Why cash covered puts are helpful to navigate market turmoil
We’re not alone when it comes to selling put options as an effective method to retain exposure to the market during periods of heightened volatility
One of the important facets while managing the International Growth Portfolio is that we remain flexible with our strategy, particularly when we are alert to evolving situations.
The sharp deterioration in the market throughout February and into March has exceeded our expectations. It now appears likely that investors will respond to day-to-day news events as they unfold, rather than paying attention to the longer-term fundamentals that have supported the multi-year bull run.
Because these day-to-day events are unpredictable in every which way, we have seen heightened bouts of volatility that are likely to hang over the market in the near-term.
Furthermore, while we would normally favour an approach that sees us retain core equity holdings as opposed to cash, developments of this dramatic and unanticipated nature often result in the market overshooting when it corrects itself.
In such instances, it’s necessary to refine our investment strategy in order to adopt an approach that we believe will serve as the most likely means of protecting the value of client funds, while also offering upside potential.
Selling put options is a strategy that aligns exactly with this objective. In essence, selling put options against stocks that we want to own allows us to generate income from the option premium that a buyer pays.
If stock prices deteriorate further, then we acquire stocks that we are happy to hold at a reasonable price for the long term. What’s more, there is also an additional ‘discount’ on the price we pay because of the option premium we receive.
This sort of strategy is a favourite of some of the most successful investors where they suspect the market is overvalued, due for a correction or caught up in a black swan type event.
Warren Buffett used this approach in the lead up to, and during the GFC. It ultimately allowed him to get ‘set’ and position his portfolio by investing in the market and by extension, numerous solid companies, for a long-term rebound. These sort of market-wide corrections can provide once-in-a-lifetime opportunities, which means that we don’t want to be doing nothing as it all unfolds.
One of the reasons why this strategy is particularly favoured during market downturns is that it still allows us, as a seller of the put options, to retain market exposure and remain actively involved in the stock market.
At the same time, we can also preserve capital while we wait and see how the downturn pans out, with the unpredictable nature of the Coronavirus and its effect on the global economy still unknown. All the while, we can derive passive income and maintain capital at the ready to be deployed when things become clearer.
Ultimately, if we can hedge our risk and follow in Buffett’s footsteps by positioning ourselves to potentially pick up quality companies like Apple, Microsoft and the like at a discount, then we believe selling put options is a prudent, risk-adjusted strategy that is appropriate for the near-term.
International Growth Portfolio
The portfolio declined 0.3% during February, significantly outperforming each of the key US indexes. By comparison, the S&P 500 fell 8.4% across the same period, while the Dow Jones lost 10.1% and the NASDAQ dropped 11.9%.
Once again, amid the volatility that emerged across markets, our currency hedging delivered us significant benefits that helped underpin the performance of the portfolio. With the USD/AUD increasing from 1.4951 to 1.5363, this had a direct impact on the portfolio, driving NAV growth by 3.1%.