On March 14th, the S&P 500 approached to within a whisker of its all-time highs. A couple of weeks ago it appeared that Implied Volatility (IV) was finally coming up from its multi-year lows. I wrote that it was time to pack up the “ultra-low-volatility strategies” and break out the “just-low-volatility strategies.” But IV has once again dropped back into ultra-low territory. What could happen from here?
Well, anything could happen, of course. The market might continue its rally, in which case IV could continue to drop even lower. During the sustained rally from 2003-2007, at times IV did spend months near these IV levels and even lower.
Or, the market might fail near this mega-supply level, and pull back or even reverse. In that case, IV would probably rise.
A good case can be made for both the bullish and the bearish argument. Let’s assume we’re more persuaded by the bearish side. After all, this is a supply level on any chart timeframe. It’s also a confluence of several important Fibonacci levels, if you follow those. Economic fundamentals are pretty good, but not that good. Multiple shoes are ready to drop all over the world, as they always are, any one of which could precipitate a crisis. By the time you read this article, we’ll know whether the line has held or not.
But for today, let’s call this a bearish situation, with the direction of IV uncertain. What would be a useful strategy for that outlook?
One choice here would be a Put Butterfly. This might seem an off-the-wall suggestion, but it really isn’t. Assuming the bearish outlook, and the desire to be neutral as to volatility, it fills the bill.
Currently, SPY, the ETF for the S&P 500, is just under $157. It has an average weekly range of around $3.00. There is a strong demand level a bit above $141, which could conceivably be hit in a month or so in the event of a strong drop. With these numbers in mind, let’s build our position.
A Put Butterfly is built around a long Put. On its own, that is a bearish position. It has negative Delta (it profits from a drop in the price of SPY); positive Gamma (it needs price movement and loses if price stands still); negative Theta (it loses time value every day); and positive Vega (it is affected strongly by changes in IV, profiting from a rise and losing from a drop). We are buying the Put for its negative Delta, but we would like to eliminate its Vega (sensitivity to IV).
Since we expect the anticipated price drop to take place within a month, we’ll buy a put that will not decay too much in that time. Its strike price will be a little higher than the price where we would place a stop if we were shorting the SPY. Adding about a weekly Average True Range ($3) to the current price of $157, we’ll select the June 160 Put. We could buy that on March 14 for $643.
If SPY does rise above the 160 stop price, we’ll plan to exit the whole position. We’ll also plan to get out if a month passes with no movement, if the position still has negative theta at that time. It might in fact have positive Theta, as explained below. In that case, we will hold until our downside target is met, expiration, or convincing upward reversal signals, whichever comes first.
The next step is to neutralize our exposure to changes in IV. To do that, we add two short puts at a strike price that is below our 141 target price, with the same expiration as the long June 160 put. The June 140 Puts will do the trick. We could sell them for $85 apiece, for a total credit of $170. We’ll plan to exit the position and take profits if SPY drops to 140 within our time frame.
Now we have one long put, and two short ones. That makes one of the short ones naked. We don’t want the unlimited downside risk of a naked short put. So we’ll add one more long put at an even lower strike, to cut off that unlimited risk. This one will be at a strike that is lower than our short puts by the same 20-point margin as our first two strikes (160 – 140). That makes it the June 120 Put. We could buy this one for $19.
Our complete price tag is:
– One long June put $643 money out
– Two short June 140 puts at $85 each ($170) money in
– One long June 120 put $ 19 money out
Total $492 money out
Once again, the June 160 Put is the whole point of the exercise. The other three options are just tagging along to reduce our Vega (exposure to changes in IV). We hope that the June 160 gains in value and that all the others expire worthless. If so they will have done their jobs.
Below is the payoff diagram for this trade.
Here are the salient points about this diagram:
- Current price is $157. This is just to the right of where the curved P/L lines cross the straight green line.
- The entire expiration P/L curve (green line) looks like an inverted V flanked by two horizontal lines. Profit increases as SPY’s price drops from the current $157 level (moving left on the chart), and peaks out at our $140 target (the short put strike). Profit then declines with a further drop in price.
- The relevant part of the diagram to us, is just that portion in the gold box. That covers the price range between our $140 target price and our $160 stop price. Outside that range, we’ll be out of the trade.
- Even if we fail to exit the trade, or price gaps by a huge amount, our loss is limited to the net debit we paid to enter the trade, which is $492.
- The blue line is today’s P/L curve (March 14). The magenta line shows the P/L curve a month from now, assuming the same IV as today. The yellow line is the P/L curve a month from now, assuming that IV increases by half, to 18%.
- The magenta and yellow lines show that in a month, at our $140 target price we would make around $750; and that at our $160 stop price we would lose about $150-175.
- The yellow and magenta lines, which represent P/L a month from now at 18% and 12% IV, respectively, are very close together. Different volatility, same P/L – this demonstrates that we have in fact neutralized volatility.
- Theta is currently slightly negative (curved lines above straight green line). It becomes positive (curved lines below the straight green line) at SPY prices below around $153. Below that price, if nothing has happened to change our bearish outlook, we don’t have to be in any hurry to exit. Time will then be on our side.
So there you have it. A bearish trade with little impact from IV, a good reward/risk ratio, and limited risk. Just what we were looking for.
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