Creating an All-Weather Portfolio Using Poor Man’s Covered Calls - Cabot Wealth Network

Creating an All-Weather Portfolio Using Poor Man’s Covered Calls

gld-poor-mans-covered-calls

Over the past year I’ve discussed several of the income strategies I like to use in my overall portfolio, covered calls and poor man’s covered calls.

Today, I want to focus on how to build out a portfolio using a poor man’s covered call strategy.

Now I tend to take a diversified portfolio strategy approach. And by using poor man’s covered calls I can diversify my strategies of choice far easier. For instance, I might use poor man’s covered calls on an All-Weather portfolio, Dogs of the Dow portfolio, Growth/Value portfolio, Contrarian portfolio, Earnings Yield portfolio and several others.

The one stalwart is the All-Weather portfolio, which is what I’m going to focus on today.

The All-Weather portfolio is a portfolio that is available to the masses. All investors have access to some form of the risk-parity-based All-Weather Fund that was created by legendary hedge fund manager Ray Dalio.

The portfolio is designed to survive all different types of market environments.

Here is a breakdown of asset allocation:

  • 40% long-term Treasuries
  • 20% U.S. stocks
  • 10% International
  • 15% intermediate-term Treasuries
  • 5% commodities, diversified
  • 5% gold

Next, I want to find a few ETFs that work. The selection is harder than you think because we have a few more requirements than just buying the ETF outright. We need to think about an ETF that:

  1. Falls into one of the asset classes above.
  2. Has liquid options.
  3. Offers LEAPS that have roughly two years until expiration.

Thankfully, there are choices, but I wouldn’t say they are plentiful. Liquid options markets can be tough in certain asset classes. As a result, I have no choice but to alter my allocation to differ ever so slightly from Dalio’s allocation.

Here is the allocation I use:

  • iShares 20+ Year Treasury Bond ETF (TLT)
  • SPDR S&P 500 ETF (SPY)
  • iShares MSCI EAFE ETF (EFA)
  • SPDR Gold Shares ETF (GLD)

The four ETFs above allow me the opportunity to buy LEAPS that have at least two years in duration. Again, the goal is to buy a LEAPS as far as possible and continue to sell short-term calls against my LEAPS contracts. Once my LEAPS have roughly 8 to 12 months of life left, I then begin the process of rolling my LEAPS contract out as far as I can and continue the process of selling more premium.

Historically, I have been able to outperform major market indices by three to five times using a poor man’s covered call approach while simultaneously limiting my downside risk.

Here is an example of how I would initiate a position.

SPDR Gold Trust ETF (GLD)

The SPDR Gold Trust (GLD) is currently trading for 172.75.

GLD-stock-chart-may-11

I choose my LEAPS call contract by the delta of the option. I prefer to initiate a LEAPS position by looking for a delta of 0.80. With a delta of 0.78, the January 19, 2024, 145 call strike with 618 days until expiration works.

GLD-LEAPS-poor-mans-covered-calls

I can buy one options contract, which is equivalent to 100 shares of GLD, for roughly $37.60, if not slightly cheaper. Remember, always use a limit order, never buy at the ask price, which in this case is $37.90.

If we buy the 145 strike call for roughly $37.60, we are out $3,760, rather than the $17,275 I would spend for 100 shares of GLD. That’s a savings on capital required of 78.1%. Now we can use the capital saved ($13,515) to work in other ways, preferably to diversify our poor man’s covered call strategy among other stocks and ETFs.

Once we make the initial LEAPS purchase, we can maintain that position and focus on selling near-term call premium against our LEAPS each month – thereby generating income and lowering the original cost basis with each transaction.

I begin the process of selling shorter-term calls against my LEAPS by looking for an expiration cycle with around 30-60 days left until expiration and then aim for selling a strike with a delta ranging from 0.20 to 0.40, or a probability of success between 60% to 85%.

As you can see in the options chain below, the 178 strike call with a delta of 0.31 falls within my preferred range.

GLD-poor-mans-covered-calls-short-calls

I can sell the 178 call for roughly $1.92.

My total outlay for the entire position now stands at $35.98. or $3,568 ($37.60 – $1.92). The premium collected is 5.1% over 37 days. Not a ton of premium, but remember, we are going out 30 days and using an ETF that has, by most comparisons a low level of implied volatility (IV).

But remember, if we were to use a traditional covered call our capital outlay would be $17,275 and our return would be 1.1%.

Also, the 5.1%, or 45.9% annually, is just the premium return, it does not include any increases in the LEAPS contract if the stock pushes higher. Since our initial delta is 0.47 (0.78 – 0.31), the LEAPS contract will increase by $0.47 for every dollar GLD moves higher.

The overall delta of the position will eventually hit a neutral state if GLD continues to move higher over the next 37 days. If it does, we simply buy back our short call and sell more premium.

Delta is a major factor in managing poor man’s covered calls. I’m going to start going over the Greeks, including delta, theta and gamma next week. Stay tuned!

So, as you can see above, we have the potential to create 5.1% every 37 days, or approximately 45.9% a year using a fairly conservative ETF like GLD. This is our baseline and should be our expected return in premium, but again this does not include any capital gains from our LEAPS position if GLD trends higher.

My next steps would be to add a position in SPY, EFA and TLT using the guidelines mentioned in my GLD example above.

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