Posted: April 25, 2017 | by: Thomas F. McKeon, CFA
Collecting option premium in a sideways market is as good as it gets.
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As we do, we rolled option hedges on the monthly expiration (April 21) and sold new short option hedges for the May expiration. Like all investment strategies, sometimes they work a little better and sometimes a little less so. This month was an example of how powerful the rules-based hedged strategies are when they work.
When we rolled the hedges in March it was very near the recent market highs, especially in the US. For the next five weeks thru the April expiration, equity markets drifted sideways to lower. As such, the option premium we collected for your accounts was pure gain as each of our four hedged strategies rolled the April hedge established in March down to a lower strike for the May expiration.
One of our colleagues who is familiar with the time-decay aspect of option prices calls this “getting paid to wake up.” The gains realized for our clients this month equate to 1.263% on the market value of the hedged ETFs. A simple extrapolation out 12 months to a full year implies that the annual return from collecting option premium each month would be something close to 15%.
Of course it never works out like that in the real world because the markets don’t just move sideways, they fluctuate—as JP Morgan famously said. But this month showed the value of the methodical approach to hedging. This month, our clients earned 1.2% on their hedged positions that unhedged clients do/did not earn.
This simple activity smooths and enhances portfolio returns, mitigates risk and when added to a traditional unhedged portfolio, makes the resulting portfolio less risky, less volatile and more efficient. Because whatever the market is doing, the time decay of option prices is always working for you.