Derivatives and FIRE (Financial Independence and Early Retirement) sound like two things that don’t mix. Like oil and water. Financial derivatives (options, futures, etc.) have the aura of opaque and highly risky investments. On the way to Financial Independence, most people are either oblivious to derivatives or avoid them like they carry communicable diseases. Probably derivatives are also traded in some smoke-filled backroom or an illegal gambling joint, right?
Let’s look at the myths vs. facts!
Myth: ordinary investors should never touch options
Truth: if you currently own stocks and/or corporate bonds you already own options, whether you realize it or not. Equity in a corporation is essentially a call option on the enterprise value (the sum of all the firm’s assets) with a strike price equal to the firm’s debt. The firm’s bonds are a risk-free bond with a short put option where the strike price again equals the debt face value. In other words, as a bondholder, you lose money if the value of the assets drops below the debt load and the firm declares bankruptcy.
If you think that this is thought-provoking and brilliant, thanks, but unfortunately it’s not my invention. It’s called the Merton Model, named after Robert Merton, the famous finance researcher, professor and Economics Nobel Laureate.
Myth: Derivatives are too complicated for the average investor to understand
Truth: Some derivatives may be too complicated for the average retail investor to handle (e.g., Swaps, Swaptions). But options and futures are actually very easy to understand, trade and maintain. In fact, I would pose the following challenge:
If you liked playing with Legos and building blocks as a kid, you will enjoy trading futures and options in your portfolio!
In other words, if you liked constructing, taking apart and rebuilding things and then rebuilding them bigger and better, then futures and options are going to be very exciting in your portfolio. Here’s one example of how the Lego and building block analogy works:
Step 1: recognize that the equity index return, including price movements and dividend payments, has to yield the same return as an investment in futures contracts. Any difference in return prospects between them would be quickly arbitraged away.
Step 2: hence, the two building blocks that exactly replicate the equity index return are holding cash at the current prevailing overnight interest rate and a long equity index futures position. The expected return on that investment is the same as the equity index expected return.
Step 3: why would I want to hold a lot of money at currently 0.375% p.a.? Let’s replace the boring low-yield cash building block with something more exciting: higher-yielding bonds! This could be a government bond fund (e.g., iShares ticker IEF, 7-10Y Treasury bonds) with a slightly negative correlation to the equity exposure. Or corporate bonds with an even higher yield, though the diversification potential is also lower. We’re killing two birds with one stone; higher expected return and lower risk through diversification.
Side note: A great advantage of this method: You can mix in close to 100% bonds into the portfolio, without reducing the equity exposure. That’s much better than replacing a few % equity with bonds with hardly any diversification benefit, see our previous post The Great Bond Diversification Myth.
Step 4: well, regular bonds are a bad idea in a taxable account. Let’s replace them with tax-efficient Municipal bonds, at a slightly lower pre-tax yield but higher post-tax yield. We also realize that the equity futures portion is taxed as 40% short-term gains and 60% long-term capital gains (regardless of holding period due to IRS Section 1256). To overcome this effect, let’s scale up the equity portion by a factor of about 1/(1-tax rate). Or maybe even a little bit more because our bond portfolio diversifies our equity risk.
Step 5: the after-tax return of the whole thing should now be higher than even the before-tax return of the regular equity investment. All the while, volatility is contained due to the negative stock-bond correlation and the whole construct has a correlation with our other equity holdings of less than 1.0.
If I can do this with my daughter’s Legos I can do this in a portfolio! So, dealing with derivatives is not all that complicated, conceptually. Trading futures in practice is just like trading equities and ETFs, with limit orders, market orders, etc. The one difference is that futures contracts have an expiration date and once that date approaches one would have to sell the current contract and replace it with a later-dated contract, a process known as “rolling the contract.”
Myth: derivatives are risky
Truth: they can be, but they don’t have to be. Quite the opposite, a very popular strategy implemented through options is the so-called “covered call” strategy. You own the underlying stock and sell a call option, thereby selling the upside potential of the stock you own. Thus, you will experience lower risk than holding the underlying stock only:
A lot of academic research has pointed out the superior risk-adjusted performance of strategies with this style, see a piece by Ibbotson. That paper was written in 2004, but results are updated to 2012 in this piece by CBOE, so this approach worked also during the Global Financial Crisis. The covered call writing and put writing indexes all had comparable average returns vis-a-vis the S&P500 but a significantly lower risk level (10%-12.5% vs. 15% in the SP&500).
By all subjective and objective criteria we can think of the covered-call strategy is less risky than the direct equity index investment!
Why is this strategy, selling the upside, uniquely suited for the Early Retirement crowd? If you have already achieved Financial Independence, you no longer need to throw financial “Hail Mary passes” or shoot the moon, or win the lottery, whatever you want to call it. You have already saved enough for a comfortable life and all you need in terms of upside potential is the inflation rate plus withdrawal rate plus maybe a few more percent cushion to make up for occasional losses.
Again, to use our Lego analogy, we can split the equity volatility into upside and downside risk and sell off, for a nice premium, of course, the portion that we don’t need very urgently right now. So, wouldn’t you be willing to give up some of the upside in exchange for a relatively stable cash flow of option premiums? A yield that can easily surpass the dividend yield in your average equity portfolio? I would! And I can do that very easily and cheaply with options. There are some companies that will do this for you (Wisdom Tree has an ETF, ticker PUTW) but they charge you 0.38% for something you can do yourself for a fraction of the fees.
A lot of personal finance bloggers, e.g. Amber Tree Leaves, Investment Hunting, The Retirement Manifesto, and many others, implement the covered call writing strategy on individual stocks. Yours truly, Mr. ERN, implements this with options on index futures (more details in our post on option writing). And, you guessed it, the advantage of implementing this with futures is that we can use the same building block methodology as above: Hold the margin cash in (tax-free) Muni bonds, implement the option strategy on margin, scale it up to a comfortable after-tax risk level and enjoy! More details here.
Myth: derivatives are expensive to trade
Truth: it’s partially true. I would never trade futures contracts at a regular brokerage firm, like Fidelity. The fees are too high. But some brokers specialize in derivatives trading, for example, Interactive Brokers, which is the firm we use. The trading and maintenance of a simple long equity futures contract is in the low single basis point range (~0.02-0.03% p.a.), which is even slightly cheaper than the lowest cost equity index ETFs.
Myth: derivatives are opaque and unregulated
Truth: most derivatives are trading on highly reputable exchanges and are regulated to ensure integrity and investor protection. In the U.S., options trade on the CBOE, and futures and options on futures trade on the various exchanges belonging to the CME group. The CFTC (Commodity Futures Trading Commission), the SEC (Securities Exchange Commission) and a few other authorities (public and industry) keep everybody honest.
Some options are indeed unregulated and there’s potential for fraud and abuse. The SEC has recently issued a fraud alert (as well this warning) on binary options. We personally stay away from binary options because they seem too much like a pure gamble.
More information
- Option education podcasts (via The Options Industry Council). I checked out some of the option education videos and they are pretty good!
- Whaley: Derivatives (paid link) – Book on everything derivatives. Includes an Excel add-in with option pricing formulas. Geez, that book is expensive now. I think I paid only ~$80 many years ago.
- National Futures Association: Education on everything Futures related.
Conclusions
- Everybody who owns stocks and corporate bonds already has option exposure of sorts.
- Options and futures are a great way to fine-tune the FIRE portfolio and increase exposure where desired or sell off the upside potential for guaranteed extra yield (covered call strategy). After getting over my initial fear of derivatives, I’ve been very happy with my recent performance.
- If you are trading with a reputable brokerage you should be safe from fraud, but still, educate yourself before investing. Even with perfectly legitimate brokers, you could still legitimately lose a lot of money. Never use excess leverage. A little bit of carefully measured leverage is OK, see our previous posts Lower risk through leverage and How to create a no-limit Synthetic Roth IRA in a taxable account.