In a previous post, we covered buy-write strategies and related ETFs, which are currently offering very attractive yield levels. Today, we’ll look a bit further into the buy-write’s cousin, the put-write.
What is a Put-Write Strategy?
Like buy-writes, put-writes also earn income by writing options to collect premiums with the hope that the options will expire worthless. Unlike a buy-write, where the call is covered by the stock, put-writes either write naked puts or must maintain a cash account to cover the payout if the put is exercised.
Relationship to Buy-Writes
There is a fundamental relationship between put-writes and buy-writes that can be seen by rearranging put-call parity:
C – P = S – D × K
-P + D × K = S – C
where P, C, and S are the put, call, and stock prices, respectively, K is the strike price, and D is the discount factor to maturity. This assumes no dividends and European options, but the intuition is still helpful.
The left-hand side of the equation is the put-write and cash invested to cover the strike price at maturity (long a zero-coupon bond); the right-hand side is the buy-write written at the same strike. From this we can equate an out-of-the-money (OTM) buy-write strategy to a cash-secured in-the-money (ITM) put-write. Likewise, we could say that a cash-secured OTM put-write is equivalent to an ITM buy-write.
In reality, the relationship is more of a similarity than an equivalence. Puts and calls are often American options, which can be exercised before maturity. So even though writing a covered call (or cash secured put) that is ITM may have similar mechanics to writing an OTM covered call (or cash secured put), the OTM option is generally preferable to reduce the risk of early exercise.
…or more appropriately, ETF. Currently, the only ETF available for put-write strategies is the U.S. Equity High Volatility Put Write Index Fund ETF (HVPW). It has $52 million in AUM and an expense ratio of 95 bps. Every two months, it sells 15% OTM cash-secured puts on 20 of the largest stocks with the highest implied volatility. The idea is that investors will pay a premium for insurance on these stocks, allowing the fund’s management to target a 9% annual distribution, a goal that the ETF has been able to achieve since its inception in Feb. 2013.
Many of HVPW’s recent puts have been sold on the large U.S. airlines and other travel related stocks and companies in technology, consumer discretionary, and healthcare. From period to period, about seven of the companies remain in the portfolio. When a put is exercised early, the ETF holds the stock until the next turnover date. This opens the fund up to risk of further declines in the stock price prior to the sale, but, from a quantitative perspective, the stock could also mean revert and generate a positive return for the fund. HVPW uses liquidity constraints to reduce the risks associated with liquidating the stock position on the rebalance day.
Likelihood of a Payout
Put-write strategies rely on the puts expiring OTM. Thus, they have significant downside potential in a bear market. However, the hope is that the premium can offset losses even a few puts are exercised.
The following chart graphs the probability of a single 15% OTM put option expiring ITM (with Black-Scholes assumptions) for a range of volatilities. It also shows the annual yield that the option would generate assuming it always expires worthless. The calculations assume a 10 bps risk-free rate and 2 months to expiry.
From the chart, we can see that a volatility of at least 43% is required in order to generate 9% annually in premiums. At this volatility the probability of the put expiring ITM is 17%.
A Portfolio of Puts
Of course, using a single option would not be prudent risk management. Assuming this is done independently six times in a year on options with a 17% chance of expiring ITM, the probability of never having a payout is only 33%, and that only accounts for if it will lose money, not how much.
Thankfully, diversification can help. HVPW writes options on 20 stocks. The average of the trailing 100-day volatility of the current holdings is 44%, and the average probability that the options expire in the money is 17%. Assuming independence, there is a 98% probability that at least one of the options will expire in the money in each two month period. Indeed, since HVPW’s index went live in Feb. 2012, an average of 3-4 options have expired in-the-money in each period, with a maximum of 10 in Feb-Apr 2014 and a minimum of 0 in Jun-Aug 2013.
A few options ending slightly in the money will not break the bank, but a strong, highly correlated bear market could be detrimental. The hope is that, when a stock is declining, the implied volatility of its options is higher than the realized volatility so that HVPW can sell over-priced options. These outsized premiums are intended to mitigate payouts for the exercised puts. HVPW may write puts on the most volatile stocks, but its limited upside potential and offsetting premiums on the downside should reduce its volatility relative to the underlyings.
As with buy-write strategies, put write strategies comes with unique risks that many investors may not be fully aware of. Option payoffs are inherently nonlinear, and understanding the behavior of the options in different market environments is a key to understanding the strategy as a whole.
Aside from the general mechanics of the put-write strategy, there are many parameters that investors should know before investing: the strike price of the options, how diversified the fund is, what happens to the stock if the put is exercised early, and what types of assets the puts are being written on. All of these factors can affect the yield of the strategy and the total return.
Put-write strategies can be a great way to increase portfolio income, especially in a low and rising rate environment (stay tuned for more on this in a future post), but during a strong bear market, they can be exposed. Specifically, for HVPW, currently the only put-write ETF, as the volatility of the underlying securities increases, more puts will have a higher probability of expiring in the money (or being exercised early since they are American puts). However, during sideways and bull markets, the high volatility of the underlying securities should be beneficial since the strategy can capitalize on inflated option premiums while benefiting from fewer put payouts. As with buy-writes, ultimately, put-write strategies may be a good source of income diversification as long as one is aware of their highly path-dependent nature and how the strategy is specifically structured.
Note: Newfound does not currently utilize any put-write ETFs in its strategies but may choose to do so in the future. Newfound encourages investors to seek the advice of a financial advisor as the appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.
If you are interested in learning more about other income generating asset classes along with a discussion on how they may perform in a rising rate environment, check out our previous posts on Bank Loans, MLPs, Convertibles, and Preferreds.