Generating Income and Managing Risk: Cash-Secured Put Writing in a Low Equity Return Environment

Guest Author: Stephen Solaka, Managing Partner, Belmont Capital Group

Current Challenges

 Since the end of 2021, investors in traditional asset classes, stocks and bonds, have experienced strong headwinds:

• Federal Reserve held federal funds rate at around 0% as recently as the first quarter of 2022.
• The Fed also continued buying billions of dollars of bonds monthly to stimulate the economy despite 40-year highs in various measures of U.S. inflation.
• The Fed has rapidly raised the Fed funds rate by more than five percent reducing red-hot inflation rates at the expense of equity and bond asset class returns.
• Despite a strong YTD return in equities, the S&P 500 has been nearly flat over 20 months.
• The Bloomberg Aggregate Bond Index, a proxy for bond investors worldwide, is still over 11% below its peak in the same period.
• The traditional allocation of 60% stocks/40% bonds has stalled after years of impressive performance.

The overall expectations of the Fed cutting interest rates in the short term remain low and a projected anemic return on U.S. Equities over the next ten years. 

As a result of the Fed’s actions, 2023 Vanguard’s (as of June 23, 2023) expects 10-year nominal annualized S&P 500 return to be between +3.7% to +5.7% annualized.

Rising rates have wreaked havoc on traditional portfolios, but there is one silver lining: cash is currently paying a healthy interest rate with short-term rates now paying greater than 5%. This higher rate regime can help meet return objectives with lower risk. However, many investors need more than this return to achieve their objectives, and longer-term rates could decline. Individual investors and institutions are now facing challenges in reaching their target returns…so what’s an investor to do?

Given current market dynamics, investors are increasingly seeking collateralized option strategies for better risk/adjusted returns. For decades, institutional and sophisticated individual investors have been utilizing a cash-secured put write strategy.

The current short-term interest rates at higher levels create a tailwind for a put write strategy offering the potential to help investors reach a return target with less risk.

Understanding a Cash-Secured Put Writing Strategy

Mechanics: This strategy involves selling a put option while holding an amount of cash sufficient to purchase the underlying stock should the option be exercised.

Income: The premium collected from selling the put option is the maximum profit potential. If the underlying stock's market price remains above the put's strike price upon expiration, the option expires worthless, and the investor retains the premium as profit.

Potential Discounted Acquisition: If the stock's price falls below the put strike’s price, the investor might be obligated to buy the stock, potentially at a discount. This is attractive for investors bullish on the stock in the long term but seeking a favorable entry point.

Risks and Potential Rewards

As with any financial strategy, cash-secured put writing presents its own set of risks and rewards:

Rewards

• Regular Income: The most evident benefit is the regular income from the premiums received by selling the put options. Over time, these premiums can accumulate, offering an attractive return, especially in flat or moderately bearish markets.
• Stock Acquisition: For those bullish on a particular stock, this strategy offers the chance to acquire said stock at a predetermined and possibly discounted price.

Risks

• Declining Stock Price: The main risk is a steep stock price decline. Should the stock price plummet significantly below the strike price, the investor might suffer losses that could outweigh the received premiums.
• Opportunity Cost: The return of the cash-secured put strategy could be lower than buying the underlying in a rapidly rising equity market.

The Role of Cboe’s S&P 500 Cash-Secured PutWrite Index (PUT)

Cboe's PUT Index provides an empirical lens through which one can assess the performance of the cash-secured put writing strategy against the broader market. The PUT Index tracks a hypothetical portfolio that writes monthly, at-the-money S&P 500 Index (SPX) put options against interest-bearing collateralized cash reserves.

Key Attributes of the PUT Index Include:

• Performance Measurement: The PUT Index offers a direct comparison to other benchmarks, most notably the S&P 500. This comparison provides insights into how cash-secured put writing performs in varying market conditions.
• Diversification Potential: The PUT Index often exhibits a different risk-return profile than traditional equity or fixed-income indices. This can aid investors looking to diversify their portfolio, potentially reducing its overall volatility.
• Income Representation: The index encapsulates the income potential of the strategy, allowing for a clear understanding of how premiums can bolster returns over time.
• Volatility Insights: Historically, the PUT index has shown reduced volatility compared to broader equity markets, particularly during downturns. This demonstrates the strategy's potential as a buffer during turbulent times.

How and Why Does It Work?

The return component in the PUT index is twofold: income from the T-Bills, which adjusts with short-term interest rates, and premiums collected from writing the put options. The option strategy seeks to capitalize on the volatility risk premium or VRP. The volatility risk premium refers to the excess return investors may expect to earn when they take on the risk associated with increased market volatility. It arises from the fact that options and other derivatives are often priced with an implied volatility that tends to be higher than the realized volatility of the underlying asset. Investors who sell these options or engage in strategies tied to volatility may receive a premium for assuming this risk, as markets typically overestimate future volatility. However, this premium has the potential for losses if actual volatility exceeds expectations.

Since 2013, the volatility risk premium between VIX and 30-day realized volatility has averaged 3.33%.

Cboe’s PUT Index Performance (Since Inception, July 1986 – August 31, 2023):

• Annualized returned: PUT Index +9.40% vs. the S&P 500 of +9.91%
• Standard deviation of returns: PUT Index 10.26% vs. 15.38% for the S&P 500
• Maximum drawdown: PUT Index -32.66%, vs. -50.96% for the S&P 500.
• Longest drawdown and recovery: PUT Index 30 months vs. 66 months for the S&P 500
• Enhanced Risk- Adjusted Returns: PUT Index annualized 9.40% vs. S&P 500 (60%) / Bloomberg Agg. (40%) annualized 8.84% with similar drawdown and volatility characteristics.

Outperformance During More Volatile Markets

Over more volatile or bearish market conditions specific periods, the PUT Index has outperformed the S&P 500, thanks to the consistent premium collection. During times of higher market volatility, the PUT Index collects higher premiums, which helps dampen volatility and/or increase returns.

The chart below focuses on the rolling one-year returns of Cboe’s Put Index and its percentage of outperforming the S&P 500 during different return regimes. For example, with the S&P 500 rolling one-year return below 0%, Cboe’s PUT Index outperformed the overall market 95% of the time. For rolling yearly returns of 0% to 5%, the outperformance frequency was 69%; for 5% to 10%, it outperformed 75% of the time. As expected, the PUT Index has a lower percentage of outperformance during outsized positive returns in the S&P 500.

Practical Implementation

Cboe’s PUT Index is one example of a type of cash-secured put strategy. However, investors can tailor their strategies, such as writing options further out of the money (less risk/return) than Cboe’s PUT Index or implementing them across other equity indices. Investors may also look to manage their options strategies more actively, such as diversifying strikes and expirations vs. a passive benchmark approach. For investors who want to own stocks or ETFs at lower prices, writing cash-secured puts at levels where you would own the underlying security can make sense. You will either own the security cheaper or collect premium and interest income in the meantime.

For investors looking to outsource their cash-secured put allocations, learning the specifics of potential strategies is imperative. Understanding potential risks, types of options written, underlying collateral management, and risk controls is very important.

Conclusion

Although equity market returns are expected to be significantly lower over the next ten years versus historical returns, these projections show that cash-secured put option-writing strategies may offer superior risk/return profiles over the next decade, with lower standard deviations and higher Sharpe ratios than projected for the U.S. equity market. Higher returns with less risk? Investors now have plenty more options to reach their goals.

^{This article is part of Cboe’s Guest Author Series, where firms and individuals share their insights, strategies and ideas with the broader Cboe community. Interested in contributing? Email [email protected] or contact your Cboe representative to learn more.}

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