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Equity index put writing: A strategy for uncertain markets

This approach can help clients stay invested while limiting their exposure to volatility or downdrafts

Aug 28, 2018 @ 11:21 am

By Derek Devens

With the post-crisis market recovery now in its tenth year and equity indexes near all-time highs, investors understandably may be thinking that no bull market can charge ahead forever. We are now in a period in which market conditions are increasingly influenced by rising interest rates and renewed volatility, despite the positive impact of such factors as strong domestic growth and rising corporate earnings. Geopolitical tensions and rumblings of trade wars only add to a growing sense of unpredictability.

These shifting market dynamics affect all investors, but have an especially serious impact on those approaching or nearing retirement. During the 2008 stock market meltdown, many investors were stunned by the extent of their paper losses, and some had to put off retirement plans or seriously consider whether they still had sufficient time to recoup large losses.

Perhaps as a result of that experience, a rising number of advisers and high-net-worth investors are telling us they want solutions that allow them to stay invested without being subject to volatility or downdrafts as severe as the underlying index. If so, investors and their advisers may want to consider an equity index put writing strategy.

Admittedly, many investors and advisers may be skeptical about options strategies, citing their use of leverage, their complexity and the propensity for most options to expire worthless, not to mention the costs. An equity index put write strategy, however, is unlike other options strategies in that puts are written on indexes, not individual stocks, there is no leverage (it's typically fully collateralized) and is often offered in a variety of vehicles.

Other key attributes of a put write strategy:

• It seeks to smooth out returns by pursuing equity-like returns with lower volatility than broad equity markets over the long term.

• It focuses on liquid exchange-traded options, offers transparency in implementation and can be used as an equity complement or supplement or as a replacement for or supplement to certain lower-conviction alternative equity strategies.

• Over the past 25 years, the CBOE S&P 500 PutWrite Index (PUT) has outperformed the S&P 500 index, with lower volatility and better risk-adjusted returns.

• Index option premiums areeligible for favorable tax treatment (IRS Section 1256: 60% long term /40% short term).

Average 1-year rolling return by S&P return scenario (June 1986 - June 2018)
Source: Bloomberg

How Equity Index Put Writing Strategies Work

Put writes work by first investing the assets in a collateral portfolio, such as U.S. Treasuries, and then writing (selling) puts to take in option premiums from investors who are willing to pay to mitigate short-term losses.

The options are written against major indexes, like the S&P 500 and Russell 2000, rather than single stocks, and they are cash-settled so the strategy never owns the underlying equity exposures. Investors generally seek out the protection offered by puts during extreme market volatility and are willing to pay a hefty premium for that downside mitigation (typically 1.5% each month; 18% annualized).

Importantly, a put write strategy generally is expected to perform as follows across several different market conditions:

• In down markets, an equity index put write strategy is generally expected to outperform major indexes, like the S&P 500, because the premiums taken in, plus the collateral, help cushion the downside.

• In a flat market, the strategy is generally expected to outperform, because the fund will keep the premiums and collateral.

• When the market is up modestly, the strategy is typically expected to keep pace.

The strategy will generally underperform when the market is up aggressively, as premiums and Treasury notes can only compound a finite amount. Even so, put write still has potential to generate an attractive return. Basically, put write is designed as a conservative strategy that enables market participation while seeking to dampen volatility and reducing downside risk.

(More: Hedging stock risk can hedge your business, too)

The Potential for Put Writing

For investors concerned about uncertain markets, collateralized equity index put writing has the potential to seek to improve the risk-return efficiency, liquidity, flexibility and cost-effectiveness of investment portfolios without compromising the potential for equity-like returns over the long run. Simply stated, a put write strategy is designed to allow investors to maintain their participation in the market that may still have potential for expansion, but with the goal of pursuing less volatility and less drawdown risk than broader equity markets.

(More: A smarter way to rebalance)

Derek Devens is managing director and senior portfolio manager of the option group at Neuberger Berman.

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