Mid-Year Rebalancing Ideas: Part 3

by Wayne Ferbert on June 13th, 2013

So now after Part I & II, you know what your allocation strategy will be and you have adjusted your concentrations. But you need to also sell some calls to help cover the cost of the protection in your hedges. Let’s examine how we would handle that in today’s market.
The market over the last 500 days has had many times where the monthly covered call strategy would have been very painful if you were not watching it every day for the chance to exit. The market would have marched upwards right thru your strike price – thereby giving up too much of the upside.
So, around Fall 2012, we recommended that you just start to match your short call month with your put expirations. If you have a laddered put, you have several months of put expirations. Look to match the calls against the puts – meaning you will have your calls laddered also.
Why do we prefer this approach right now? As long-term investors, we want to capture the long-term trajectory of the markets as they grow. And the weak short term call premium has left us setting our calls too close to the market price. With the longer term calls that correspond to our ladder, we can sell calls that are more like +10% away from the market price.
Look at the S&P500 right now thru the lens of the SPY etf. You can purchase the June 2014 protection at $150 strike right now for about $8.40. This is $12 out of the money protection. You can sell the June 2014 call for  the $174 for about $4.80. This leaves about $3.60 of premium you are paying. You have reciprocal $12 price bounds on either side of your collar. The $3.60 you pay is roughly 2.2%. So, that is your cost of being hedged in the next year.
You would have the equivalent of a 120 point collar on the broad S&P500 – plus you will still collect the annual 2% dividend.  Feel free to also sell the call even further out of the money to give your portfolio room to run if you are a bull for the coming year. Remember that the dividend can help to fund this upside capture with a higher strike.
I like this overall 120 point S&P500 collar structure because it has significantly closer protection than we are accustomed for the current market levels – down 7.5% from today’s price.
If you are looking at re-balancing and have a significant number of June protections expiring, strongly weigh these strikes.

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