Selling Volatility

Today I was reading in Barron's about an interesting idea. The idea is for skittish buyers to use options to hedge their bets. It's an interesting strategy. Let's take a look at how it might play out given my current price projection targets. Here's the SPY chart as a reminder:

I have a very strong belief that the market will hit 106. I think the actual bottom is likely to be between 106 and 102. As indicated in previous blog posts I think the most likely scenario at that point would be a retracement back up to 120 (about where it is now) and then a fall back to the same area for a retest. I believe there is a smaller chance that the market would fall back further to the 90 area. I believe there is little to no chance that the market would get all the way back to the 2009 lows.

The option strategy is to sell a put at the price that you would be willing to buy. So given our probabilities, I'd be willing to buy at 106. I'd be very willing at 102. I'd bet the farm at 90.

The upside to the option strategy is:
1) You earn the time premium while waiting for the stock to fall to where you think it is going
2) You get a consolation prize (the option proceeds) if you're wrong and the market never gets where you're going
3) You get a bonus (the option proceeds) if the market falls to where you think it's going, but it doesn't get there before expiration

The downside risk is:
1) If the market falls further than you're expecting then you're locked into the target price. For instance, say you had a 106 put but the stock fell to 102. Now you're worried it might fall to 90! You're options then are:
   a) Buy back the option and pay a very steep penalty because the price has gone way up from volatility
   b) Short the stock and risk getting whipsawed
   c) Suck it up and own the stock for the long term
2) Not so much of a risk but an opportunity risk is that the stock falls very close to the strike price but doesn't quite make it. Then if you want to buy the stock you'd have to double your capital commitment, at least until the option expired.

So basically, this is a tradeoff of many upsides with high probability moderate return vs. one downside but it's a doozy. Let's see how the numbers actually work out. Here are the latest quotes on options for the three price points I've identified:

SPY Sep 30th @ $90           .37-.45 (down 25% on Friday)
SPY Sep 30th @ $102         1.10 - 1.09 (down 32% on Friday)
SPY Sep 30th @ $106         1.57-1.67 (down 15% on Friday)

The first thing to notice is that this would have been a much better strategy if we'd done it Thursday when the market was down! Oh well. You could wait and buy it when the market is down again...if you're sure the market is heading down. Note that now you're gambling with upside #2, the consolation prize.

Let's take the conservative approach and assume that we sold at the bid:

$90 = $9000 capital earning $37 over 30 days: 5% annualized return
$102 = $10200 capital earning $110 over 30 days: 13% annualized return
$106 = $10600 capital earning $157 over 30 days: 18% annualized return

Well, since I'd be wiling to bet the farm at $90 then selling those options ends up being a nice alternative to keeping the money in cash. If the market does come down to 102-106 then these options (or the October equivalents) will get very expensive and offer an even better yield. Pyramiding a position in this option is a nice strategy if one is holding cash in reserve for a potential bargain basement day. This is basically like getting a 5% yield on a one month CD! (Note that this doesn't include commissions. The price for a single contract trade at Interactive Brokers would be $1 so the price is negligible. The same cannot be said for some other brokerages).

The $102 - $106 levels offer better annualized returns but one needs equivalently greater conviction that the price level will hold and a good strategy to manage whipsaw risk. Here I don't think the premium is worth the risk if one really wants to buy the stock. There's no guarantee that the option holder will put the stock to you and so you need twice the capital. You could easily miss $600 worth of upside appreciation while stuck holding a $100 option through to expiration.

So in conclusion, I don't think the Barron's strategy is a good one for nervous buyers because of the complication involved in managing the expiration dates. However, I do think that selling the deep puts is a very good strategy for earning a yield on idle cash that would be deployed if the market reached that level. Given that volatility is very high, there's no guarantee that the $90 options (even for future months) will get more expensive.

Given our very strong belief that 90 would mark a bottom and tremendous buying opportunity. One might even consider a ladder of puts out to October, November, December. Heck for super idle cash one might consider:

SPY Dec @$74         .61-.68:  3.3% annualized yield

These are 30 year yields for 3 months with the downside risk being a complete market catastrophe. If a retest of the 2009 lows doesn't market a buying opportunity then what would? Again, if volatility remains high and the market does sink down to 106 in the next week or two then this yield might even spike. What an opportunity for idle cash that would be.