Call Me Crazy (Part 6)

I left off talking about RAR by PMDD. As impressive as this is in favor of the long call (LC) over stock shares, let’s consider the possibility that exposure isn’t everything.

Although a big difference exists between what is probable and what is possible, suitability standards for wealth management are based on the latter. The S&P 500 has never gone to zero* and I can hardly imagine a scenario where this happens in a sustainable society (I have seen fearmongers, omnipresent in the financial media, include Purge-like dystopias as part of their portrayal). Nevertheless, the possibility exists and risk models must respect it. We would otherwise be left to debate reasonable levels for maximum loss. Opinions on this differ and should we be wrong [likely, since “your worst drawdown is always ahead of you” (see third-to-last paragraph here)], the result could be tantamount to a true financial apocalypse.

[Deleveraged] Investing with insurance means we survive the worst. I’ve been in the trading trenches for the last 12+ years. Most of the time, things go smoothly. When markets get rocky, fear and stress mount fast. To have the confidence my portfolio will remain [healthy] even in the face of a total stock market collapse represents an enormous sense of security. Most substantial investors would feel the same way.

Backtesting the LC through the Great Recession appears quite encouraging.

Can we imagine a case where the strategy falters?

Consider how the LC fares in down markets. On the upside, the LC faces a performance drag in terms of upfront cost. An ATM (slightly OTM, actually) LC will expire worthless if the market does not go up. In the backtest, I purchased LEAPS two years to expiration and rolled after one. The market is marginally higher in two of the 14+ backtested years and only down in three. Is it true that overall, the LC fares better because most down years are small and/or because the LC retains most of its premium being closed with a full year left until expiration?

The second and fourth columns show % ROI for SPX share and LC accounts, respectively. The third column shows % ROI for the LC itself. Here are some observations:

• LC is battered and bruised in 2008 despite performing much better than the shares.
• LC underperformance during other four years averages 2.99% (not insignificant).
• LC average cost across all 15 periods (last being a partial year) is 16.10% (of account value).
• LC loses substantial value over first year in trade although hit to the entire account is less.

That final point has a lot to do with leverage. I have been enchanted by the limited exposure—how much firepowder remains dry—when investing with LCs. For a $100,000 account, every year offers the tempting opportunity to purchase up to 4 – 5 contracts. The last column increases proportionally to number of contracts, though. This is an ever-present threat.

I will continue next time.

* — SPX pulled back 57% from its all-time 2007 high by March 2009: the worst bear market
       many of us have ever experienced, but a far cry from total 100% loss.