Over-Reliance on 'Greeks' Can Be Detrimental in This Market

 |  Includes: EEM, EFA, EWY, EWZ, FXI, RSX, SPY

Knowing that I hold protective LEAP puts on the underlying ETFs in my portfolio, one of my followers sent me an email asking if I intended to shorten the duration (i.e., time to expiration) on my put options to take advantage of recent "vega effects."

In thinking about my response to this question, I came to the conclusion that yet another way to differentiate an options 'trader' from an options 'investor' is whether or not he/she considers vega to be important.

Vega is one Greek that, happily, I don't think I will ever have to consider when balancing my options positions.

So what does drive my selection of LEAPs? Well, first it is important to understand that I share the Buffett philosophy of "forever" being my favorite holding period.

I intend to hold all those country ETFs (e.g., EEM, EFA, EWY, EWZ, FXI, RSX, SPY, etc.) I have in my portfolio until a revolution shuts down their capital markets. And even then someone will be on the hook for the protective puts I have in place.

So this also means I have a "buy and hold" mentality for LEAP puts as well.

Using SPY as an example, from September through April the S&P 500 index increased by an astounding 25% or more. I had a pretty strong conviction at that time (April) that the S&P 500 couldn't continue on its steep upward trajectory much longer.

Looking at the volatility trend plot below, you can see that IV was quite low during the April timeframe. I felt this was a good opportunity to both a) extend the duration of my LEAP puts while the price was 'low', and b) adjust the strike price to be closer to ATM (at the money).

Volatility chart
(Click to Enlarge)

So in April, I rolled out my existing LEAP put on SPY to December, 2013, with a strike price of 130. At the time, SPY was trading at about $133 a share and I paid $18.68 for the option. Currently (August 8 mid-morning) the SPY is trading at $115.90 a share and the bid/ask on my Dec 2013 put is showing $27.94/$30.10.

From a trader’s viewpoint, the liquidity on that Dec 2013 put is pretty bad. If I were to consider ‘taking advantage of recent vega effects’ by, say, rolling the Dec 2013 put to the Dec 2012 expiration, the bid/ask for the new option is at $23.03/$23.99.

If I settle for the bid when selling my Dec 2013 put and the ask when buying my Dec 2012 put, I’m not getting much in the way of an advantageous ‘vega effect’ on the trade.

But even if I could get closer to the "ask" on my put sale and the "bid" on my put purchase, I wouldn't shorten the duration (or lower the strike).

This is where longer-term investment outlook gets married to the Greeks. From my standpoint, I need only concern myself with recouping the $18.68 I paid for the 'put insurance' on my SPY investment.

Over the 32 months between April, 2011, and December, 2013, that amounts to an insurance 'premium payment' of $0.58 per month. I think I can easily get this amount each month by writing OTM (out of the money) calls on SPY. For example, currently the September strike on a SPY covered call that gets about $0.58 is 128.

That strike is pretty far OTM based on today's price, but if SPY does happen to bounce back up to 128 or more by September 16 ... well, that's the problem I (and all long investors) want to have!

If, however, I were to shorten my put option expiration date to December 2012 by accepting the "bid" on the put I sell and the "ask" on the put I buy, then I have to "amortize" the $23.99 I paid for the put, minus the $3.95 profit I get on the trade, for a total of $20.04. But I now have only 20 months in which to do this. So I need to generate $1.00 in covered call sales each month to pay this new "insurance premium." This is a much higher hurdle to consistently reach each month, particularly if implied volatility comes down to more realistic levels over the coming months.

Plus, by keeping the Dec 2013 put option I sleep better at night knowing that even if we sink into a deep recession lasting 2 years or more, I can get $130 a share for my holdings of SPY ... And I even get the chance at some dividends that might be paid out from all that cash that corporations are sitting on!

This is the essence of an options "collar" strategy that was evaluated by the authors of a recent study conducted at the University of Massachusetts. I'm convinced that sooner or later more investors will begin to adopt this type of methodology, particularly as ETFs (and options on ETFs) continue to increase in popularity. This is especially the case if we continue to experience extraordinary periods of volatility spikes over the coming months or years.

But those that view ETFs and options only as a day-trading opportunity to be driven solely by mathematical models may well be missing out on the longer-term investment potential. This is especially the case when radical price movements don't adhere strictly to the Black Scholes equation.

In times of high market uncertainty, therefore, one relies on the accuracy and predictive power of the Greeks at his/her peril.

Disclosure: I am long EEM, EFA, EWY, EWZ, FXI, RSX, SPY.