The previous two posts Pay a 30-Year Loan On a 15-Year Schedule and Borrow 30-Year and Invest The Difference showed how you can save money if you are committed to making higher monthly payments on your mortgage. This fits into a general theme: pay a lower price if you commit to something and you make that commitment known to the other party.
Buying in bulk also fits into this theme. When you buy detergent in a gigantic size container from Costco, you are saying to the manufacturer you are committed to their brand. As a result, they give you a break on the per-ounce price. When you buy a season pass to a ski resort, you are saying you are committed to skiing there, and they give you a deal versus buying single tickets.
In each case, just making the commitment in your own mind isn’t enough. You have to make your commitment known to the other party. If you are committed to paying off your 30-year mortgage in 15 years but you don’t let the lender know, you are not going to get the lower rate. If you are committed to a detergent brand but you buy one small bottle at a time, you don’t get the price break. If you always ski at the same place but you buy a day ticket every time you go, they just treat you like a one-timer.
Now, when it comes to rebalancing your portfolio, are you committed to buy when prices get low or sell when prices get high? Maybe you are absolutely committed in your own mind but does anybody else know? If you let somebody know, you can get paid for your commitment.
How? Through the options market.
An option is the right to buy or sell by a date in the future at a predetermined price. To someone looking for a buyer (or seller), knowing that you are committed to buy (or sell) at a set price is very valuable to them, so much so that they are willing to pay you for your commitment.
Here comes the test: are you truly committed to rebalance at a set price point? So much so that you are willing to put your commitment down in writing? If yes, you are a candidate for getting paid for your commitment.
There are always divergent opinions among market participants. As I’m writing this, SPDR S&P 500 ETF (ticker SPY) is worth about $131 a share (corresponding to S&P 500 at 1,310). A call option — the right to buy — at $140 a share in the next six months is worth about $3.00 per share. Someone paying $3 for a right to buy at $140 is thinking S&P 500 will go above 1,430 in six months. Meanwhile a put option — the right to sell — at $120 a share in the next six months is worth about $4.60 per share. Someone paying $4.60 for a right to sell at $120 is thinking S&P 500 will go below 1,154 in the next six months.
If you are close to a rebalance such that S&P 500 falling to 1,200 will make you buy to rebalance anyway, why not let others know you are out there and get paid for it? You can sell a put option on SPY expiring in six months at $120 per share for $4.60 per share. For each $12,000 you are committing to buy, you earn $460. That’s a 3.8% return in six months, 7.7% annualized, which is much higher than you expect to earn from a bond fund if you just make the commitment to yourself without telling anybody.
Is it speculating? No because you are not betting that the prices will go one way or the other. It’s all about formalizing your commitment to rebalance at a set price point and letting others know about it. If when S&P 500 drops to 1,200 you want to say "Hmm it looks like it will go lower. I will wait for the bottom before I rebalance." selling options isn’t for you because you are not truly committed to rebalance at a set price point.
Is it risky? Yes in a sense a 15-year mortgage is riskier than a 30-year mortgage but you get compensated for it. There’s a cost for the rebalancing flexibility insurance just as there’s a cost for the payment flexibility insurance embedded in a 30-year mortgage.
I trust that you won’t go out and start selling options like crazy just because someone on the Internet said so. Think about it. Maybe you are not as committed as you thought. If you decide to try it, only sell as much as you are willing to rebalance anyway.
Some pointers on logistics if you want to explore this. To be able to sell ("write") options, you need a brokerage account; just mutual funds with Vanguard isn’t enough. Then you need to apply for options trading. Selling "cash-secured puts" and "covered calls" are 100% collateralized; you have cash ready to buy or shares ready to sell. You don’t need a margin account. Because of taxes, it’s best if you do it in an IRA.
The options market in Vanguard ETFs isn’t as active as that in some other ETFs such as SPDR S&P 500 ETF (SPY), iShares Russell 2000 ETF (IWM), iShares EAFE ETF (EFA), or iShares Emerging Markets ETF (EEM). If you end up with SPY ("assigned") but you prefer a Vanguard ETF, just swap to what you really want. The online trading commissions are very low.
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I just started doing this a couple weeks ago (after a good bit of research) and I am very happy to see another low cost passive investor thinks it is reasonable to sell options as part of rebalancing. Readers should know they need to do a good amount of calculations to make sure they don’t lose the money they think they are making on the option trade fees & commissions. And like you said: some options on Vanguard ETFs are thinly traded, which can make it hard to get a bid that is worthwhile, or even get any bid at the strike price you want.
Wai Yip Tung says
Good to understand how to make use of options. I don’t think I’m going to do this though. It hurts my brain to work through these numbers and I don’t think it worth my while for $460. I guess if I have millions I will hire a professional to do this.
That says, wouldn’t a life style or targeted date fund take advantage of this and make them perform a little bit better.
Isn’t there still the risk that the price falls further below the strike price before the option expires? I would want to see some studies showing that this strategy actually provides an increased risk adjusted return before trying it myself.
This article is wrong, one of the very few blunders in an otherwise very good and useful blog.
The fundamental mistake is, like Jason says, that options don’t get exercised at strike price, but when the buyer decides to, or by expiration date. This means the buyer can keep you from rebalancing when you would have, and instead makes you sit on a position with 100% risk, zero rewards for quite a while instead of going into normal investments with both risk and reward, such as bonds.
It’s not a problem that can be fixed. One has to accept that selling options involves making a gamble, not merely getting paid for timing. And then the question of “am I getting paid enough for those odds” that should give every individual investor pause, considering who’s on the other side of the trade.
Harry Sit says
Wrong as in you don’t come out ahead 100% of the time, that’s true. There are very few of those in investing.
When the market price touches the option strike price before the option expires, there can be three outcomes by the time the option expires: (1) the market price is lower than the strike price; (2) the market price is exactly the same as the strike price; or (3) the market price is higher than the strike price.
In outcomes (1) and (2), you buy the underlying at the committed price. You are in the exact same position as someone who rebalanced at the pre-set price, except you earned the option premium. You win.
You are concerned about outcome (3). If the price snaps back, you missed the opportunity to rebalance at the pre-set price. There are ways to mitigate this risk. One, keep the option term short. Shorter time reduces the risk of a large bounce back. Two, consider just biting the bullet and closing out the option when the market price hits the pre-set price. You pay the remaining time value, which may or may not be higher than the option premium you collected up front. You also have the option premiums you collected from previous rounds as a cushion. If this happens once in a while, overall you still come out ahead.
Options are priced primarily for protecting against outcome (1). People buy a put option to protect against falling prices. As a committed rebalancer, you are not concerned about that outcome. That puts you in the position to earn the insurance premium.
Harry: thanks for the response! As I was saying, I continue to have the utmost respect for your work here.
Yes, (3) is the problem. You say in the article that you get paid for announcing rebalancing, but you don’t *actually* get to rebalance when the price hits that point. The price for the option premium is that the rebalancing outcome got tilted against you: in the one scenario where you would have benefitted, you don’t.
Buying out of the option will be quite expensive then, possibly much more than you made on the initial trade; after all, the option holder is sitting on an instrument with zero risk and full stock market rewards (at least for the remainder), so he’d be a fool to let it go cheaply.
So what this leaves us with is a delicate balance of premium received vs odds of this scenario, both varying greatly with option duration. I maintain that individual investors are very likely out of their league trying to evaluate this balance. At the very least, it’s a far cry from the notion that we got paid for something we would have done anyway — which is the part that I’m calling wrong.
Harry Sit says
That’s why you keep the duration short. If the price hits on day 20 of a 1-month option, with only 10 days to go, the risk of it running away from you big time isn’t very high. You may end up losing money in that round but you made money in other rounds when the price never hit or when it hit and it went down some more.
To elaborate: I am against the notion that you get *anything at all* for the “announcing” part.
Imagine there was an option that gave you the right, once price crosses X, to buy at the *market price*. As a rebalancer, this is what I’d want to sell you because this is how I want to rebalance. The problem is that such an option would cost exactly zero, because you can always buy at the market price without needing an instrument.
It’s clear to me that all the premium I’d get is because of the difference between X and the market price of the buyer’s choosing. I’m not getting paid for the willingness to rebalance, I’m getting paid for the willingness to, once market price crosses X, sit for the remainder of the time on a position with 100% of stock market risk and 0% of the stock market reward. It’s a willingness I don’t have; my original rebalancing plan was to be in *bonds* with 10% of the risk and 10% of the reward.
Our messages crossed paths, sorry.
I understand the point about duration, but you can be sure that the buyer is thinking about it too and paying you much less.
In any event, wouldn’t it be fair to say, as per my message above, that you “get paid for taking on someone’s market risk for N days”, as opposed to “for your rebalancing commitment”, which I argue is not worth anything?
P.S: I find it easier to reason about the “covered calls” part of rebalancing, another very common proposal, but the arguments are the same for cash secured puts.
Harry Sit says
I covered rebalancing flexibility in the article. You give that up when you sell the put option committing to buy at a pre-set price (worth something) versus buying at the then current market price (worth zero). If you say ‘announcing’ means retaining rebalancing flexibility, that’s debatable. I don’t see it that way. I see ‘announcing’ as a firm commitment. If you rebalance as soon as the pre-set price hits, you are taking 100% of the risk from then on anyway. So taking on 100% of the risk isn’t the problem. Not participating in the upside above the pre-set price for the remaining short duration is a problem, but the risk is low and manageable in my view.
The similar covered call strategy is implemented by some buy-write ETFs. I see they do better than bonds in general.
Harry: the lack of participation in the upside is not just “a manageable problem”, but the entirety of what you are getting paid for. It’s hard to say how much payment is enough for such a tradeoff, but it should be *a lot*; if it were cheap we would not be investing in stocks at all.
You say in the article (and this is the main theme) , “If you let somebody know, you can get paid for your commitment”. This is wrong. It’s not what you got paid for.
In any event, not wanting to continue a debate of nuance past the point of diminishing returns (e.g. the term “flexibility” which sounds harmless but hides a huge risk/reward tradeoff) , my summary of sorts for readers considering the strategy is these two rhetorical questions:
Q: What is your commitment to rebalance normally, i.e. at market prices, worth to a prospective buyer?
Q: What are you actually getting paid for, with covered calls / cash secured puts?
A: You are getting paid for being willing to postpone your rebalancing for an amount of time after your chosen price is met, meanwhile assuming the full risk and none of the rewards of your investment.
Hope this helps someone.
Harry Sit says
I respectfully disagree it’s the entirety of what you are getting paid for. You are getting paid primarily for taking the downside risk.
There’s that phrase “protective put.” Put buyers buy protection, not the upside for only a very short time after the strike price is hit. Put buyers cheer when the price keeps going down after the strike price is hit. That’s their payoff. You are paid to deliver that payoff to them on an off chance it happens. That’s why the put price is higher if the strike price is higher (more protection). I haven’t seen anything suggesting the put buyers are motivated by the bounce-back.
Harry Sit says
P.S. Consider this conversation:
You: Put Buyer, pay me $0.50 per share so that if the price hits $37 and then bounces back to $38 before December 15, you will get the upside between $37 and $38.
Put Buyer: Why? Don’t I get it anyway if I do nothing?
You: Because I’m making a sacrifice to rebalance at $38 versus $37.
Put Buyer: Not my problem.
Harry: it’s really easy (and free) to protect against the downside of stocks: don’t hold any. Put buyers are paying to have the upside, with no downside. You can’t take the upside out of the equation and say that you primarily got paid for the downside. It’s the combination that’s so expensive (and toxic for the seller, in certain circumstances).
And I know I said I wouldn’t discuss nuance any more, but let me clarify why I think “flexibility” is such a poor description for our transaction. You’re using “flexibility” to imply that because I don’t care whether I rebalance in January or February, or at this price or that, it’s a very small sacrifice.
This is not the case. What the proposition really is, it’s that I rebalance in February at January’s prices; worse yet, that I rebalance at the *worse* of January and February’s prices. This means that for a month or so, I sit on pure risk. This isn’t “flexibility”, it’s options trading.
I don’t know how to state this any clearer.
Harry Sit says
So far we focused on outcome (3) but we brushed aside outcome (1). I say outcome (1) represents the bulk of the value to the put buyer. If I write the option contract this way:
(a) I promise to buy at $37 at any time before December 15; and
(b) Only if the price hits $37 or below before December 15, I have the right to buy at $37 on December 15.
This eliminates the bad outcome relative to a committed rebalancer. I say this contract is still valuable to the put buyer. The conditional call in (b) reduces its value relative from the put in (a) but not by much. If the price hits $37 and it keeps going down, the put buyer is still protected.
You are saying this contract has zero or negative value. The put buyer is only willing to pay if part (b) isn’t there. Any way to test it?
Well, this is certainly not the option discussed in the article, but we can explore it.
It’s a compromise of sorts, a put plus a European-style call and someone somewhere probably has a name for it. Vs the original option, the seller is better off, the buyer worse off. The seller still loses the upside between, say, $35 and $37; so same risk but reduced upside. The buyer has their upside limited to that very same $2; still no risk but now limited upside. The buyer is not as willing to pay as much, the difference being the price of that European style option. The seller has to think hard whether the $2 is worth giving up for the premium difference. Both are likely to change their minds quite often based on market conditions.
I don’t think *this* is a zero value proposition, but it’s unlikely that the call premium will *consistently* be a small proportion of the put premium, leaving the “bulk of the value” in the difference.
In any event, this still doesn’t satisfy me as a rebalancer. While I might be willing to commit to rebalancing at $37, OR on December 15, I am NOT willing to commit to rebalancing at $37 ON December 15 when the market price might be quite far from that value. When I rebalance, I want a fair deal based on market price. Once again, it walks and talks like option trading, not rebalancing.
Harry Sit says
The point is that if you are truly committed to rebalance at $37, you would do it at the first hit anyway. You don’t care if the price falls to $35 on December 15. For giving up the choice to change your mind and wait for a possible better price, and for having a risk represented by the lack of part (b) of the contract, you get paid. You use part of the premium earned to manage the bounce-back risk.
The buyer’s upside isn’t limited to $2. The market price can go to $20 on December 15. The buyer’s option would be worth $17 and your call option would be worth zero. Also note the European style call in part (b) is conditional. If the price never hits $37, you don’t have the call. Therefore its value at the time when the contract is written isn’t much. I say it’s less than the value of the put. You say not so. I don’t know how to prove it one way or the other.
P.S: to clarify, the example $35 is a price at which the buyer would likely exercise the option. It’s not known in advance, which makes the conceptual tradeoffs harder to reason about though the pricing doesn’t depend on it.
Harry: I didn’t do a good job expressing my analysis of the non-existent option clearly last night because I was focusing on the scenario where market price blows by that $37 on the way down. Here’s a more complete attempt.
Suppose I’m the option buyer. I am sitting on an equal amount of stock and debating whether to purchase this option for protection. I am considering this as strategy (A) and comparing it to the *free* strategy (B) of simply selling the stock once the price hits $37. The scenarios:
1) The price never goes below $37. Both strategies have the same outcome; (B) wins on price.
2) The price goes below $37, never goes back up. Both strategies have the same outcome (*note); (B) wins on price. It doesn’t matter if the stock goes at deep as $20; both strategies give me roughly $37 for my stock.
3) The price goes below $37 to, say, $35, then recovers to above $37. (A) allows me to pocket the difference between $35 and $37; but loses anything above $37 to the option seller. (B) loses the entire rebound of the stock.
So what I’m paying for with buying option (A) is that $2 of re-appreciation if the market moves just-so in December. I may or may not be willing to buy it, but I don’t want to pay very much, because the “(B) wins on price” in the other scenarios are also on my mind. This was what I meant by “the buyer’s upside [for buying this option] is limited to” the $X of re-appreciation.
The key point is that I can get downside protection for free by simply selling at market prices, at the cost of any appreciation following. Your option only sweetens the deal a bit by giving me a piece of the re-appreciation, so it’s not worth much premium. Once again, you can’t separate the downside from the upside in these arguments.
(*note) The keen observer would notice I lied a little bit here. It’s possible for the market to drop overnight to $35 without giving strategy (B) a chance to sell at $37. So option (A) also offers *that* little bit of protection. But it’s also the case that this event makes a difference between the “simple rebalancer” and the “rebalancer short option A” — the former would have bought at $35 ant the latter buys at $37. So it’s something that the sophisticated rebalancer would count as a negative tradeoff of option A, small as the chance might be.
Fundamentally, the originally discussed option to “sell at market prices once they cross $37”, which is what the rebalancer would actually like to sell, is not worth anything to the buyer because there will alway be stock buyers at the market price. So the seller can’t make anything from selling it. You can try to alter it slightly with various tradeoffs, but this only clouds the issue.
Here’s the other thing: you can make a case that puts and calls are perpetually overpriced, it’s a fairly common argument; e.g. the buy-write funds you mentioned are an instance of it and it seems to have been the case in recent memory. However, that would be a case for doing this on a continuous basis and becoming an option trader. I still don’t think it has anything to do with rebalancing.
Thanks ogd. Here I side with ogd.
I was thinking of selling put options to juice the returns for committing to re-balance. This matrix helped me understand the risk reward.
As of this writing
SPY at $453.44
31st Mar 2022 $330 Put @ $4.13
Entry credit: $413.00 net credit see details
Maximum risk: $32,586.90 (at SPY$0.00)
Maximum return: $413.00 (at SPY$330.00)
Max return on risk: 1.27% (3.92% ann.)
Breakevens at expiry: $325.85
Say SPY = $320 on 26th Dec 2021
If the put buyer exercises the put option. It matches to the commitment of buying at 330. Well and good, but the put buyer dont exercise as it is in their best interest not to. The price of the put is now $33.47 (it is a far cry from $10(difference in strike and market price) + $4.13(premium collected initially))
So now I am forced to close the position as I dont want to missout on the potential rally from 330 and want to by the stocks at 330.
Trades to close position, No., Price, Total
Buy 31st Mar 2022 $330.00 Put, 1×100, $33.47, $-3347.00
Entry cost $413.00