By Jay Pestrichelli & Derek Moore
The Current Market Environment
With short-term rates pressing towards the 5% level, we’ve begun to see an impact on the pricing of near-the-money calls and puts.
For close to a decade, when rates were near zero, the premiums were generally the same once adjusting for dividends. This means that the extrinsic value (time value) was close when comparing calls and puts at the same strike price which sat around the current price of the underlying.
In plain English, puts are now less expensive than calls due to rates moving higher.
Buy and Hedge Retirement Strategy Tweaks to Optimize Current Market Environment
The main adjustment is switching to using deep in-the-money calls to replicate long exposure to the S&P 500 Index or SPY ETF.
The portfolio is much simpler than previous versions and feels more like a married put than our usual synthetic stock build. However, the portfolio still gets the efficiency of using calls at a fraction of the cost of long shares of SPY. We utilize longer time to expiration calls which cost less on an annualized basis.
Then, we added a ladder of protective puts to act as a hedge over the next 1 to 2 years.
You’ll notice this construction still results in the benefit of leaving a significant portion of the portfolio in cash that we then invest into shorter term US Treasuries currently able to capture a higher yield or return to maturity.
How Does This Affect the Hedgers Opportunity?
We mentioned laddering the long protective puts into varied maturities (expirations).
What this means is it still allows for locking in gains early as well as taking advantage of monetizing hedging profits. Putting avoided losses or hedging profits into more shares (exposure to S&P 500 Index) allows for the potential opportunity to reinvest at much lower market levels should there be material drawdowns.
This has always been a cornerstone to the Buy and Hedge approach.
How Does This Affect Downside Risk in Portfolios?
We guide that the strategy goal is to limit the equity downside to 8-10% over a 12-month period.
At the same time look to participate in 75% to 85% of the market upside. This is consistent with how the Buy and Hedge Retirement strategy operated in the past. With these adjustments, we think it will be even easier to explain to your clients and point to the floor in portfolios (long puts), as well as the equity upside opportunity generated via the deep in-the-money calls. We should also mention that US Treasuries held in portfolios tend to have shorter durations which carry less interest rate risk than bonds going out further in maturity.
All of this also comes with a reasonable cost of hedging which is how we measure what the portfolio gives up in exchange for having downside protection.
We thought we’d post some details for all of you currently using the strategy and of course don’t hesitate to reach out to a member of the ZEGA team with any questions.