Rising Rates and Options Strategies in 2014

A second common trade is the collar. Typically, investors look to transact in a "zero-cost" collar, whereby one writes a 5% out-of-the-money call option and purchases a put option in the same expiry such that he is not paying or collecting the option premium. At the onset, this trade's expected value at expiration is 5.0% assuming no change in the level of the S&P 500.   As the market moves, the position is fully capped on both the downside and upside at -11% and 5%, respectively. 

In the third trade example, we take a different position using a cash protected put with a strike price 5% beneath current levels.  Here, our upside is capped at roughly 5%, but our downside profile is more attractive. In a market down 10% in 2014, the position can expect to lose only approximately 30bps. 

The outcomes displayed in the preceding tables depict the challenge of the strategic allocation decision. On one hand you are at risk of a rising rate environment eroding away principal, and on the other, you are constructing a skew profile that limits your upside, but protects your equity portfolio from outsized losses. In a market on the heels of the sustained bull run since the lows of March 2009, this could be a potentially valuable trade. If we assume a scenario where the U.S. creates a modicum of GDP growth in the early part of 2014, driving the 10 year up to 4%, and the equity market merely trades flat, these basic option strategies will have many opportunities to outperform. 

This is outlined not to advocate any one strategy or asset allocation, only to provide a probabilistic viewpoint to the investing climate today. As one considers a move into options strategies from a fixed income portfolio, it is worth examining the breakeven scenario. As we touched on earlier, if the 10-year yield rose to 4%, bonds prices will fall. In our example, LQD could see 4% depreciation, while GVI potentially returns -2.3%. For the three said option strategies to generate similar performance, the equity market would have to return -10% in the ATM buy write, -6% using the zero cost collar and -14% in the 5% OTM cash secured put.  

Essentially, unless the equity markets tumble severely, these options strategies will provide fixed-income-like volatility and a return stream correlated to the equity market, but with a fair amount of downside buffering or even outright protection.  

If rate increases put the brakes on what has been a 30-year bull market in credit, this seems like a logical alternative.