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Revisiting Anchor Part 2


Last month we posted some updates to the Anchor strategy that were obtained using an in-depth back testing of the strategy and variations of it using the ORATS Wheel software.  We adopted three conclusions last month:

  1. Selling calls for a credit to help offset the cost of the hedge is, more often than not, a losing strategy over time in the Anchor strategy.  It tends to hurt performance more than help it;
  2. About a month is the ideal period for selling short puts over both in bull and bear markets.  This tends to be the ideal trade off between decay, being able to hold through minor price fluctuations, and available extrinsic value.  Since options come out weekly, we’ll be using a 28-day period;
  3. Rolling on a set day like Friday is not the most efficient method of rolling the short puts.  Rather having a profit target of between 35% to 50%, and rolling when that target is hit, leads to vastly improved outcomes.  Waiting until profits get above 50% tends to start negatively impacting the trade on average.

 

This month we’re going to look at another technique which has the possibility of increasing Anchor’s performance over time – namely reducing the hedge.

Reducing the Hedge

The single biggest cost to Anchor is the hedge.  Depending on when the hedge is purchased, it can cost anywhere from 5% to 15% of the value of the entire portfolio.  In large bull markets, which result in having to roll the hedge up several times in a year, we have seen this cost eat a substantial part of the gains in the underlying stocks and/or ETFs. 

 

There is also the issue of not being “fully” invested and this resulting in lagging the market.  If the cost of the hedge is 8%, then we are only 92% long.  In other words if our ETFs go up 100 points, our portfolio would only go up 92 points.

 

A large hedge cost also has a negative impact at the start of a bear market as well due to the losses on the short puts.  If the market drops a mild amount, particularly soon after purchasing the hedge, the losses on the short puts will exceed the gains on the long puts, negatively impacting performance.  This loss is less noticeable as the long hedge gets nearer to expiration and/or market losses increase as delta of the long hedge and the short puts both end up about the same.  However, as was seen a few years ago, if the market drops slightly, then rebounds, those losses on the short puts are realized and any gains on the long puts are lost when the market rebounds.

 

If there was a way to reduce the cost of the hedge, without dramatically increasing risk, the entire strategy would benefit.  A possible solution comes from slightly “under hedging.”  Testing over the periods from 2012 to the present and from 2007 to the present has revealed if we only hedged 95% of the portfolio, returns would be significantly improved.

 

Let’s take a look at the data from the close of market on September 14, 2018, when SPY was at 290.88.  If we were to enter the hedge, we would have bought the September 20, 2019 290 Puts for $14.96.  If we have a theoretical $90,000 portfolio, it would take 3.1 puts to hedge (we can’t have 3.1puts so we’ll round down to 3).  At that price, three puts would cost $4,488 or 5% of the portfolio (almost historically low). 

 

However, if we were to say “I am not upset if I lose five percent of my portfolio value due to market movements; I am just really worried about large losses,” we could buy the 275 puts instead of the 290.  The 275 puts are trading at $10.61 – a discount of thirty percent. 

 

This means we need less short puts to pay for the position, paying for the position is a simpler process, and rolling up in a large bull market is cheaper.

 

Yes it comes at a cost – risking the first five percent – but given the stock markets trend positive over time, this pays off in spades over longer investment horizons.  Even if you are near retirement, any planning you do should not be largely impacted by a five percent loss, but the gains which can come from (a) having a larger portion of your portfolio invested in long positions instead of the hedge (meaning less lag in market gains), (b) having less risk on the short puts in minor market fluctuations, and (c) paying for the hedge in full more frequently more than offset that over time.

 

We will implement this in the official Anchor portfolios by simply delaying a roll up from gains.  The official portfolio is in the January 19, 2019 280 puts.  We’d normally roll around a 7% or 10% gain (or around SPY 300), instead we’ll just hold until we get to our five percent margin.  OR when we roll the long puts around the start of December, we’ll then roll out and down to hit our target.

 

Note – if you do want to continue to be “fully” hedged, you can do so.  There’s nothing wrong with this, you just sacrifice significant upside potential and will be continuing to perform as Anchor has recently.  If we had implemented this change in 2012, Anchor’s performance would have been more than five percent per year higher.  This is not an insignificant difference. 

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Regarding the management of the short put Reel Ken favors going one week out while "holding the strike" in this recent article: 

 

What´s your opinion on this? Obviously theta is higher while having the same benefit in riding smaller pullbacks. At first glance this approach may work better than going 28-days out at first place.

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That doesn't work as well.  We've back tested it, thoroughly.  Using every weekly holding from one week to three months, rolling up, keeping the same (e.g. rolling out to same strike as current) or rolling down.  

 

We used Orats and tested two periods 2007 through the present (as far back as the data goes) and 2012 to the present (from the advent of weeklies to the present). To verify our results we had multiple starting dates (Jan 1, Feb 1, June 1).  We then wanted to make sure it wasn't local to SPY, so tested IWM as well and got the same results.

 

When I originally started Anchor, we started with 1 week puts - it doesn't work as well, whether it rolling down or keeping the same strike.  In down markets you get just CRUSHED and rolling out to the same strike eventually becomes infeasible.  (E.g. if the market dropped 10%, you can't roll to the same strike, you'd only get .01).

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It is not surprising that a reduced hedge would have improved performance in the period since 2012, as this was a bull market. Have you backtested the results to include the 2008 bear?

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4 hours ago, ykotowitz said:

It is not surprising that a reduced hedge would have improved performance in the period since 2012, as this was a bull market. Have you backtested the results to include the 2008 bear?

Yes, starting in 2007.  What was interesting, other than if you ONLY had this from mid-2008 through mid-2009, reducing the hedge was always better.  So unless you just have a very short term time frame, or we enter a very extended bear market (which could occur), a 5% reduction is typically worth it.  Though that can vary depending on risk preferences.  

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