Lessons from the Pros


More Happy Days?

Even after a pretty good drubbing on May 22-23, the S&P 500 index was still showing an 18% year-to-date gain for 2013. SPY, the exchange-traded fund that tracks the S&P 500, was at $165.42 per share, a $23 gain from $142.41 at the end of 2012.

Last week’s article was called “Happy Days Are Here Again.” I noted that equities markets were making new highs day after day, as they have been for some time. I said that there were several ways for longer-term traders to respond to a situation where they had big gains, to try to balance the desire to keep making money if the bull market continues, against the need to guard against giving up too much of the gains that have been made to date.

Below are the option-related alternatives I listed. Let’s compare some of them to see their pluses and minuses in the current environment.  Here’s the list of possibilities:

A. Keep the stock position; sell call options to collect premium that will cushion some downside movement.

B. Keep the stock; buy put options as insurance.

C. Combine the above two alternatives. Keep the stock; sell call options; use the call proceeds to buy put options as insurance. This then becomes a collar, also known as a fence or split-strike conversion.

D. Sell the stock position. Determine at what price we would be willing to buy back in, and sell put options at that strike price. This enables us to bank our profit now, and be paid to wait for the stock to reach our buy price.

E. Sell the stock position and bank the profits. Use some of the cash to buy call options to participate in further upside movement. We still have unlimited upside profit, and most of our money in our pocket.

F. Consider other variations of choice E., substituting for the long calls cheaper  bullish option strategies, such as vertical spreads, horizontal spreads, diagonals, call backspreads or butterflies.

As a first pass at deciding among these choices, consider the Implied Volatility (IV) situation. IV measures how relatively cheap or expensive options are. It does this by measuring the expected rate of change in the price of the underlying asset, that is being signaled by the prices where options are trading.  When traders believe that the underlying price will change fast, they pay more for the options, driving their prices up. IV is expressed as an annualized percentage. An IV level of 15% means that option buyers and sellers in the aggregate believe that price is likely to change at a rate near 15% per year.

As of May 23, the IV of the S&P 500 was at 13.6%. In the preceding 12 months, IV of the S&P has been as low as 11.1 % (last week) and as high as 25%. For perspective, in the crash of 2008, IV briefly was as high as 90%, and stayed above 50% for many weeks.  So at 13.6%, we’d have to say that IV was quite low.

This is important in selecting our option strategy. When IV is low, options are cheap. When it’s high, they’re expensive. When it’s very low, as it is now (May 23), IV is more likely to have a big increase than a big decrease going forward. Increases in IV that happen while we are long options (whether puts or calls) push upward on the price of our options, which is good. On the other hand, if IV increases while we are short options (as in covered calls, naked sort puts, or cash-secured short puts), that is bad for us. We could have to pay more to buy back the short options than we received for selling them.

This pretty much eliminates short options strategies from consideration at this time, which knocks out alternatives A. (selling covered calls – doesn’t pay enough) and D. (short puts – also doesn’t pay enough). That leaves the alternatives where we are long options.

Alternative B. is to keep the stock and buy put options as insurance. With puts quite cheap compared to their historical levels, this might be viable. If we wanted a low-premium, high-deductible insurance policy, we could buy August 2013 puts at a strike price of $157 for about $1.70 per share, about 1% of the current price. These puts would give us a guaranteed sell price of $157 for the next 3 months, no matter how low SPY might go. So in the worst case we would “give back” $8.42, or about a third of the year-to-date gains. This would still leave us comfortably ahead (from a long-term investor’s standpoint). We would still have unlimited upside potential if SPY should continue up. Owning the puts doesn’t force us to sell the SPY at $157 – it just gives us the right to do so if we need to.

It’s rare that buying puts as insurance is a good bet. They’re usually too expensive for the amount of protection they afford. In the current case, however, they could be a good answer if you’re willing to give back up to 6% to insure against larger losses, accepting that you would have “only” a 10-12% YTD gain if SPY should immediately crater. You would still retain the potential for unlimited profits in case the rally continues.

Next week we’ll continue looking at our bull-market alternatives. The remaining ones also involve buying options now while they’re cheap. They provide different sets of tradeoffs between the amount of profit to bag now vs protection from losses in case of a new crash.

For questions or comments on this article, contact me at rallen@tradingacademy.com.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.