Aug 26

A Mindless Way To Beat The S&P 500

By MultiplyWealth's Team

As the story goes all of the world's creatures walked two by two onto the ark to escape the floods. There were innumerable species and so many incredible differences, yet they all had some common characteristics.

The solution to saving the world's diversity was really pretty simple. So is it too with investors. Although they don't have to walk hand in hand, there are so many different types of investors, yet they all share the goal of making a profit. The paths, of course, can be wildly different. You can make things as complicated as you like or as simple as you can comprehend. I happen to like trading. I also happen to accept the use of covered calls as a religious calling, but I do understand that at least one of those two characteristics may not appeal to everyone.

Of course, I'm talking about trading, because anyone with the slightest ability to set emotion aside and dispassionately look at the real world of stocks would recognize that covered options are a tremendous way to achieve the dual goals of portfolio protection and income, while still allowing for upside appreciation, as defined by the option writer. Sadly, sometimes it requires lots of energy and thought. Sometimes it also means the risk of selecting the right stocks at the wrong time, as well as the wrong stocks regardless of timing. Those liabilities reside in human judgment, whether decisions are based on technical analysis, fundamentals or some less faux rigorous approach. Whereas I like trading with great ferocity and sometimes believe that even a week is too long of a holding period for some, there is an alternative and I see myself evolving into that alternative as my attention span recedes, but my love for profits still rules. My entire philosophy regarding investing is the need to beat an index that reflects your own temperament for risk. I'm a middle of the road kind of person so I always look to the S&P 500 for guidance.

Most everyone knows of or has heard of that index and most with any minimal investment knowledge have herd of the SPDR S&P 500 ETF (SPY). In a nutshell, it tracks the S&P 500 reasonably well. In today's grading system, its tracking would warrant an A+. The longer the term of observation, the better the tracking. To invest in the S&P 500 in any form, whether futures contracts, mutual funds or ETFs means that you haven't your personal stamp of approval on the 500 companies with the highest market capitalizations. Having a lot of money isn't necessarily a stamp of approval of a way of life, if for example you peddle drugs, but when it comes to publicly traded companies, it's a good place to begin passing judgment. For the more adventurous, any ETF that tracks its underlying index will do, such as the more volatile PowerShares QQQ which tracks the NASDAQ 100. Most people have seen or used retirement calculators. Every financial web site has one. Even I have one. What all of these calculators have in common is asking you to guess what your average annual rate of return will be until the day the you retire, die or stop investing. It's not as if you could ever know and certainly the past decade or so has shown that there can be lots and lots of variation in annual returns.

What guides me is knowing that it is much harder to gain 100% following a 50% decline in prices than it would be to gain that 50% in the first place. What further guides me is the very simple Rule of 72's. I assess return on the basis of how much less time would it take me to double my money. Even a single percent difference, in absolute terms, can be significant. Take the difference between return rates of 7 and 8%. At 7% it would take slightly less than 10 years to double assets, while at 8% it would require just 9 years.Trust me, as you're getting older, that single year is appreciable. Put it all together and the goal remains beating the index, The moire the better.

So let's start with a mindless investment in SPY. Now, it's time to play the guessing game, as if you were staring at a retirement calculator. For the next year, what rate of return do you believe the S&P 500 will achieve? 5%? 10%? How about minus 10%? At the moment (August 25, 2012) the S&P 500 is at 1411 and the SPY is 141.52. Let's be bold and say that by September 2013 the index and SPY will both appreciate by 10%. Being the perfect predictor, you sold SPY option contracts at a strike price 10% above the current price. Based upon the current dividend rate of 1.9% and the annual premium for the 156 September 2012 strike price would yield a total of $2,161 in capital gains, dividends and option premiums for a final return of 15.3% or 5.3% better than the S&P 500. How about if the index lost 10% for the year? In that case, again being the perfect predictor of market direction, you sold the 127 strike price options, receiving a final 5.8% return, besting the S&P by 15.8% But what if you're not a particularly good predictor? What if you sold $156 strikes in a belief that there would be a 10% appreciation, yet instead the market dropped 10%? Or you bet the market would go down when in fact it went up.

Looking at the 21 different strikes from 127 to 156, representing a negative 10% to positive 10% range, refer to the details. The bad news is that if you bet that the market would go down, but instead it went up by 10%, there is a chance that you would underperform the market. That's especially true if you believed the market would go down the full 19%). However, if you bet that the market would be flat for the year, yet the market actually appreciated 10%, you would equal S&P performance. The news is especially good if you bet the S&P goes up, but instead goes down. Within the -10% to 10% range, you will outperform at all levels. The lesson is that you should probably not be in the business of predicting however, as we want mindless. Instead, just take the nice middle ground and sell yearly options at the current SPY price and then sit back. If the market does nothing for the year, you beat it by 9%. If it goes up by 10% it's a draw and if it goes down by 10% you actually beat it by 15%, although your actual return is solely based on income of 5.3% if you bet on a 10% rise. In that event your shares go unassigned and you begin the process all over again at a new set of strike prices, knowing that successive years of double digit losses are quite rare.

Of course for those that do want to complicate things a bit as the year moves up one can still be relatively mindless and practice some form of cost averaging with an eye toward developing a new cost basis once it's time for the next option cycle, but I'm not going there. That may require too much effort. Can you do this while in a coma? Maybe not, but you don't have to be too far removed from your own flat line to profit from a flat line.
 
If you want to talk about how potential market events or the fiscal cliff might affect your equity portfolio, and perhaps talk about whether some of our defensive-minded investment strategies might be right for you, write Multiplywealth at notice@multiplywealth.org
It’s your own account; you can see the balance change on a daily basis, make investment changes extremely quickly, and add to or pull your money at your complete discretion.

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