If your portfolio loses 1% today and gains 1% tomorrow, are you back to even? Not quite, but you’re awfully close. You actually need a gain of 1.01% to get back to where you started.
While that difference seems trivial, it gets magnified when the ups and down of your portfolio get larger. A loss of 5% requires a 5.26% gain to recover, while a 20% loss needs 25%. As for a 50% drawdown like we saw in 2008–09, well, that’s even worse than it appears. Your portfolio needs to double (a 100% gain) to return to its starting value. Stocks do recover from devastating declines like this, but it can take many years: the Canadian and US markets are still well below their 2007–08 highs.
Some investors simply don’t have the ability or the stomach to endure drawdowns of 20% or more. As index investors all know, the most straightforward way to protect your portfolio from catastrophic loss is to adjust its asset allocation: a 50-50 mix of Canadian stocks and government bonds lost just 12% in 2008.
But as I wrote about last week, markets are filled with uncertainty. We simply don’t know how far stocks can fall, nor can we be certain that bonds will be there to catch them. That’s why some index investors look for ways to build a floor under their portfolio.
Exploring your options
One way to set a limit on your portfolio’s losses is to buy put options. A put gives you the right to sell an asset—such as a popular ETF—at a certain price within a specified period. Here’s an example that was kindly provided by Alan Fustey of Index Wealth Management, the author of Risk, Financial Markets & You. (These prices were accurate as of May 1, but they will change with market conditions.)
- You purchase the iShares S&P/TSX 60 Index Fund (XIU) at $17.60.
- You also purchase put options with a strike price of $17.00, expiring in six months.
- These puts cost you $0.62 per share.
With this strategy, no matter how far markets may fall in the next six months, you can’t lose more than 6.9%. Here’s why:
- If XIU has declined below the strike price when the options expire, you have the right to sell your shares for $17. Since they were originally trading at $17.60, that works out to a maximum loss of 3.4%.
- You also need to account for the premium you paid for the puts. At $0.62 per share, that’s an additional loss of 3.5%.
As you’ve probably figured out, this protection is not free. Remember that the cost of the options will reduce your return by 3.5% no matter what happens. The value of XIU needs to increase by 3.5% for you to break even, and if markets go up by 10% you’d get only 6.5%. (Note that we’ve ignored dividends here to keep things simple. With XIU you can add about a 1% dividend every six months.)
Calls for help
Clearly protective puts, as they’re called, are an expensive insurance policy. One way to lower the cost is to also sell call options on your ETF. A call gives the holder the right to buy an asset at a certain price within a specified period. You sell (or “write”) calls in order to earn income from the premiums. Here’s another example from Fustey to illustrate this strategy, which is called a collar. Again, prices were accurate as of May 1.
- You buy the iShares S&P/TSX 60 Index Fund (XIU) at $17.60.
- You purchase put options with a strike price of $17.00, expiring in six months, at a cost of $0.62 per share.
- You also sell call options with a strike price of $18.50, collecting a premium of $0.30 per share.
- Your net cost for the options works out to just $0.32 per share, or 1.7% of original value of XIU, about half what you paid for the puts alone.
Now the maximum loss you can suffer is just –5.2%. But with this strategy you limit your upside even further. If the price of XIU rises above $18.50 (about a 5% gain), the holder of the call options will buy the ETF shares from you at the strike price. You’d get the 5% gain, but no more. And once you factor in the 1.7% cost of the options, you’re guaranteeing that your maximum return over the six months will be 3.3% (plus any dividends).
Weighing the costs
There are a number of other ways to combine options strategies with index investing in order to limit catastrophic drawdowns and to generate additional income. When properly managed, they may be appropriate for investors who understand the trade-off. But while that trade-off may seem small when markets are trending down or sputtering along with single-digit returns, it won’t always seem so comforting. Investors will feel pangs of regret when they get left behind by a market surge like the one that began last October (US markets are up about 25% since then). As Fustey explains: “There is no free lunch that allows an investor to receive complete protection against loss without either an outlay of cash or capping upside return potential.”
For investors who are still in the accumulation stage—who have lots of time to recover from losses and no need to generate income—a traditional asset allocation strategy is likely to be far more efficient.
Hey Dan,
I hope you are well. I like the article. A couple quick thoughts.
Aren’t you worried about the downside of a 40% weighting in bonds? I think interest rates have generally fallen since 1980 (with a few bumps along the way), so only one way to go is up which hurts bonds. Perhaps very short term is okay??
Separately, I think a 10 year govt bond pays <2% and if we avg 2% inflation, one would lock in a loss over then next 10 years??
Cheers,
John
@John: Thanks for the comment. There’s little doubt that bond returns going forward cannot match the bull market of the last 30 years, so anyone expecting 8% to 10% returns will be disappointed. There’s nothing wrong with keeping bonds shorter (or using GICs) if you prefer, or with lowering your allocation to bonds in general.
But I think we do have to be careful about forecasting interest rates. The gurus have been using the “nowhere yo go but up” line for three years while bond returns have been excellent. Rates can stay low for a long time, or they could creep up slowly, which actually be good over the long term.
What level of brokerage fees would be typical for buying or selling options (say on a $50,000 holding of index funds)?
Hi Dan,
As usual, it’s an interesting and informative article. Here’s a question. For taxable accounts, what is the fiscal impact of put and call options?
@Arrow: I just looked at TD Waterhouse’s schedule, and the commissions seem to be the same as for stocks: $10 per contract. A contract covers 100 shares, and with XIU trading around $17, you would need close to 30 contracts to cover $50,000. So they ain’t cheap.
@CCP Fan: My understanding is that it the strategy is quite tax-efficient, because call premiums are generally taxed as capital gains, not income.
Useful article
To use options in some discount broker accounts you have to apply to be approved to trade them – at least with Waterhouse. There is an option trading agreement and risk disclosure agreement you have to understand.
One simple portfolio that uses options is to have a large core of bond ETFs and high interest savings accounts or GICs and real return bond ETFs (say 90% or more of capital) and use the remainder to periodically buy longer dated call options on equity index ETFs, maybe out of the money. If the call comes into the money and is exercised the capital gain is used to buy more of the bonds or GICs. If the option expires worthless you lose the premium so the premium is your cap of what is at risk. Longer dated and especially long dated out of the money options can be quite cheap sometimes.
The idea is to gradually grow the income from the low risk part of the portfolio with a known amount of risk. Works best if you can make it tax efficient. However the premium carry can become a constant drag on performance if the options expire worthless so it is a timing issue and there could be periods of poor performance. I guess there are three approaches I suppose you can take to this – buy calls when the market looks oversold relative to the time period of the option (ie based on some technical or fundamental indicators), to do it in a regimented way every given period, or just do it randomly. The premise of the idea however is to control risk while capitalizing on the tendency of equity markets to gain value over time.
Some people do a similar strategy with most capital in cash and short term bonds and lots of very concentrated small bets on very high risk stocks and maybe ETFs through out of the money options on them, both calls and puts, both bought and sold.
Thanks for addressing an interesting and important topic, one I think is not addressed by the customarily recommended 60/40 portfolio.
I’m not keen, however, on either of the approaches you suggest. The put option approach is very expensive, both because the bid/ask spread is huge and because a put is a depreciating asset; and I don’t think the call option approach works, as it what is does primarily is just increase portfolio yield, which is not really the objective.
The most effective way to achieve the objective is to purchase a negatively correlated asset, and to my knowledge the only asset that is negatively correlated to equities, at least over the recent past (and this could change), is treasuries, and the more duration the better. Long duration treasuries pay you (not a lot) to wait and provide very effective drawdown protection. Correlations may change at some point. But unless and until they do, I think TLT and ZROZ in the US and XLB in Canada are the most effective and least expensive securities for reducing equity volatility in a portfolio; and far easier to implement than trading options.
@Drew: Thanks for the comment. I should make it clear that I’m not recommending these strategies, just explaining how they work. I agree with you that most efficient way to limit the severity of a drawdown is to allocate a portion of the portfolio to high-quality bonds.
I’m not sure I agree that a going all the way out to XLB is optimal, however. Most of the research I have read (from Dimensional, for example) indicates that short to intermediate maturities offer a better risk-reward tradeoff.
I simply don’t understand this strategy enough so not going to touch it. But ccp thx for being blunt on non-endorsement, on my first read of this article i thought it was april fools again :(
Drew
You may be interested in this paper. Near the end it talks about the concept of modified duration and how duration is not a 1:1 function of the term of the bond. As bond term lengthens duration “tightens” up because more of the return of the bond is from the cash flows from the bond.
This opened my eyes toward holding longer term bonds to reduce risk which I was wary of doing because I bought all the arguments in favour of short term ladders (as this paper also discusses)
http://www.himivest.com/media/PrefsAndGICs_090814A.pdf
@CCP says: “We simply don’t know how far stocks can fall, nor can we be certain that bonds will be there to catch them.” I’m glad you’re doing this series of how to protect your portfolio given that possibility! The 5o:50 stock/bond portfolio is simple except for that risk of drawdown which is very real for European investors presently methinks. Is further diversification then the answer to reduce risk? Like into real estate, gold, precious metals, and cash? The permanent portfolio comes to mind as being better diversified than a simple 50:50 equity/bond portfolio although it lacks real estate. Is more global diversification safer than being over weighted in one or two countries?
@Jon: I think it’s fair to say that global diversification will almost always lead to less volatility, though as we saw in 2008-09, it cannot be expected to protect you from a major drawdown during a global crisis. Real estate did not help either. Gold can often help, but it is very volatile asset class, too. It seems likely, however, that during any “flight to safety” high-quality government bonds will do well. That’s why the drawdown on 50-50 portfolio is not likely to be more than about 20% or so. But of course we can’t be certain of that.
The bottom line, as I see it, is that investors can’t have it both ways. If you want certainty, then you must accept lower returns. An options collar like I describe here can protect you from a catastrophic loss, but the insurance is expensive and your upside is severely constrained.
In this environment I’m happy to be 65-80% bonds in my accounts. Mostly shorter (cbo) with some very modest long exposure, and some high yield. Equities are mostly higher income. Some materials/gold (the Permanent portfolio shading).
My goal was to generate income for reinvestment with greatly reduced volatility. Mission accomplished so far. I have not dropped more than 2% at any time from new highs made over the past two years or so. Even while tsx and dow have had gyrations of 10, 15 and 20%.
You can greatly reduce volatility (and mistakes due to fear) with basic asset allocation of bonds, equities and reinvested income from holdings.
And this is fascinating. Rebalancing that greatly boosts returns and reduces volatility.
http://seekingalpha.com/article/587491-adaptive-asset-allocation-a-true-revolution-in-portfolio-management
I’m a little late to the party, but this question has been troubling me recently. The market is a lot higher now than when this article was first posted. By some measures, equities would seem to be at the upper bound of reasonable valuations, but, of course, no one knows when a correction will come. A long time ago, I tried a covered call and it was a profound disappointment. My shares rallied and were called away. I just felt whipsawed by the market. One of the problems I see with the collar strategy is that it could become a little addictive. There would never be a time when an investor would not feel vulnerable to a correction and so he might be tempted to keep on renewing his collar play thus denying himself any real upside. Larry Swedroe, an author I much admire, has argued that the collar strategy is a drag on performance. See his article http://www.etf.com/sections/index-investor-corner/swedroe-beware-drag-collar-strategies
David