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Monday, October 3, 2016

The Case for Put Writing in an Expensive Market

Pensions and Investments wrote about the interest pension plans have shown in put writing (seemingly one of the more misunderstood investment strategies out there) in a recent article Funds Go Exotic with Put-write Options to Stem Volatility. I thought the article did a nice job of outlining the strategic case for the strategy as a risk reducing equity alternative. In this post I'll outline why current valuations among U.S. stocks may actually make the trade-off even more interesting (than normal) relative to an allocation to the S&P 500.

For a deeper dive into what put writing entails, including how they have the same economic exposure as covered calls... see past posts here and here.

But Short Naked Options Sounds Scary... How Can They Reduce Risk Relative to Stocks?

I regularly see articles / posts / tweets outlining the "complexity" and/or "danger" of put writing.

Example 1) The WSJ reported on the same topic In Scramble for Yield, Pension Funds Will Try Almost Anything:
Pension funds in Hawaii and South Carolina are plying an arcane options strategy called cash-secured put writing.
Example 2) AAII published an article Taking on Risk and Hoping the Strategy Doesn't Backfire where Charles Rotblut, the editor of the investment association, reveals the mistaken belief that covered calls provide a different exposure than put writing (click here for a chart showing they are identical):
If an investor holds a stock and writes call options (a strategy referred to as covered calls), the investor gives up potential upside if the option is called. Assuming the investor wrote the contracts with a strike price above what the stock cost to acquire, a profit is made, though a smaller profit than could have been made if the contract hadn’t been written.  
Conversely, all of the stock’s potential downside is taken on by the investor writing the put. Assuming the investor wrote the contracts with a strike price below what the stock cost to acquire, a profit can only be made if the premiums received and the proceeds from selling the stock exceed the loss incurred from being forced to buy the stock at a price below the put’s strike price
In reality... writing puts simply converts the upside potential of the stock market to a premium collected up front, while the downside (excluding the premium collected) remains the same. The result is a more consistent return stream (the premium collected cushions / offsets the downside when markets sell-off) while it has kept up with the S&P 500 since inception (despite the lower risk profile), given volatility is routinely overpriced by the market. In addition, puts tend to be priced more expensively than calls (in part) because they are less understood by investors, thus put writing has historically outperformed covered calls.

In other words, I largely agree with the P&I article that shifting equity exposure to put writing can reduce risk in any market environment:
The put-write strategy serves both as protection against downside risk and volatility but has the added bonus of providing income, said Frank Tirado, vice president of education, Options Industry Council, Chicago.

The Current Relative Opportunity for Put Writing Appears Greater than Normal

The current opportunity to shift a long position in the S&P 500 to put writing may be greater than normal given current extended valuations. The reasoning is as follows:
  • The opportunity cost of writing puts relative to owning stocks is the upside of the market (the upside is capped by what is collected as a premium when writing puts, but unlimited for stocks)
  • The upside of the market is greater when valuations are lower (and expected returns are higher) and lower when valuations are higher
  • With the S&P 500's cyclically adjusted P/E "CAPE" at 26.5, the market appears relatively expensive, thus upside potential / opportunity cost of stocks are very low vs history (another way of saying forward returns are likely lower than normal)
The data bears this out... going back to the CBOE PutWrite Index' 1986 inception, the S&P 500 has outperformed put writing when valuations were cheap and has underperformed put writing when valuations were expensive. In fact, while the S&P 500's forward return has varied by almost 8 points when the CAPE was below / above it's current 26.5 level, the forward seven year return of put writing has hardly varied when below / above this same 26.5 level.

Scatter plot of starting CAPE vs forward seven year CBOE PutWrite and S&P 500 returns.

Geometric one month forward returns annualized of starting CAPE vs forward seven year CBOE PutWrite and S&P 500 returns.