Introducing Buy And Hedge Retirement

by Wayne Ferbert on February 21st, 2014

We have been posting mostly about using collars to build a hedged portfolio for the last 3 years – just like our book recommends. But our book also talks about how to use ITM calls to build a hedged portfolio. Today, we want to introduce the Buy & Hedge Retirement portfolio that uses ITM calls.
 
Using ITM calls as stock/ETF replacements makes a lot of sense – but because the calls eventually expire, it creates a tax consequence earlier than owning the ETF in a collar would create. This is where the RETIREMENT part of the strategy name comes in. We recommend this strategy for qualified accounts like IRAs and 401ks. You can have short term gains or regular turnover in the portfolio and not have any tax consequences.
 
In our book, we talk about buying the call in-the-money – and you determine how far in the money based on the max loss you would be willing to incur. In this strategy we are launching today, we plan to buy right AT-THE-MONEY or just 1-2% in-the-money. Our rationale: the cost to hedge is still hovering near historic lows.
 
Let’s look at an example: You can purchase ATM call on the SPY (S&P500 ETF) that expires in January 2015 for about $9.40 with the SPY trading at $184.75 (the ATM call is the $184 strike in this case). That has an extrinsic value of roughly $8.65 – or 5.1% annualized.
 
At 5.1% annualized, that is reasonably low – but you wouldn’t look back on the year and think that paying 5% cost of protection was going to be an acceptable drag on your portfolio. But you are left with a lot of cash in your portfolio when you buy this ATM call. If that cash can be invested in a protected income device, you might be able to reduce that cost of hedging. Let’s explore.
 
If you bought 10 contracts on the January 2015, it would cost $9,400. You are controlling an implied portfolio value of 1000 shares times the SPY price of $184.75 -> or $184,750 portfolio. We don’t recommend having a notional value greater than your portfolio value, so, we recommend this portfolio strategy for a portfolio of $185,000 at minimum.
 
After buying the call, you would still have roughly $175,000 in cash remaining. If you can invest that in a fixed income ETF with around a 3% to 5% return, you could generate a lot of the return needed to pay that 5% cost of hedging.
 
In the past, we have purchased the JNK (Hi Yield ETF) and collected around a 6-7% dividend – then we re-invested half of the dividend in to protective puts that were out of the money. We netted to a 3%+ return from that strategy – and the puts provided crisis protection in the event of a credit event in the markets.
 
So, in effect, we transferred our risk from the equity markets (because we own ATM returns) to risk in the credit markets (the fixed income ETFs). This strategy worked very well through the last couple years as interest rates were on the decline and the ETF in JNK was increasing.
 
But now we face a rising interest rate environment where the prices on fixed income are declining. The hedge we built on JNK before would not save you from the slow decline that accompanies a slowly rising interest rate environment.
 
Which is why we are interested in the new product from ProShares – the HYHG. It owns similar investments in Hi Yield corporate bonds and then it shorts Treasuries. In effect, you are interest rate hedged – but not credit crisis hedged. You capture the spread between interest rates on Hi-yields and Treasuries - at a matching duration of around 4.5 years. The net interest after the cost of the treasury hedge is around 3.5%.
 
What have you done here? You have traded equity risk for bond risk – but not normal bond risk. You are taking credit crisis risk – not really interest rate risk.
 
So now, you are making 3.5% return on 95% of the portfolio. That leave you with around 1.5% cost of hedging. That is getting closer to what we can stomach – especially for ATM protection.
 
But we can cut a chunk in to that also. We can sell an OTM call against the long call we bought at the money. We generally like to look at about a one standard deviation stock move in the underlying that is implied by the options pricing. In this case, that is selling the $210 strike in the January 2015 expiration to match your long call. You can sell that for about 85 cents – or exactly 0.5% annualized.
 
In general, if we cannot get at least ¾ of 1% for our short call a full year away, we don’t take it. It’s not enough to entice us to give up the upside. So, we may settle on the 1.5% cost for hedging – but for AT-THE-MONEY protection, we like that set-up.
 
Next week, we will write about some short put strategies you can use help close that 1.5% gap.
 
Lastly, we have back-tested this strategy buying one year out in a 2-step ladder – meaning we were always buying on the June and December expirations. The chart of the returns back to December 2007 to December 2013 are included. The returns are attractive – especially given the protection it provided through the 2008-09 crisis. The primary benchmark is the S&P500 itself.


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