Many alternative portfolios have been designed to outperform the 60/40 portfolio on a risk-adjusted basis, but few have had long-term success. The death of the 60/40 portfolio is often proclaimed by many in the industry, but often by those with competing products. In this article, I’m going to share a simple idea for active options traders to improve rather than compete against the 60/40 portfolio.
Short strangles are a multi-leg option strategy that is usually written about a month after it expires by combining an Out of the Money (OTM) with an OTM call. This creates a profit zone at expiration where the goal is for the underlying asset to end between the exercise prices so that all of the option premium accumulated is retained as profit. The special thing about put options is that no cash is required, just a collateral requirement known as margin. This offers opportunities for creativity. With an allocation of 60/40 as the underlying portfolio, the short puts can be secured by bonds and the short calls can be secured or “covered” by stocks. 60/40 effectively combines covered calls with a short strangle overlay cash-secured puts.
A specific example could be using a fund such as the Vanguard Balanced Index Fund (VBIAX) as the underlying 60/40 portfolio. This fund maintains a US 60/40 asset allocation in a low-cost fund with a track record of 8.6% annualized average return since 1992. An active trader could then enhance this base portfolio in an options-approved margin account by typing SPX. XSP or SPY strangle part of the VBIAX position. If a trader wanted a notional allocation of 30% to the Strangles, the short calls would be fully covered by the underlying stocks and the short puts would be fully backed by the underlying bonds. Short strangles have a historical risk profile that has a low beta under most market conditions for both stocks and bonds, which diversifies the portfolio. Although a strangle overlay increases the overall portfolio risk, it should increase the return more, which should lead to a higher expected Sharpe ratio.
In my next article, I’ll present historical data that illustrates the concept in more detail. I personally find this portfolio compelling as it is easy to manage and relatively tax efficient due to the buy and hold nature of the underlying 60/40 portfolio and the 1256 contract handling of the option strings when using a cash settled index like XSP. The portfolio combines three different sources of return for stocks, bonds and option sales. It also combines passive investing with active trading in a well thought out way. Like a good recipe, the ingredients taste best when combined with one another.
Jesse Blom is a licensed investment advisor and vice president of Lorintine Capital, LP. He is advising clients in the US and around the world on the plant. Jesse has been in the financial services industry since 2008 and is a CERTIFIED FINANCIAL PLANNER ™ Professional. Working with a CFP® expert is the highest standard for advice on financial planning. Jesse holds a BS in Finance from Oral Roberts University.
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