investments always with one eye toward fast changes and try to invest as much as I can in actual non-correlated assets.


If your investment adviser has you in a small-cap fund, a mid-cap fund, a large-cap fund, a foreign investment fund, a commodity fund, a bond fund, and a high dividend fund such as a REIT or pipeline, and tells you that you’re adequately diversified find a new investment adviser. In a market crash, ALL of those asset classes will get hammered. Sure, on a week to week basis in a bull market you are diversified and relatively protected against company and sector risk. But you are horribly exposed to market risk, and the vast majorities of investment advisers either simply do not understand this or believe that “that’s just the way things are.” However no investor should accept that answer.


Yes, all of those investments have a place in a portfolio, but that should not be the end of the investment discussion. Rather the next questions have to be “how to I protect those investments,” as well as “if these investments do not perform, how do I get income/growth.” It is entirely possible to have it all in a well-designed portfolio.


Anchor Strategy Update


There is an entire thread, open to all members, where I provide a full review, analysis, and critique of the Anchor Strategy as a whole and as it applies to Steady Option's members, If you have questions on the strategies performance, please direct them there.


In a short synopsis though, the strategy is performing as expected. It's not under performing and it's not over performing.


As for new developments, we are in the process of developing a "leveraged" Anchor strategy. With interest rates (particularly the margin interest rates available through Interactive Brokers) where they currently are, the potential for massive returns appear to exist. Note that this strategy is in its initial testing phases. It has been back tested and is currently being paper traded. I try not to recommend, or put my own money at risk, until I have (i) back tested the strategy, (ii) paper traded it for close to a year, (iii) submitted it for a full Monte Carlo simulation, and (iv) traded it live with few funds committed. In the present case, I will have to avoid step (iv), as the strategy requires portfolio margin. I want to introduce the strategy here (as well as in the Anchor Trade forums) for members to comment on.


The basic premise behind the Anchor Strategy, for those that don't know, is to fully hedge a "normal" stock/ETF portfolio, that is highly correlated to the S&P 500 through the purchase of LEAP puts. In essence, an investor is buying insurance in the form of puts that if the market goes down then the investor’s portfolio would not. However, such "insurance" typically cost (depending on volatility) anywhere from 7%-15% of entire portfolio. This is simply too expensive. If the markets average a 7% return over a decade, you'd only break even on such a strategy. If the markets average a 5% return over a decade, the investor would be down well over 20% while anyone just holding the SPY ETF would be up well over 60% (compounding). That's simply not acceptable -- so a way to "pay" for the hedge has to be found. The Anchor Strategy does this by purchasing "extra" LEAP puts and then selling short against them weekly. A full discussion of how this works is available in the Anchor forums. As noted the goal of the Anchor strategy is to not lose money, while not sacrificing too much upside in bull markets.


However, investors are always on the quest for outsized returns. The question this is if this can be accomplished with the Anchor Strategy. It appears as if in the current interest rate environments it can. Again note, this is not a fully developed strategy, and I would not advise anyone to utilize it or trade it right now without further work and a very in depth understanding of the risks of trading options on highly leveraged portfolio margin.

Here's the basic premise:

  1. Interactive brokers, on portfolio margin accounts, currently charges 1.09% margin interest;
  2. A weighted combination of the SDY, RSP, and VIG etfs (which HIGHLY correlate to the S&P 500), pays a dividend of 1.79%;
  3. On portfolio margin, these ETFs can be traded at ratios of 10:1 or 15:1;
  4. Going on "full" margin (a 10:1 or 15:1) is too risky, as it leaves no "wiggle room," so let's target a use a 6:1 ratio;
  5. Assume an account of $1m, with which we buy $6m of ETFs (using $5m in margin);
  6. We then apply the Anchor Strategy to the entire $6m we just bought. To hedge at current levels and costs would cost about $750,000.00 (so now at 5.75:1);
  7. Then just use the Anchor strategy week to week to "pay" for the full hedge;
  8. Margin interest on the year is 1.09%, on $5,750,000 that's $62,675.00 (that's not entirely accurate as it will be less than that as the year goes on as the hedge will be "paid for," so the number will be dynamic, but let's keep the calculations simple for now);
  9. Dividend payouts on the $6m will be $107,400 -- or at least $44,725 more than margin interest.


What then are the possible outcomes, assuming the Anchor Strategy works as designed as a hedging vehicle?

  1. In a flat market (S&P 500 return of 0%, but dividends of 1.89%), the leveraged strategy would return more than 4.47% -- so it would out perform the S&P 500;
  2. In a slightly up market (5% or so), the S&P 500 would return 5.89% (inclusive of dividends) and the leveraged strategy would return 34% (inclusive of dividends);
  3. In major up markets (S&P 500 up 20%), the S&P would return 21,89% (inclusive of dividends) and the leveraged strategy would return 94% (this assumes a "lag" of about 5% due to the lag in the Anchor Strategy, so each $1m would only be up 15%);
  4. In slightly down markets (-5% or so), the S&P 500 would be down 3.11% and the leveraged Anchor Strategy would be up 4.47%;
  5. In large bear markets (-20%), the S&P 500 will be down at least 20% (who knows what dividends will be slashed), and the Anchor Strategy will be up 20% or more (due to increased value in the long puts because of volatility).


Back testing validates the strategy. Paper trading started in July 1. Over that time the S&P 500 is up 10.01% and the leveraged strategy is up 13.5% (only one quarter of dividend payments). This includes "rolling" the hedge from 166 to 176 a week or so ago. In other words, in the absolute worst market for the strategy (S&P up over 10% in the immediate months after starting), the strategy is out performing the S&P 500 and working exactly as designed.


The biggest risks I see to this is (i) interest risks, if interest rates go above 3.5%-4% I'm not sure it still makes sense as flat markets could really hurt, (ii) margin calls -- in wild markets, option pricing on bid/ask spreads sometimes gets out of proportion, and margin calls are based on the side of the bid/ask you don't want to be on.


Once the strategy is fully tested I will update more, but I wanted to introduce it to members for thoughts, questions, and comments.


Professional Update/Lorintine Capital


As many of you know I have an investment advisory firm, Lorintine Capital. For quite some time the primary focus of the Firm was to serve as a manager to a few hedge funds. However, due to numerous client requests, this year the Firm elected to become a “traditional” investment advisory firm offering a full range of services. Lorintine Capital is now also provides traditional investment management services to its clients, including providing investment advice, portfolio management services, retirement account services, and generally serving as financial advisers.


personally am adverse to long term buy and hold, “riding” the market waves, and cannot stand advisers who just stick investors in their firm’s “plan” and take their 1.5%-2% in fees per year for basically doing what Morgan Stanley (Dain Rauchser, Edward Jones, Merrill Lynch – take your pick) publishes. This is not a good value for the client-investor. Too many investors are unprepared for market crashes, miss out on potential income, and have investment advisers who are reactionary instead of proactive. Lorintine Capital tries to avoid that, while at the same time actually educating investors about their options and assisting them in meeting their long term goals.


In furtherance of this change, the Firm recently added a new investment adviser, Jesse Blom, who runs the Firm’s South Dakota office while I still run the Dallas, Texas office. We are currently in negotiations to bring another advisor on board in January, will have a new website by the end of the year, and are actively adding clients of all kinds.


initial feedback to this change has been overwhelmingly positive. Given the Firm’s advisers’ backgrounds and the fact that it is a completely independent Firm, we have the capability of bringing hedge fund models, conservative strategies, and any products to the table that fit our clients’ needs. We now operate managed accounts specifically garnered toward the strategies discussed through Steady Option (Anchor and Steady Condors), retirement accounts, and typical investment portfolios. If you would like to discuss any of the products or services Lorintine Capital provides, contact me or Jesse at your convenience.

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Probably due largely to my ignorance in the matter, but the thing that concerns me is still assignment of those pretty deep in the money short puts.  Yes you have the long closer to the ATM puts covering them, HOWEVER, lets say the market fluctuations get violent and you get assigned and you are now long tens of thousands of shares of SPY OR there is some "flash crash".  Could you end up with a margin call AND could your broker liquidated you during some volatile price action that leaves you taking a bit hit on the long SPY position while very shortly after SPY recovers and you also take a hit on the long ATM puts?


Just wondering if there is the possibility to get wiped out?



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I think you have the strategy backwards --


You should only very rarely end up with DITM short puts -- and that's in the event of a market crash (in which case, most likely, your longs will be ITM as well). 


Here's the standard setup if we opened today:


1.  BTO 10 contracts of Dec 2014 182 puts

2.  STO 4 contracts of Dec 13 2013 182 puts


So if SPY plunged to 150 in one week -- yes you'd lose 32 on the shorts, but on a fall that big you'd gain even more on the longs


But let's take one of the model portfolios that hasn't been rolled, and let's say we originally opened the September 2014 177 put and today we sold 4 Dec 13 2013 182 puts.  If the market falls from 182 to 178 you would lose probably $3.00  or so (remember we use the full 2 week options, so there is some time value left).  When we rolled the next week, you would realize this loss -- but you wouldn't be wiped out, again you have the longs.


Depending on if you have a margin cash account or not, you can bleed some cash on a week - week basis.  But as long as we roll again to the proper ITM strike the next week, we will be fine.


As far as assignment risk?  It's pretty low, and if you were assigned, it would probably only happen when your longs are sky rocket.  If you were assigned, it actually is almost always better.  Let's go back to the above example.  If your shorts are currently down $3.00, with a week to go, and you get assigned, you essentially were just given $1.00 in value (time value).  And if you did, you would just immediately sell SPY, and make money.


To your other fear -- what if you get assigned in the middle of a flash crash?  (So SPY drops from 182 to 150, you get assigned, and the market rebounds), three comments:


1.  That's not how assignment works, if an option is exercised you don't "instantaneously" get assigned, it's an overnight process, so you won't get caught up in a "rebound";

2.  In flash crashes and rebounds, option assignments (and purchases) are now unwound (I have personal experience in this).  Typically the next morning your account has been "fixed" (or screwed depending on your point of view) to reset to pre-flash crash settings.  They changed the regulatory rules to require this;

3.  If you WERE to get assigned on that big of a loss position, your broker would automatically unwind your long SPY position to cover


And that would be a good thing because in a flash crash like that, volatility goes through the roof and the longs actually become quite valuable.


I'm not sure where your fear of "DITM short puts" comes from -- since we always sell weekly pretty close to ATM.  And the chances of being assigned a short ATM option with a full week of time left, is VERY small.  And again, if it happens, its good for you because you just realized the full TV of the position and can go ahead and roll to the next week, having realized more extrinsic value than you should have.

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Hi Chris. It's a smart plan. For those of us using brokers with higher margin interest rates, and also to avoid possibility of increased interest rates once in the trade (and need to earn dividend to cover interest), how do you think it would work if you increased leverage by using puts as portfolio replacement, using SPX as an example:-

Buy 20 x Dec 2014 1800 puts

Sell 10 x Jan 2013 1850 puts

Sell 4 x Jan 2013 1800 puts


10 long and 10 short DITM puts are portfolio replacement, 10 long/4 ATM are Anchor. protecting the former.  You can of course play with the numbers depending on portfolio size, it's the principle i'm interested in.


The main risk as I see it would be the market running past the DITM puts, in which it case it would under perform as compared to ETFs. Perhaps they could be rolled up.


The advantage is, if the extrinsic on the 10 DITM puts can cover the cost of the 10 long, then the replacement portfolio, in contrast to ETFs, will break even in down markets.

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