Options-Based Portfolio: 50% Cash and Matching S&P 500 Returns

2019 shaped up to be a historic year for the stock market indices. The S&P 500 posted its fourth-best annual return in over 20 years, coming in at a ~29.5% return (my options-based portfolio has generated the same returns). Only two other years have outpaced these 2019 returns. These occurred in 1995 and 1997, posting returns of 34.1% and 31.0%, respectively. 2019 was a unique year on multiple fronts, most notably because the market returns outpaced even the most bullish forecast by any Wall Street analyst. The markets roared higher in the face of impeachment proceedings, U.S.-China trade war, Federal Reserve actions, inverted yield curve, and slowing economies abroad. Furthermore, for the first time in history, the U.S. economy has started and ended a decade without a recession, with the economy expanding for a record 126 consecutive months (Figure 1).

Figure 1 – S&P 500, Nasdaq, and Dow Jones all set all-time highs as 2019 came to a close. The markets are in rarified territory with stretched valuations absent of any volatility. The Santa Claus rally capped off a euphoric market, generating the best returns in over 20 years

A data-driven, options-based portfolio sells options and collects premium income in a high-probability manner to generate consistent income for steady portfolio appreciation. This strategy mitigates risk and circumvents drastic market moves and is done without predicting which way the markets will move. Options are a great way to generate superior returns with less volatility in both bear and bull market conditions over the long term. Despite my 2019 performance lagging the S&P 500, the options-based strategy has generated the same returns when factoring in the Q4 2018 market sell-off. As 2019 comes to a close, my options-based portfolio returned ~19% relative to the S&P 500 return of 29.5%. Despite the epic 2019 market, when including the market sell-off of Q4 2018, my options-based portfolio has returned 11.6% relative to the S&P 500 return of 11.2%. I was able to achieve the same market performance over the past 15 months with my current cash position at ~50% of my portfolio.

Staying Grounded and Data-Driven Patience

My data-driven decision-making is rooted in the fact that 92% of actively managed funds do not outperform their benchmark, thus do not generate superior returns relative to their index. Furthermore, over 26 years, from 1983–2006, the Russell 3000 index had 39% of stocks that were unprofitable investments, 64% of stocks that underperformed the index, and 25% of stocks were responsible for all the market’s gains. Effectively, there’s a 36% chance of picking a stock that will outperform the market, thus generating superior returns relative to the broader index.
Stock picking essentially boils down to chance hence why over 90% of professional money managers underperform their respective benchmark. Even Warren Buffet is a huge supporter of index funds and favors these vehicles most over other investment options. Case in point, he’s instructed his trustee in charge of his estate to invest 90% of his money into the S&P 500 after he dies.

Based on these data, I stay grounded and run an options-based portfolio that places the statistical odds of success in one’s favor to generate portfolio appreciation in all market conditiony consistently. Options trading allows one to profit without predicting which way the stock will move. Options trading isn’t about whether or not the stock will move up or down. It’s about the probability of the stock not moving up or down more than a specified amount. As a result, options allow your portfolio to generate smooth and consistent income month after month for steady portfolio appreciation. In addition, running an option-based portfolio offers a superior risk profile relative to a stock-based portfolio while providing a statistical edge to optimize favorable trade outcomes over the long term. Put simply; an options-based approach provides a margin of safety with a decreased risk profile while providing high-probability win rates.

Figure 2 – Options-based portfolio returns overlaid with the S&P 500 returns over the same period. Options based portfolio return (11.6%) in comparison to the S&P 500 return (11.2%) over the past 15 months through both bear and bull market conditions. S&P 500 closed at $2,914 on September 30th, 2018, and closed at $3,240 on December 27th, 2019

Figure 3 – Options-based portfolio - comprehensive metrics over the past 15 months. The strategy has generated winning trades 87% of the time, capturing 58% of the premium income across 70 different tickers symbols

Euphoric Market Conditions

The broader indices have marched higher and higher to set new highs on what seems like a daily basis. Stocks have been on fire in the October-December stretch due to easier monetary policy by the Federal Reserve and a completed phase one trade deal between the U.S. and China that propelled the markets to even higher levels. The Federal Reserve cut rates twice since August and has signaled it will keep them at current levels for 2020. Throughout this period, volatility has remained low, indicating that the overall market is complacent and perceived as a low-risk environment. These periods of complacency are inevitably met with increased levels of volatility. Increased market volatility is strongly correlated to decreases in stock prices. As volatility inevitably increases, options trading can be executed in an ideal environment in order to capitalize on rich premiums.

Results

Empirical results demonstrate true alpha over the previous 15 months through bull and bear market conditions, performing in-line with the index (Figures 2 and 3). An options-based approach provides long-term, high-probability win rates to generate consistent income while circumventing drastic market moves. Over the previous 15 months, my win rate percentage was 87% (304/349 – Figure 4 through both bull and bear markets). Over the same period, the options-based portfolio generated an 11.6% return relative to an 11.2% for the S&P 500 (Figures 2, 3, and 4).

Figure 4 – Dot plot summarizing ~300 trades over the previous 15-month period

Conclusion

An options portfolio enables optimal risk mitigation and realization of profits on a continual basis, especially important during euphoric market conditions such as now. Impeachment proceedings, U.S.-China trade war, Federal Reserve actions, etc., dominate the headlines with the broader indices continuing to set new high after new high. Overall, volatility remains low, indicating that market participants have become overly confident and complacent. As a result, the S&P 500 has had a banner year in 2019. An options-based portfolio can offer a superior method to constantly locking-in gains while mitigating risk in these frothy market conditions.

Over the previous 15 months through the bear market of Q4 2018 and the bull market of 2019, an options-based portfolio has returned 11.6% compared to the S&P 500 return of 11.2%. These returns have been accomplished with an 87% win rate while having the flexibility to hold ~50% of my portfolio in cash. Selling options with a favorable risk profile and a high probability of success is the key. Options provide long-term durable high-probability win rates to generate consistent income while mitigating drastic market moves. Taken together, options trading is a long game that requires discipline, patience, time, maximizing the number of trade occurrences, and continuing to trade through all market conditions with the probability of success in your favor.

Thanks for reading,
The INO.com Team

Disclosure: The author holds shares in AAPL, AMZN, DIA, GOOGL, JPM, MSFT, QQQ, SPY and USO. The author has no business relationship with any companies mentioned in this article. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned.