Hedging The SPY ETF With Options - The Seesaw Market

| About: SPDR S&P (SPY)

The focus of this article will be the problems and opportunities that exist when the market is Seesawing and highly volatile. It’s timely, as the recent weeks are fresh in everyone’s memory.

Over the last few weeks I have written a number of articles on utilizing options for Portfolio Protection. Though this is another installment in that series, it can also “stand alone” as an illustration of utilizing a Calendar Put Spread for income generation.

A common component of the Portfolio Protection strategy consisted of selling weekly puts to generate cost recovery of long dated options. These puts, themselves, were covered by a long dated option. So, if we isolate this component, it is simply a Calendar Put Spread.
The SPDR S&P 500 Trust ETF (NYSEARCA:SPY) last closed at $113.15 and the VIX (volatility index) is over 40. When the VIX is very high, option prices are distorted. As a result I don’t generally like to give examples that may prove not to be accurate when the VIX declines to more normal levels (whatever that may be!!!). However, as this focus is specifically with highly volatile, seesawing markets, the relevance factor is paramount.
Let me preface these examples by stressing that volatile markets are transitory. The uncertainty is only how long and how deep or high they go. Though they are unnerving it is important to stay focused on your plan and strategy. Making adjustments is fine, desertion is not.
So let’s start out with purchasing a long dated Put. I choose the September 2012 with a strike of $113, and a cost of $ 14.70 per option. I will buy 25 options for Portfolio Protection at a cost of $ 36,750.The weekly average cost is $ 706 and will represent my weekly cost recovery target. (See previous articles)
I will be selling five weekly options so I need $ 1.41 per option. Let’s look at the October 7th Put Matrix.
Some definitions will help us. If we look at the 114 Strike, it has a bid of $ 3.15. Since SPY is trading at $ 113.15 it is “in-the-money” by 85 cents. This is called its INTRINSIC VALUE (easy, just remember IN-the money). The remaining $ 2.30 is EXTRINSIC VALUE (remember EXtra)
If we look at the $113 strike it sells for $ 2.68. It is “out-of-the-money,” so the whole $ 2.68 is extrinsic value.
Let’s move on.
Before choosing which option strike to sell, our needs must be defined. This is a seesaw market and I need to assess how to deal with this.
Let’s see what would happen by selling an “at-the-money” put with a strike of $113. The premium credit is $ 2.68.
Suppose in a week, SPY closes down $5 to $108. The Oct 7 weekly put lost $ 2.32 ($5 down minus $2.68 credit). Compensating for this is the long dated put, which has moved $5 more in the money. The weekly cost recovery target of $1.41 is met and is according to plan. I would have preferred an up market, but this component is working according to design.
If I reset the following week (Oct 14th) sellin a put "at-the-money" with a strike of $108, I'll get another $ 2.68 (hypothetical). Now, if SPY goes back up to $113, I get to keep this $ 2.68 so I made 36 cents. (lost $ 2.32 week one, made $ 2.68 week two) NOT QUITE SO.
  1. The Sept 2012 put lost whatever it gained week 1 and is back to even. Actually it's a little behind with some time decay.
  2. The first weekly lost $2.32 and the second made $2.68.A combined gain of 36 cents
  3. But,I failed to earn cost recovery "put money" for two weeks of $2.82 ($1.41 per week) and am behind my cost recovery target by $2.46 ($2.82 minus 36 cents)
Instead of selling the Oct 14th put at $108, Let's sell it at last week's level and be $5 in-the-money at $113. The credit would be $5.69 (hypothetical). ($5 intrinsic, 69 cents extrinsic)
SPY then rebounds to $113. The long dated put is back to even. A loss of $2.32 on the first put and gain of $5.69 on the second put equals a net gain of $3.37. This is above the cost recovery target.
If SPY doesn't go up, the long dated put stays $5 in the money and I gain 69 extrinsic cents on this weekly put.The total credits of $ 2.68 (week 1) and 69 cents equals $ 3.37 and keeps the target on track.
So, the problem with a seesaw market is that if it goes down and then bounces back up, your long dated put makes nothing and you may break even, lose a little or make a little on the weekly, but you lose ground on the target.
The only way to offset this is to sell the weekly put as far above the money as possible while still hitting your cost recovery target. Meet the target by selling the weekly put with an EXTRINSIC Value equal to your target of $1.41.
Look to the above matrix to see how to figure this.
The $ 119 strike has a bid premium of $ 6.47. SPY is at $113.15. $119 minus $113.15 is INTRINSIC $ 5.85; therefore extrinsic 62 cents. Not enough.
The $118 strike has a bid premium of $ 5.69. Intrinsic $ 4.85 ($118-$113.15); extrinsic 84cents. Still not enough.
The $117 strike has a bid premium of $ 4.95. Intrinsic $ 3.85 ($117-$113.15); extrinsic $ 1.10. Still not quite enough.*
The $116 strike has a bid premium of $ 4.29. Intrinsic $ 2.85 ($117-$113.15); extrinsic $ 1.44. Perfect. ON TARGET
Depending on my thoughts about a recovery bounce I may choose the $117 instead of the $116 strike even though the $117 is 1/3 below my target. After all the 34 cents difference on five options is only $170. But this is about as much as I'll gamble and I wont make it repeatedly.
Now, continue to sell the weekly put as high as possible while matching the extrinsic value of the weekly put to the target income. Do not deviate from this until volatility comes down. At that point, if you are pessimistic sell the weekly at or below the money. Always remembering to set the EXTRINSIC at TARGET.
Say, in today’s market you continuously do as suggested here. The SPY works its way back to $ 125 and the VIX falls to 30. You are happy as your base portfolio has recovered.
But, stay vigilant. Reset the long dated put at $125 from $113 to lock in the new value. Continue to sell the weekly puts looking for an extrinsic value to recover the cost of the new $125 long-dated put (see my other articles).
Disclosure: I may buy or sell SPY puts or calls