Stages of Hierarchy



Introduction to Stages

     The Stages of Hierarchy attempt to present a prioritization to the numerous investment opportunities.  For example, paying down a revolving credit card balance that charges 20% annual interest should take priority over investing in a money market account that pays a 1% annual return.  Likewise, establishing tax preferred accounts takes priority over standard accounts.  Following general principles provides a framework for balancing investment priority.

     The Stages listed are not definitive rules applicable to any situation, however.  Investor age and time frame may significantly alter the prioritization, as will investor knowledge and experience.  Young investors looking at a 50-year time frame for investment may well prefer, and take advantage of, the leverage available in certain equity option securities in specific conditions.  Account balances and progress against retirement goals will have an impact on investment choices.  Personal health, family situation, employment and income expectation, lifestyle choice, and risk tolerance all play their part.  Balance is a key component to any financial plan.

     Providing a framework is a double-edged sword.  It does offer a perspective for prioritizing investments and investment choices, but it must also remain flexible enough to accommodate the large variance in personal situations.

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Targets by Hierarchical Stage

Note: Targets may vary by stage based on knowledge and experience of the investor, age of the investor, size and type of accounts, personal goals and opportunities, and personal risk tolerance.

Accounts by Hierarchical Stage

Note: Targets may vary by stage based on knowledge and experience of the investor, age of the investor, size and type of accounts, personal goals and opportunities, and personal risk tolerance.

Wealth Accumulation

     In The Millionaire Next Door by Thomas Stanley and William Danko, the authors establish a formula for assessing a person’s wealth accumulation.  Through their research, an Average Accumulator of Wealth (AAW) should have a net worth equal to:  Current Annual Income * Age * 10%.  A Prodigious Accumulator of Wealth (PAW) should have 2x the AAW level, while an Under Accumulator of Wealth (UAW) would have 50% of the AAW level.  Critics note that this estimation poorly accounts for younger people who have had little time to save in their career.

     While no assessment of net worth will be universally accurate, the Millionaire metric can serve as a worthwhile reference if applied with situational understanding.  The further an investor falls into the PAW category of wealth accumulation, the more likely that higher stages for investing are appropriate.

     As an example, assume a 50-year-old doctor with an income of $250,000 per year.  The AAW level of net worth is $1.25MM.  A PAW would have $2.5MM in net worth while a UAW would have only $625k.

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Summary of Hierarchical Stages

     Delving into the details of the Hierarchical Investing Stages along with related account types falls beyond the scope of Strategic Option Investing.  The provided framework may offer a general guideline to prioritization, but individuals with specific knowledge and personal situations will make the investment decisions.  The internet abounds with detailed information for prioritizing investments, investment vehicles, taxation effects, risks, returns, asset allocation, and investment choices.

     Rather than swim against the current, a generalization provides better guidance.  Investing with leverage or with options provides better returns when conducted in tax preferential accounts.  Investing with leverage and options works better with knowledgeable and experienced investors.  It is recommended to have long-term time horizons when investing with leverage (or, in fairness, when investing in any asset).

     The internet provides a great deal of information on option trading strategies, focused on time-frames less than 45 days.  However, there has been little interest to date on long-term option investing strategies, the focus of Strategic Option Investing.

Complexity in choice …

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… transformed into …

… standard priorities

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Account Set-Up / Recommendations

  • Fund tax-advantaged accounts to limits prior to investing in standard taxable accounts
  • Utilize a dual-account framework for option investing, with portfolio allocation based on dual-account value (sum) and investment size based on notional exposure
    • A tax-free account, such as a Roth IRA, holds the long delta option positions as the ‘Offensive’ or ‘Aggressive’ Account
    • Counter to the Offensive Account, the ‘Defensive’ or ‘Passive’ Account holds lower risk securities, Section 1256 contracts, and standard stock holdings
  • Option investing inherently requires more transactions than long-term buy-and-hold (even LEAPS are restricted to three-year maximum expiration cycles)
    • With every transaction or rollout, the holder is susceptible to a realized gain on an appreciated investment
    • Employing a dual-account framework shelters high transaction, tax-susceptible assets while placing more tax efficient assets in standard accounts

Account Relationship Example

1) Blue (Offensive) and Orange (Defensive) are each valued at $100,000.

2) Blue is a Roth IRA and Orange is a standard taxable brokerage account.

3) The only non-cash holding is 100 shares of XYZ in Orange, priced at $150/sh.

4) After researching the options market for XYZ, the holder wishes to use options to replicate the position while employing the reduced cash outlay for a financial return benefit.

5) 100 shares of XYZ are sold from Orange for $15,000

   1) Blue buys 1 XYZ 365 DTE Call $80 for $72

   2) Blue sells 1 XYZ 35 DTE Call $170 for $2

6) Blue manages covered call if needed.  Orange invests incremental $8k by selling a SPX Vertical Put Spread with 180 DTE at 3 Delta (40% below market).  If successful, return on this vertical is approximately 4.5% p.a.

7) Provided SPX remains above 60% current level (no market crash >40%)

   1) Blue has notional exposure to XYZ nearly equal to 100 shares

   2) Orange realizes $360 on SPX Put Spread (assuming rollouts with expiration), benefitting from Section 1256 tax treatment

8) Assume after-tax return on SPX Put Spread of $272 (24.5% net tax rate).  XYZ overall return increase by $272.

   1) Calculated on long stock with $15k, +$272 equivalent to +1.8% return

   2) Calculated on options as stock substitute, +$272 equivalent to +3.9% return