Turning your portfolio into an insurance operator by selling put options
Health warning: options are risky business. They can cause significant losses and blow up your entire portfolio if you get them wrong. In fact, they are best avoided unless you really know what you’re doing. Even if you do know what you are doing, options can go badly wrong!
With all of that having been said, they are an instrument I am increasingly looking at as a source of income.
The way I think about it is this: by selling put options, I am providing insurance to my fellow market participants. I’m insuring other people’s portfolios against losses they might incur from a market meltdown.
In exchange, I get some very useful tax-free income (your tax position might be different). It’s hard to say no to that!
The difficult bit is that I have to stand ready to buy a large quantity of shares in the event of a market crash, and be willing to buy them at a fixed price.
For example, I am currently examining the FTSE 6400 put (December 2018) and the FTSE 6100 put (March 2019). As I write, the FTSE stands at 7000.
The Cash-Covered Put Strategy
For those who are unfamiliar with options, the idea is that if I sell the FTSE 6400 put (Dec 2018) when it is priced at 36, then I will make a profit of £36 (multiplied by my position size, which we shall assume is one for the sake of simplicity), so long as the FTSE is priced above 6400 on December 21st 2018.
If the FTSE is priced below 6400, then I will still receive that £36 income but I will also suffer a loss equal to the difference between the “strike price” (6400) and whatever level it actually finishes up at. So if the FTSE finishes at 6000, I will lose £400 and my net loss will be £364.
Put Option Payoff: Fixed Upside, Variable Downside!
Here’s the trick which makes this something more than mere speculation. Suppose that I happen to have at least £6,400 in fixed income or cash which I would be happy to switch into equities if the FTSE index was at or below 6400.
In that case, it turns out that I have a ready-made strategy for option expiry day. This is is the basis for the cash-covered put strategy.
Let’s suppose that the FTSE is at 6000 on expiry day. I sell my fixed income or cash position, use £400 to fund my losses on the put option, and plough the remaining £6,000 of capital into a FTSE tracker fund while the index is still sitting at 6000. In spread betting terms, my position is equivalent to being long £1/point.
My ending position is no worse than if I had managed to buy the FTSE tracker fund when the index was at 6400 (which we’ve assumed is something I would be eager to do anyway). I’ve actually bought the tracker fund at the cheaper price of 6000, but also paid out £400 in losses on the option position.
Hopefully you can see that the put option committed me to buy the tracker fund at the equivalent of 6400, regardless of how far below the strike price the index finished up.
If the index finished at 5400, then I would buy the tracker fund with £5,400 of remaining capital while suffering a £1,000 loss on the option, and would still have a £1/point long position. Exactly the same as if I had bought the tracker fund when the index was at 6400.
How to think about put options
As described above, I view this activity as if I am selling insurance policies. I’m insuring my fellow investors by promising to compensate them for any mark-to-market losses below the strike price that they might be suffering on expiry day. There are legitimate reasons why other investors might need that sort of insurance.
For someone like myself with a bullish long-term perspective on equities, it’s an attractive play to take this side of the transaction. Specifically thinking about these strike prices, I’m confident that I would be very eager to buy the FTSE at 6400 in December (or 6100 next March). The FTSE already looks decent value to me at c. 7000, so I’d be delighted to get involved at those lower levels.
We can put it in physical terms if we think of the FTSE as a house owned by my fellow investors. If the house goes on fire, I’m required to swoop in and buy the house at an attractive price for the sellers. This is no problem for me, if I’m confident that it will eventually recover in value.
Putting this strategy into action is not exactly straightforward. The most important thing is to make sure that I don’t sell too many options, because then I will have an exposure that is simply too big in relation to my portfolio (like an insurance company selling a policy it can’t afford to honour).
I also have to decide which put options to sell: would I be happy to buy the FTSE at 6400? Or 6600? Or 6800? In December, March or June?
There is also the question of timing and whether the options under consideration represent good value or not. The Black-Scholes formula for valuing options is a great tool, but it does require the use of some computing power. Warren Buffett has sold vast quantities of put options at Berkshire Hathaway (BRK.A) and I imagine that his own calculations had a heavy weighting in common sense rather than arcane numerical methods.
My own approach involves plugging option data into Black-Scholes, to see which options it thinks are the most overvalued. I then apply my own personal considerations to select the ones I want to trade.
A platform such as Bloomberg would help to automate these processes. There are also free options calculators available online.
Black-Scholes: A nightmare for maths-phobes. Source.
The Importance of the Volatility Assumption
A major input into Black-Scholes and indeed any options strategy must be some view on volatility, i.e. on the movement expected in the price of the underlying asset.
The VIX Index, often referred to as The Fear Index, directly measures the volatility which is implied by the latest options prices in the US. When it is high, it means that US options are expensive and therefore the volatility implied by options prices is also high. When it is low, it means that US options are cheap.
Applying a simple approach, we can say that it is better to sell options when they are expensive, not when they are cheap. And so it is better to sell US options when the VIX index is high.
For UK investors, there is a poorly-recognised equivalent called the FTSE 100 Implied Volatility Index (VFTSE), using FTSE 100 call and put options.
It is currently at its highest level since February of this year:
Source: Google Finance
Though it is still far below the levels seen during periods of major panic, when it has been at 30 or 40.
Source: Google Finance
The index represents the expected change in the FTSE over a year, with a 68% probability (i.e. one standard deviation). So a reading of 18 means there is a 68% chance that the FTSE will rise or fall by less than 18% over the next 12 months.
A reading of 40 would mean there is only a 68% chance that the FTSE will rise or fall by less than 40% over the next 12 months. That would imply amazing levels of volatility! It would mean there is a 32% chance that the FTSE moves by more than 40%.
Historic option pricing says that options are usually overvalued.
We can see an example of this in the below chart, where the dark red line is FTSE 30-Day Implied Volatility, and the grey line is FTSE 30-Day Realised Volatility. The red line is usually above the grey line, i.e. the volatility implied by options is usually higher than the volatility subsequently demonstrated by the actual movement of the FTSE. We can think of this difference as the profits enjoyed by those who sell options.
Source: FTSE Russell.
The cash-covered put is a great strategy to boost returns for investors who have liquid, fixed income assets which they would be willing to convert into equities at cheaper valuations.
Implementing the strategy requires careful risk assessment. Some familiarity with financial maths is highly beneficial and perhaps required.
With the VFTSE Index currently around 18.5, and with the FTSE already at what seems to me a reasonable entry point for a long position, FTSE put options could easily be overpriced. For the risk-tolerant and the financially astute, selling options in the weeks and months ahead could make a lot of sense.