An Equity Alternative: Cash Secured Put Selling

Key Takeaways

Cash secured put selling offers a new income source with potentially lower downside risk than traditional equities.
Simulations show improved risk-adjusted returns when combining this strategy with traditional income portfolios.

A cash secured put selling strategy can offer an alternative source of income generation for portfolios, with potentially lower downside exposure than traditional equity allocations

Traditional income generating portfolios tend to rely on higher dividend yielding equities, longer maturing fixed income instruments, or a combination of, to produce returns. In 2022, with the rise in long-term interest rates, equity market drawdowns, and the corresponding increase in correlation between stock and bonds, this approach has produced higher volatility and lower returns than expected.

A cash secured put selling strategy can offer an alternative source of income generation for portfolios, with potentially lower downside exposure than traditional equity allocations, by generating income through a combination of options premiums and short-maturity money market instruments.

To illustrate, we simulate the historical potential portfolio benefits of a cash-secured equity put selling strategy on the S&P 500, when combined with a traditional income focused balanced allocation (Figure 1).

We find that over the period examined, risk-adjusted returns are improved when the simulated put selling strategy is substituted for the equity exposure. We also find that standalone downside capture of the put selling strategy is lower than both the equity and balanced portfolio in most of the highlighted periods of market declines (Figure 2).

Figure 1: Simulated Portfolio Returns [1]

How it works:

A cash secured put selling strategy generates income through a combination of premiums collected from selling put options, and reinvesting the cash held as collateral in short-term money market securities. The put selling index referenced within the simulation, systematically sells 1 year expiry 10% out-the-money put options laddered quarterly, on the S&P 500 underlying. This provides rolling downside protection of -10% before options premiums and investment principal are put at risk contributing to the defensive properties of the strategy.

Figure 2: Downside Performance Scenarios

What are the risks of investing in a traditional income focused balanced allocation?

Fixed income portfolios may fail to provide sufficient diversification to a portfolio in stressed market environments.
Investors must take on the higher volatility of equities and longer maturity bonds to generate the desired income through dividends payments and coupons.
Inflationary periods can drive poor performance for both stock & traditional bond portfolios.

How does a cash secured put selling strategy help manage those risks? (Figure 3)

Improved diversification when undesirable correlation between stocks and bonds occurs.
Differentiated income stream through harnessing the volatility risk premium inherent in options.
Higher potential for positive risk adjusted returns in periods of poor risk asset performance.

Figure 3: Summary of Simulated Risks and Returns

Source: Bloomberg and Ninepoint calculations, quarterly rebalanced using quarterly data 2007-06-29 to 2022-12-21

[1] Income Focused Balanced Allocation: 6% SPTSX High Dividend Index (TXEITR), 30% TSX Composite (0000AR), 24% MSCI ACWI Local Currency Equity Index (NDLEACWF), 39% Bloomberg Barclays US Aggregate Bond Index CAD Hedged (LBUSTRDH), 1% FTSE Canadian 1 month Treasury Index (SPFICTBT).

Equity Stand Alone Allocation: 10% SPTSX High Dividend Index (TXEITR), 50% TSX Composite (0000AR), 40% MSCI ACWI Local Currency Equity Index (NDLEACWF).

Cash Secured Put Selling Strategy: RBC US 90 Strike Put Selling Strategy (RBCUS90P) quarterly return + Canada Bankers Acceptance 1M Maturity Index (CDOR01) beginning quarterly yield calculated as a total return.

[2] Sharpe Ratio: Annualized Total Return of allocation minus annualized return of FTSE Canada 1 month Treasury Index divided by standard deviation

All strategies are rebalanced to the specified allocations on a quarterly basis with graphs and charts depicting quarterly timeseries.

For illustrative purposes only and is not indicative of future performance. Subject to change without notice.

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