Can you beat the risk/return profile of a 60/40 stock/bond portfolio, using stock options instead of bonds?

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atrchi
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Can you beat the risk/return profile of a 60/40 stock/bond portfolio, using stock options instead of bonds?

Post by atrchi » Sat Feb 01, 2020 6:51 pm

Assume for simplicity of discussion, that we'll use the SPY ETF for "stocks" and TLT ETF for "bonds."

Can you beat the risk/return profile of a 60% SPY, 40% TLT portfolio, by using only SPY and Options on the SPY?

Here's my reasoning:
- In a 60/40 portfolio, you're giving up 40% of your gains in a bull market, in exchange for giving up 40% of your losses in a bear market - except in those times where both are highly correlated. (for simplicity, I'm ignoring TLT's coupon yield)
- Now suppose that instead of allocating 40% to bonds, I went to a Cost-Free Options Collar layered on top of a 100% allocation to stocks. Suppose I size the collar boundaries such that I give up 40% of my gains/losses "on average" (since I can't predict the future, the boundary would be based on past-return statistics, i.e. each collar is limited to approximately a 1.3-Sigma price movement up or down over the lifetime of the collar)

Would the resulting SPY+Collar portfolio have better risk/return characteristics than the SPY/TLT portfolio, or same, or worse?
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europeanwizard
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Re: Can you beat the risk/return profile of a 60/40 stock/bond portfolio, using stock options instead of bonds?

Post by europeanwizard » Sun Feb 02, 2020 12:57 am

Noob here. Isn't the risk/return hard to evaluate if you don't know the chance of counterparty risk?
atrchi
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Re: Can you beat the risk/return profile of a 60/40 stock/bond portfolio, using stock options instead of bonds?

Post by atrchi » Sat Mar 14, 2020 4:09 pm

europeanwizard wrote:
Sun Feb 02, 2020 12:57 am
Noob here. Isn't the risk/return hard to evaluate if you don't know the chance of counterparty risk?
Let's make some assumptions and simplifications in order to move the discussion forward:
- Assume U.S. will not default on U.S. treasuries during the horizon of this analysis
- Assume markets remain open
- Assume the investment is small, so there are no liquidity concerns as far as "getting in and out of the trade"
- Assume options settlements are adequately protected from counter-party risk

If any of these turns out to be false, the investment will go to $0 and you better have other assets outside of the financial system.

But as long as the assumptions hold, how do the risk/return profiles of the two investments compare?
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