Not Exactly a Cash Replacement Strategy (Part 2)

Today I continue study of what I am calling not exactly a cash-replacement strategy: the first component of a new (to me) investing approach.

This component is not exactly a cash-replacement strategy because it carries more risk than cash, which can really only lose to inflation. Backtesting will help to put context around “more risk,” but max loss being realized over a string of consecutive years would severely damage core equity. If I deem the potential for adverse performance to be limited, then I may choose to use this as a cash replacement.

I can think of a few potential variants with the first being leveraging up leftover cash. In the example I gave last time, on a $247 investment my max risk is less than $20 (not counting dividends) for the year. Why not double to 200 shares and buy two puts? My max risk would then be less than $40, which is just under 17%, and my potential profit (unlimited) would increase twice as fast. The downside is that losses start to accrue with anything less than a $20 (per 100 shares) gain by expiration.* I am interested to look at the historical distribution of returns to get an idea of the probabilities.

A second potential variant to the married put cash replacement is resetting the long put ATM to lock in gains once the market rallies X%. This would cost more money although if months have passed, then I can seize the opportunity to roll the put out in time, which would eventually have to be done anyway.* I think backtesting this entire approach will have to be some sort of horizontal (by date) summation of components. For this variant, separate backtesting of the put involves exit after an X% gain in the underlying (for a loss) or exit with Y months to expiration (for a gain or loss): whichever comes first.

A third variant to the married put cash replacement is to buy a put debit spread for limited downside protection if VIX > Z. This would limit cost of insurance at the risk of losing more overall if the market decline continues thereby forcing an early exit (e.g. at the long strike?). From a backtesting perspective, this would be challenging because not only do I have to backtest across a range of Z, I should also backtest across a range of vertical spread widths (or debit spread prices).

A married put is synthetically equivalent to a long call, which suggests as a fourth variant purchase of a long-dated ATM call alone. With one leg instead of two, this might be an easier trade (unless I were to hold SPY shares and only move around the long put, which would nullify the simplicity advantage). Done this way, I should invest the remainder in T-bills or some other cash proxy unless I intend to leverage up as described three paragraphs above.

I will continue next time.

* — My intent will not be to hold to expiration due to accelerated time decay in the final months.