The Smoother "PATH": PutWriting At The High

The analysis presented below combines two separate frameworks that were previously outlined:

• Avoiding Bear Markets to Improve Risk-Adjusted Returns
• The Case for Put Writing / Further Improving PutWrite Performance

The first post outlined how avoiding bear markets (by only holding equities when they were near an all-time high) has lead to very strong risk adjusted returns, going so far to show the great performance of a strategy that only allocated to stocks when they were at an all-time high. The second post outlined what an investment in put writing provided and pointed out the surprising fact that selling puts on the S&P 500 has actually resulted in better risk-adjusted returns when markets were calm than when volatility was heightened (and premiums were higher). I recommend reading either / both if interested in more detail.

When Does Put Writing Make Money?
Selling puts make money when the premium collected is greater than the decline in the market (relative to the strike price) from the time the puts were sold to the time the puts expire (i.e. ignoring financing costs if you sold an at-the-money put, collected a premium worth ~5% of the notional value of the S&P 500, and the S&P 500 went down less than 5%, the trade was profitable). Thus, despite the lower premiums collected, selling puts more consistently make money when market volatility is low because the market is much less likely to decline (i.e. selling insurance to safe drivers is more lucrative even if you charge a lower premium).

Going one step further, the chart below shows all forward one month returns for the CBOE PutWrite Index and the S&P 500 Index only for periods when the S&P 500 reached an all-time high the previous month-end going back 25 years.

Highlighting the consistency of returns for both the CBOE PutWrite Index and S&P 500 when the previous month-end value of the S&P 500 was at an all-time high:

CBOE PutWrite

• 11.1% annualized geometric returns
• 4.6% annualized standard deviation
• 2.9% annualized downside deviation
• Positive 79% of the time

S&P 500

• 8.5% annualized geometric returns
• 10.3% annualized standard deviation
• 4.8% annualized downside deviation
• positive 60% of the time

The PATH Model
The model below is a simplified / lower risk version of one I've kicked around for a while, but it has resulted in an interesting historical path of returns.

The rules:

• If the S&P 500 ended the previous month at an all-time high, allocate to the CBOE PutWrite Index (PATH = Putwrite At The High)
• Otherwise, allocate to Aggregate Bonds
• Levered version = 2x levered allocation to the CBOE PutWrite Index at-the-high financed at the applicable cash rate

The caveats of how this will perform going forward should be pretty obvious, namely that the path of the S&P 500 is hugely important.

• If there is no new S&P 500 high, the strategy will simply sit in bonds (and yields are much lower)
• If there is a huge market downturn in the period that puts were sold, that loss may take a LONG time to make up (especially at low yields)

Caveats aside, the relative historical returns of the non-levered model were ~2% higher annualized than bonds with an almost identical risk to the index, while the 2x levered version provided returns that were "stock-like" (~4% higher than bonds), but with a 60% lower standard deviation and a 90% lower max drawdown than the S&P 500.

At some point in the likely distant future, I hope to put out a white paper with a much more in-depth background and details of the broader model. For now, please feel free to reach out to me with any thoughts on Twitter @econompic.