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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 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. 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. 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.
"The CBOE S&P 500® PutWrite Index (ticker symbol “PUT”) tracks the value of a passive investment strategy (“CBOE S&P 500 Collateralized Put Strategy”) which consists of overlaying S&P 500 (SPM) short put options over a money market account invested in one- and three-months Treasury bills. The SPX puts are struck at-the-money and are sold on a monthly basis, usually on the 3rd Friday of the month. This is called the “roll date” and it matches the date of S&P 500 option expirations." Here is the performance of PUT (Portfolio 1) vs. VFINX (Vanguard S&P 500 Index Fund) from 1990-2016: The most attractive part of PUT vs. VFINX is the improvement in risk-adjusted returns. Both volatility and maximum drawdown were cut by about a third, resulting in a nice increase in Sharpe Ratio. Even the most passive investors could benefit from this approach as the PUT selling strategy is now available in an ETF structure from Wisdom Tree. More active investors that follow our Steady Options content may be interested in replicating the PUT selling strategy themselves, saving themselves the 0.38% management fee. In addition to saving on management fees, an active investor with a creative mind can potentially further increase potential returns by keeping collateral in something other than T-bills. Momentum What if we add a trend-following, or "time-series momentum" overlay to PUT? We already know that it has been peer reviewed and validated out of sample on multiple underlyings, so why would PUT be any different? Answer: It's not. Below is the performance of all three: VFINX, PUT (Equal Weight Portfolio), and PUT with a 12 month time series momentum filter where we are invested in PUT when its rolling 12 month excess return is positive, otherwise VBMFX (Timing Portfolio). The timing portfolio reallocation period is monthly. All charts and statistics were custom generated at www.portfoliovisualizer.com. As expected, adding time-series momentum cuts off a substantial part of the left-tail of returns. This benefit can't be emphasized enough in the real world of human emotion. Sophisticated traders and investors like those following all of our content at Steady Options could benefit from this approach as part of their long-term portfolio. In our firm, we already utilize a variation of this strategy for our clients.
Buy the Winners Eugene Fama, Father of the Efficient Market Hypothesis (EMH), has referred to momentum as "the premier market anomaly" which represents "the biggest embarrassment for Efficient Market Theory". And it's also very simple. So simple that it's under appreciated. Source: http://systematicrelativestrength.com/2015/10/26/buy-winners-2/ In 1937 Cowles and Jones shared their findings that “taking one year as the unit of measurement for the period 1920 to 1935, the tendency is very pronounced for stocks which have exceeded the median in one year to exceed it also in the year following.” The key here is that it doesn't work 100% of the time. Listen to Jim O'Shaughnessy discuss this here. Jim was comfortable writing "What Works on Wall Street" because he knew the tendency of humans to abandon strategies as soon as they went through a drawdown or period of relative underperformance. Human nature is unlikely to change, and this is a key belief to why simple strategies can continue to persist in a world of competitive markets. Since nothing works (meaning always producing profits and/or outperforming a benchmark) 100% of the time, the weak hands will eventually drop out. This is why I believe in combining together a few simple strategies where you have done a high degree of due diligence, and then follow them faithfully. When the next strategy of the month is in favor, you treat it with a high degree of caution and skepticism before even considering adjusting your plan. We all want to believe that the perfect strategy is out there that we just haven't found yet. I found it interesting as I read Ben Carlson's book that the largest Ponzi Scheme in history, run by Bernie Madoff, did not promise investors excessively high returns. It promised very good returns, but with almost no risk. Bernie was not stupid, he knew very well that humans desperately want to believe in the idea of making very good returns with little or no risk. From Ben's book: "The beauty in Madoff's scam was the fact that he never promised home runs to his investors. Over an 18-year period, Madoff claimed to offer 10.6 percent annual returns to his investors, fairly similar to historical stock market gains. But the annualized volatility was under 2.5 percent, a fraction of the variability seen in the stock market, or the bond market for that matter. And what do investors want more than anything? If you answered a stock market return profile minus the stock market risk profile, you answered correctly. Investors want to believe this is possible." Michael Covel had a discussion around this topic with Ewan Kirk of Cantab Capital during one of Michael's Trend Following podcasts. I'm going to paraphrase about a five minute clip of the podcast which can be heard here. I highly recommend it. The podcast Covel: Losses are statistically inevitable. There are still a number of people out there, some astute and some not, that still don’t want to imagine losses as a part of the game. Kirk: Yep, people are desperate to invest in something that never loses money. And that, of course, is why Bernard Madoff existed. Everyone is desperate to invest in something that never loses money. I’d like to invest in something which never loses money. I’d love to come up with a strategy that never loses money. Of course, we all want that. The reality is that maybe the best you can look for over a long period such as 20 or 30 years is a Sharpe ratio of .8, .9, maybe 1. Take a simulation of a 20% volatility with a 20% return per year. Every 2 years you will have a drawdown of 15% statistically, and a 20% drawdown every 4 years. And you don’t have to run very many simulations before you get a 40% drawdown that can last five years. Remember, this (simulation) is something that is guaranteed to make 20% per annum over a long enough period of time. The expectation of losses should be something everyone should build into their investment process at all times. Summary The enemy of a good plan is the dream of a perfect plan. Drawdowns and losses are part of the game but your human nature of survival will put up a fight against rationality when drawdowns occur. The human brain is capable of incredible optimism as well as pessimism. Be aware of it, and have expectations that are statistically valid. Not just past performance. 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 achieving multiple industry achievements including qualifying membership in the Million Dollar Round Table for 5 consecutive years. Membership in this prestigious group represents the top 1% of financial professionals in the world. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse is managing the LC Diversified portfolio.
Keep in Mind, Stocks Rose 1,100-fold During This Period From Morgan’s article: The S&P 500 rose 1,100-fold over the last 70 years, including dividends. But look what happened during that period: May 1946 to May 1947. Stocks decline 28.4%. A surge of soldiers return from World War II, and factories across America return to normal operations after years of building war supplies. This disrupts the economy as the entire world figures out what to do next. Real GDP declines 13% as wartime spending tapers off. A general fear that the economy will fall back into the Great Depression worries economists and investors. June 1948 to June 1949. Stocks decline 20.6%. A world still trying to figure out what a post-war economy looks like causes a second U.S. recession with more demobilization. Inflation surges as the economy adjusts. The Korean conflict heats up. June 1950 to July 1950. Stocks fall 14%.North Korean troops attack points along South Korean border. The U.N Security Council calls the invasion “a breach of peace.” U.S. involvement in the Korean War begins. July 1957 to October 1957. Stocks fall 20.7%. There’s the Suez Canal crisis and Soviet launch of Sputnik, plus the U.S. slips into recession. January 1962 to June 1962. Stocks fall 26.4%. Stocks plunge after a decade of solid economic growth and market boom, the first “bubble” environment since 1929. In a classic 1962 interview, Warren Buffett says, “For some time, stocks have been rising at rather rapid rates, but corporate earnings have not been rising, dividends have not been increasing, and it’s not to be unexpected that a correction of some of those factors on the upside might occur on the downside.” February 1966 to October 1966. Stocks fall 22.2%. The Vietnam War and Great Society social programs push government spending up 45% in five years. Inflation gathers steam. The Federal Reserve responds by tightening interest rates. No recession occurred. November 1968 to May 1970. Stocks fall 36.1%. Inflation really starts to pick up, hitting 6.2% in 1969 up from an average of 1.6% over the previous eight years. Vietnam War escalates. Interest rates surge; 10-year Treasury rates rise from 4.7% to nearly 8%. April 1973 to October 1974. Stocks fall 48%.Inflation breaks double-digits for the first time in three decades. There’s the start of a deep recession; unemployment hits 9%. September 1976 to March 1978. Stocks fall 19.4%. The economy stagnates as high inflation meets dismal earnings growth. Adjusted for inflation, corporate profits haven’t grown for eight years. February 1980 to March 1980. Stocks fall 17.1%. Interest rates approach 20%, the highest in modern history. The economy grinds to a halt; unemployment tops 10%. There’s the Iran hostage crisis. November 1980 to August 1982. Stocks fall 27.1%. Inflation has risen 42% in the previous three years. Consumer confidence plunges, unemployment surges, and we see the largest budget deficits since World War II. Corporate profits are 25% below where they were a decade prior. August 1987 to December 1987. Stocks fall 33.5%. The crash of 87 pushes stocks down 23% in one day. No notable news that day; historians still argue about the cause. A likely contributor was a growing fad of “portfolio insurance” that automatically sold stocks on declines, causing selling to beget more selling — the precursor to the fragility of a technology-driven marketplace. July 1990 to October 1990. Stocks fall 19.9%. The Gulf War causes an oil price spike. Short recession. The unemployment rate jumps to 7.8%. July 1998 to August 1998. Stocks fall 19.3%. Russia defaults on its debt, emerging market currencies collapse, and the world’s largest hedge fund goes bankrupt, nearly taking Wall Street banks down with it. Strangely, this occurs during a period most people remember as one of the most prosperous periods to invest in history. March 2000 to October 2002. Stocks fall 49.1%. The dot-com bubble bursts, and 9/11 sends the world economy into recession. November 2002 to March 2003. Stocks fall 14.7%. The S. economy puts itself back together after its first recession in a decade. The military preps for the Iraq war. Oil prices spike. October 2007 to March 2009. Stocks fall 56.8%. The global housing bubble bursts, sending the world’s largest banks to the brink of collapse. The worst financial crisis since the Great Depression. April 2010 to July 2010. Stocks fall 16%. Europe hits a debt crisis while the U.S. economy weakens. Double-dip recession fears. April 2011 to October 2011. Stocks fall 19.4%. The U.S. government experiences a debt ceiling showdown, U.S. credit is downgraded, oil prices surge. June 2015 to August 2015. Stocks fall 11.9%. China’s economy grinds to a halt; the Fed prepares to raise interest rates. ____________________________________________________________ I like Morgan’s article, it reminds us that economic uncertainty has always been a regular part of the past along with frequent corrections (10%+ declines) and deep bear markets (20%+ declines). His intention is to help us have a long term perspective. Many times throughout the past seven decades, “this has never happened before”. Yet the US continued to show its strength and resiliency. For some, this is effective. For others, they need something more to help them follow their plan. Dual Momentum In the equities portion of our dual momentum model, we rotate among US Large, US Small, and International stocks based on twelve month relative strength momentum. When all three asset classes have negative absolute momentum, we switch into bonds. The idea here is to earn the risk premium in stocks with less exposure to the downside volatility and bear market drawdowns that frequently have occurred in the past and will frequently occur in the future. We emphasize less in an effort to promote proper expectations. Empirical data suggests that dual momentum can be used to earn higher returns with less risk than buy and hold, but it’s not a Holy Grail. Holy Grail strategies tend to fall apart in real time because they were over fit to a limited amount of past data with no economic argument to support why they work. Researchers refer to this as data-mining. With dual momentum, we believe having a proven rules-based method in place to exit equities ahead of the majority of major bear market declines can be all that is needed to help investors have the confidence to stick with their strategy for the long term. And the right strategy for every investor is the one they will stick with. This is key. Since Morgan is using data since 1946, we thought it would be fun to look at showing our dual momentum equities model during this same period (note: international is excluded in this example due to lack of data prior to 1970 although we use it in our actual trading model). Here are a few things to take notice of on both the chart and in the statistics. On the chart, it’s important to notice that our dual momentum approach did NOT outperform an equal weighted buy and hold portfolio in the first thirty years, but slightly lagged or matched buy and hold for most of the period. Thirty years is the investment time horizon for many investors, not seventy. If only relative strength momentum would have been used during this period, outperformance would have occurred. Absolute momentum, or trend following momentum, will take you out of the market at times when doing nothing would have ended up being the better short term outcome. We call these whipsaws, and they are expected as a short term price to pay for risk management that can allow us to sidestep the majority of painful bear market drawdowns. Over the long term, relative strength and absolute momentum tend to contribute fairly equally to excess returns. If the future ends up looking more like this specific period of the past, we still would prefer dual momentum’s slight underperformance as a small cost to pay for the psychological comfort of knowing a plan is in place to protect capital against 50% drawdowns. The total outperformance of dual momentum in the last seven decades comes in the more recent four decades where three separate bear markets of 50%+ losses occurred for buy and hold investors. Two of these occurred in the last fifteen years. This is when absolute momentum does its job of taking us out of equities in the early stages of bear markets. Even during the first thirty year period, dual momentum still produced lower volatility and maximum drawdown, and a higher Sharpe Ratio. The period of 1946-1972 produced an annualized return of 12.1% for buy and hold and 11.78% for dual momentum, while over the entire duration dual momentum produced both higher returns and less risk. We make clear to our clients that beating the market isn’t a financial goal, and it would be intellectually dishonest for us to suggest we can guarantee anything about the future. What we can guarantee is that we have vigorously researched a robust investing plan supported by decades of historical data and third party validation. When combined with disciplined execution and realistic expectations, we believe the probabilities are highly in favor of a successful long term investing experience. Investigate carefully Choose wisely Follow faithfully Fama/French (2008): Momentum is “the center stage anomaly of recent years…an anomaly that is above suspicion…the premier market anomaly.”  The Credit Suisse Global Investment Return Yearbook shows how both US and World ex-US (in USD) equity risk premiums have far exceeded those of bonds and bills since 1900 forming the portfolio theory basis for focusing on equities in our dual momentum model.  Relative strength momentum compares total returns of one asset class to another over an applicable lookback period. The asset class that has risen the most is held for the next month.  Absolute momentum is defined as having a total return less than the risk free rate (such as US T-bills) over the applicable lookback period.  Maximum drawdown measures total peak to trough loss suffered prior to reaching new equity highs. Maximum drawdown is much more important to most investors than the more frequently mentioned measure of risk known as standard deviation or annualized volatility. Past performance doesn’t guarantee future results. The concepts of dual momentum were pioneered by the research of Gary Antonacci. We recommend using his best-selling book and blog as an additional resource for studying momentum. This is a hypothetical model intended to show the efficacy of dual momentum, and is not intended to represent specific investment advice. Data is gross of any applicable taxes and transaction costs, and investors should always consult with their tax advisor before investing. All investments carry risk, may lose value, and are not FDIC insured. We provide the hyperlink to Morgan Housel’s article as a convenience and do not endorse nor guarantee the accuracy of any information he has presented. Feel free to contact us if you’d like to discuss your specific situation further. We welcome every opportunity to discuss how we could add value to your financial life. Related Articles: Buy The Winners: The Power Of Momentum Momentum – The Premier Market Anomaly