Finding Upside on the Downside
Know your options
At Luminist Capital, we use option overlays to provide protection against investment losses. An option overlay is a combination of call and put options layered on top of a core investment. We apply option overlays to ETFs in several of our models.
On 12/29/17 I put some new money to work in one of our Alternative Yield models. I bought shares of XLU @ $52.59 and layered in our yield enhancing option overlay on the stock. Fast forward to 3/16/18 and XLU is now $50.25, 4.4% lower, as rising interest rates have taken their toll on utilities. This model is down just 0.32% over the same period. There are several reasons for this outperformance, first among them is the downside protection the option overlay provides. We buy puts to cap the downside and sell other options to cover the cost of the protection. One of the very tangible benefits of this strategy only reveals itself in down markets. Here’s an example of how it works:
Let’s say I buy 1,000 shares of XYZ @ $100 per share, total investment = $100,000. If the stock drops 10% I have 1,000 shares worth $90 and my investment is now valued at $90,000. When we use our option overlay, something different happens. We still have 1,000 shares that go from $100 to $90, but we also have a 95 strike put option that in this example that goes from $1 to $5. When we sell that put and roll to the next expiration, cash goes up. We use that cash to buy more stock. Instead of owning 1,000 shares @ $90, I now have 1,040 shares @ $90. It might not seem like a big deal, but it is. If I only had shares, I need the stock to go up $10, an 11.1% rally, to get back to my original $100,000 investment value. With the option overlay in this case, I only need the stock to go to $96.15 to be back to even. At $100 per share, my original entry price, my investment value is $104,000. The overlay not only protects my downside, it increases the number of shares I can buy. More shares means more dividends, which can be rolled into buying even more shares. This is how you take advantage of the most powerful force in finance: compounding.
The beauty of this dynamic is it doesn’t require more out of pocket funds to buy more shares. The put protection we bought as a hedge has gone up in value and we are able to monetize it. The overlay makes the drawdown less severe, gives us the opportunity to lower our cost basis and add to the number of shares we own. The bigger the drop in the stock, the bigger the benefit of this dynamic. We have an opportunity to capitalize on these situations every month as we roll our protection every 30 days or so.
We didn’t get to take advantage of this benefit much in 2017, almost everything was up every month. But as we make our way through 2018 and beyond, volatility has picked up and the frequency of negative months has increased. I can’t say I’m hoping for a correction, but I’ll be there with dry powder ready if it does happen. The beauty of a correction for us is the opportunity to increase the amount of our investment at better prices. It’s how we find upside on the downside.
