split-strike synthetic PP portfolio?
Posted: Sat May 30, 2020 1:23 pm
Has anybody ever tried to run or backtest a PP portfolio modified to hold synthetic split-strikes instead of ETFs?
No I'm not talking about Bernie Madoff's split-strikes fraudulent fund.
A split-strike synthetic is where you sell an out-of-the-money PUT Option to finance the purchase of an out-of-the-money CALL Option at the same option price (but a different strike price). The resulting position resembles the risk/return profile of the underlying ETF during big moves, but returns exactly $0 when the market is range-bound within your chosen range.
Now here comes the brainy insight: Because of Implied Volatility Skew on stocks, the same-priced options are such that the CALL is closer to the current price and therefore has a higher probability of making money than a loss on the sold PUT. This strategy should have a statistical edge as long as the Implied Volatility Curve (IV vs Expiry) shows a smirk, which anecdotally has been the case since after the 1987 crash (I don't have access to historical option prices to verify this claim).
Example:
Basic PP as of the close on Friday- SPY $304.32, TLT $163.59, GLD $162.91
Instead of buying SPY for $304.32, you SELL DEC 31 '20 SPY 271 PUT @ $13.95 and BUY DEC 31 '20 SPY 320 CALL @ $13.73 (*)
The edge of this strategy is that the market right now values the EOY probability of SPY=$271 (an 11% drop) the same as SPY=$320 (a 5.2% gain).
i.e. "the market" is willing to give you any gains above 5.2% in exchange for you committing to assume any losses beyond 11%, from now to the end of the year. This is just intuitively wrong, and a better deal than holding SPY and committing to assume all losses in exchange for all potential gains.
To complete the PP:
- Instead of buying TLT for $163.59, SELL DEC 18 '20 TLT 150 PUT @ $3.35 and BUY DEC 18 '20 TLT 177 CALL @ $3.35
- Buy GLD ETF straight-up, because the Volatility Skew is inverted and not conducive to a split-strikes strategy:
e.g. if instead of buying GLD for $162.91, you SELL DEC 31 '20 GLD 146 PUT @ $2.90 and BUY DEC 31 '20 GLD 195 CALL @ $2.76, the market is only offering all gains above 19.7% in exchange for assuming all losses in excess of 10.4%. (incidentally, that makes it beautifully suitable for a Cost-Free Collar!)
Perform standard PP rebalance on 12/31, repeat every 6 months (i.e. on 1/1 trade the June or July 2021 options).
What would be the long-term result?
(*) Additional explanation for people who don't understand options:
- If the SPY finishes the year between $271 and $320, you make $0 on this part of the investment
- If the SPY finishes the year $271 or lower, you take losses on the value below $271 (same as retroactively paying $271 for the ETF)
- If the SPY finishes the year $320 or higher, you take gains on the value above $320 (same as retroactively paying $320 for the ETF)
- Just to avoid confusion, I don't differentiate "paper" gains and losses from realized gains and losses. Everything is mark-to-market.
- Assume no mid-course adjustments, hold every option until expiration
- Assume the mid-point for the option prices. One should never use a market order to buy or sell options.
No I'm not talking about Bernie Madoff's split-strikes fraudulent fund.
A split-strike synthetic is where you sell an out-of-the-money PUT Option to finance the purchase of an out-of-the-money CALL Option at the same option price (but a different strike price). The resulting position resembles the risk/return profile of the underlying ETF during big moves, but returns exactly $0 when the market is range-bound within your chosen range.
Now here comes the brainy insight: Because of Implied Volatility Skew on stocks, the same-priced options are such that the CALL is closer to the current price and therefore has a higher probability of making money than a loss on the sold PUT. This strategy should have a statistical edge as long as the Implied Volatility Curve (IV vs Expiry) shows a smirk, which anecdotally has been the case since after the 1987 crash (I don't have access to historical option prices to verify this claim).
Example:
Basic PP as of the close on Friday- SPY $304.32, TLT $163.59, GLD $162.91
Instead of buying SPY for $304.32, you SELL DEC 31 '20 SPY 271 PUT @ $13.95 and BUY DEC 31 '20 SPY 320 CALL @ $13.73 (*)
The edge of this strategy is that the market right now values the EOY probability of SPY=$271 (an 11% drop) the same as SPY=$320 (a 5.2% gain).
i.e. "the market" is willing to give you any gains above 5.2% in exchange for you committing to assume any losses beyond 11%, from now to the end of the year. This is just intuitively wrong, and a better deal than holding SPY and committing to assume all losses in exchange for all potential gains.
To complete the PP:
- Instead of buying TLT for $163.59, SELL DEC 18 '20 TLT 150 PUT @ $3.35 and BUY DEC 18 '20 TLT 177 CALL @ $3.35
- Buy GLD ETF straight-up, because the Volatility Skew is inverted and not conducive to a split-strikes strategy:
e.g. if instead of buying GLD for $162.91, you SELL DEC 31 '20 GLD 146 PUT @ $2.90 and BUY DEC 31 '20 GLD 195 CALL @ $2.76, the market is only offering all gains above 19.7% in exchange for assuming all losses in excess of 10.4%. (incidentally, that makes it beautifully suitable for a Cost-Free Collar!)
Perform standard PP rebalance on 12/31, repeat every 6 months (i.e. on 1/1 trade the June or July 2021 options).
What would be the long-term result?
(*) Additional explanation for people who don't understand options:
- If the SPY finishes the year between $271 and $320, you make $0 on this part of the investment
- If the SPY finishes the year $271 or lower, you take losses on the value below $271 (same as retroactively paying $271 for the ETF)
- If the SPY finishes the year $320 or higher, you take gains on the value above $320 (same as retroactively paying $320 for the ETF)
- Just to avoid confusion, I don't differentiate "paper" gains and losses from realized gains and losses. Everything is mark-to-market.
- Assume no mid-course adjustments, hold every option until expiration
- Assume the mid-point for the option prices. One should never use a market order to buy or sell options.