This week the equity markets are unsettled and not showing many signs of life after dropping like a rock a few weeks ago. If you were an investor starting a portfolio right now, what could you do? Not only stocks, but pretty much all asset classes are in downtrends. This includes precious metals, oil and other commodities, real estate, and most kinds of bonds. Cash returns are negligible. Annuities and other insurance products are at very low rates of return reflecting interest rates that are still not able to fog a mirror. So what to do?
One way to generate cash flow on stocks without owning stocks is to sell options on stock index exchange traded funds. In particular, we can sell put options on an index ETF, which gives someone the right to force us to buy the ETF if the index drops below a certain level.
This may seem strange. If we don’t want to own stocks, why put ourselves in a position where we may have to buy them? The reason is that we can be compensated very well for taking that chance. In the worst case, we will end up owning the index ETF, but at a much lower cost than its current level. Even though our cost might be higher than the value of the ETF, generating a loss, that worst-case loss will still be much less than if we had just bought the stock in the first place. In the best case we can generate cash flow at rates of return far above the amount we could earn by keeping the money in the bank. And we can still protect ourselves against a catastrophic market meltdown.
Here is an example:
Today (October 1, 2015) SPY closed at $192.13. There was a previous low around 182. If we were to sell October puts at the 182 strike price, we would collect about $72 per contract, which involves 100 shares. We would have to put up as margin 100 shares times $182 per share, or $18,200. The options expire in 15 days, on October 16. If at that time SPY were still above $182, we would retain the $72 and our obligation to buy the stock would expire. In that case our return would be the $72 premium collected. On an annualized basis this would be a rate of return of 9.6%, on top of whatever our broker paid us on the $18,200 cash deposit (if anything).
This 9.6% best-case return was not guaranteed. If SPY did end up below $182 at the close of business on October 16, then we would be forced to buy it at the agreed-on price of $182.00. After subtracting the $.72 premium, our cost per share would be $181.28. If SPY were lower than that amount then we would have a loss.
How likely was it that SPY would be below $182 in 15 days, taking into consideration its present price, and the volatility encoded in its option prices? Statistically, not very. $182 was about 1.5 times the 15-day standard deviation away from the current price. This translates into about a 6.7% chance of finishing below that level in 15 days.
Pretty good odds – but a 6.7% chance of a bad outcome is not zero percent. And the outcome could be very bad indeed. If we were to have a 2008-style crash, SPY could be much lower than our cost of $181.28 and we could be far under water. We would then have to decide whether to wait it out or take our lumps.
I mentioned that we could protect ourselves from a market meltdown when using this method. Next week, details on how that would work.
Meanwhile, stay safe. Educate yourself on how options can work for you.