Last week, the S&P 500 notched another record high. The new Fed chair has indicated that she’s ready to continue printing money until hell freezes over. No one knows how long the present rally will continue. The one thing we do know is that it will not be forever.
Implied volatility (IV) measures the expectations of option traders of the annualized rate of change of the underlying asset. High IV means expensive options, and low IV means cheap options. Last week the IV of the S&P 500 index was around 12%, making option prices nearly their cheapest since the 2003-07 bull market ended.
What can an investor (as opposed to a trader) do in such an environment?
The conservative option strategies often employed by investors are covered calls (selling call options against a long stock position); and cash-secured short puts (selling put options against cash in the brokerage account). Both of these are neutral-to-bullish strategies that work well in times of “normal” levels of implied volatility. But with options as cheap as they are now, an investor is being paid very little for doing either of these things.
If options are too cheap to sell, then it might make sense to buy them. Here are a couple of ways that an investor might benefit from the current cheap option prices.
First and most simply, if we owned stocks we could consider buying put options as insurance against a downturn in prices. It is usually the case that puts on the equity indexes are overpriced, so that the insurance they offer is usually not a good deal. By this I mean that the expected rate of underlying price change that’s usually built into these option prices rarely ends up actually happening. But with options now so cheap, this could change.
As of last Thursday, the SPY (S&P 500 exchange-traded fund) was a few pennies away from $180.00 per share. This is a year-to-date gain of over 28%. With a budget of an arbitrary amount of 5% of the current value of SPY, or $9.00, and a time horizon of a year, what kind of protection could we buy?
Looking at the December 2014 option chain, we see that the 168 strike puts were quoted at an $8.90 asking price. These puts would insure us against any further loss after SPY fell below the 168 strike. Our maximum total exposure (maximum loss we could sustain, even if SPY became completely worthless) would be the $12 difference between the current price of $180 and the $168 strike price; plus the $8.90 for the puts themselves. That’s $12 + $8.90 = $20.90 per share. That $20.90 works out to 11.6% of the current $180 value. In the worst case, we would still have locked in a big net gain for the year of over 16%.
Note that owning these puts would not prevent us from selling covered calls on our SPY shares. We could still sell calls each month (or even each week, if we wanted to put in that much effort). Since options decline in value very fast in the last part of their lives, we might very well eventually collect as much or more for the string of calls than we paid for the puts.
In fact there is a name for the strategy that includes long stock, long puts, and short calls. It is called a collar. In this case, where we sell short-term calls and own long-term puts, we could call it a diagonalized collar.
What if we do not currently own SPY? Owning the long-term puts at this time could turn out to be a good move even so. IV is now extremely low. Options are priced for perfection. If anything happens to upset the market, IV will increase, pushing upward on the price of the puts. With an expiration a year away, the offsetting time decay will be very slow. We can afford to wait a while for the puts to pop.
Meanwhile, as we’re waiting for the puts to rise in value due to a drop in SPY and/or an increase in its IV, we could use the puts as a component of other strategies. One of these would be a series of diagonal spreads. In this strategy, we would sell put options with nearer expiration dates. Each time one of them expires, we would sell another one. The premiums we collect on these multiple short puts would chip away at the cost of the long puts. If and when IV increases, we would benefit because our long-term puts would increase in value more than the shorter-term puts we have sold.
For example, the December 2013 $171 puts were bid at $.48. The $171 strike was almost 2 standard deviations away from the current $180 price, and so statistically likely to expire worthless. Selling it would reduce our cost on the December 2014 puts. Repeating this each month (or once again, weekly if we want to put in the effort to identify a suitable strike price each week), we would reduce the cost of the long-term puts substantially.
I hope this has stimulated your thinking about buying puts when they’re cheap, either as a hedge or a speculation. Buying volatility low and selling it high is the way to use options for an “edge with an edge.”
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