Investing In A Paranormal Market

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 |  Includes: SPY
by: JHLLC

I always look forward to reading just about anything that Bill Gross writes. His latest issue of Investment Outlook makes the case that in just a few short years we have already eclipsed the New Normal and are now entering a "New New Normal" regime of potentially bimodal outcomes.

The gist of his four-page missive seems to be this: In 2012 we might see high-risk yet highly delevered financial markets in which one's wealth truly is safer hidden at home in the mattress (as some former clients of MF Global wish they had done). Or we might see massive central bank inflationary expansion, in which case the mattress is the last place where money should be. Or we might even experience both.

What's an investor to do in such a bimodal world? Gross has his own recommendations, of course, but he doesn't offer much hope of returns beyond about 2-5% in this environment.

I'd like to respectfully add a possible alternative of my own (with the full realization that it is a hard climb to the top of his towering shoulders).

Assuming that individual investors have capitulated by now and have at least some cash that they are waiting to re-invest at the right time, one alternative might be to consider a relatively simple put option strategy against an underlying index ETF such as SPY.

Let's start by considering a strategy known as a "cash-secured put." This consists of selling a (typically) out-of-the money put option and securing it with cash in the event it is assigned. This strategy is sometimes employed when an investor is interested in owning the underlying stock, but is concerned that it may drop further in price. If the stock does indeed decline, the option seller may be compelled to buy it, but he will do so at a lower price with (presumably) upside potential gain when the stock recovers. If, on the other hand, the stock increases in price then the option he sold expires worthless and the investor keeps the premium he made on the sale.

Here's an example of how one might utilize this strategy. As of market close on Friday (6-Jan-2012), SPY was trading at $127.71. We'll sell a 122 put option on SPY expiring on 17-Feb-2012 (6 weeks from last Friday). For this we'll receive $1.56 a share (bid price for this option at Friday's close).

Since 1 option contract is a commitment on 100 shares of underlying stock, we will need to deposit $12,200 with our broker. If SPY declines below $122 a share by Feb 17, the option will be assigned and we'll be compelled to buy 100 shares of SPY at the strike price of $122. The $12,200 we deposited "secures" our obligation to buy the stock should it become necessary.

We also note that, upon the sale of the option, the cash balance in our account will have increased to $12,356 (which includes the $156 revenue received from selling the put).

So if on Feb 17 SPY has closed above $122 a share, our gain will be $156, or about 1.3% of the $12,200 we had invested over that time. In this case we will have made (in only 6 weeks) considerable progress towards potentially besting that 2-5% that Bill Gross suggested we may have to be satisfied with for the entire year.

A diagram of the potential outcomes on Feb 17 looks something like this:

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(Click to enlarge)

The horizontal axis shows how the price of SPY could change (as a percentage increase or decrease relative to the initial price of $127.71 when the put option was sold), and the vertical axis shows how much our "portfolio" (consisting of cash and the short put option) will change based on the change in SPY.

The blue dots show what the portfolio will return at expiration relative to the return that SPY achieves over the same period.

You can readily see that if the price of SPY increases by Feb 17, our return is capped at 1.3% regardless of the extent to which SPY goes up. And it's also clear from the chart that our downside loss could be significant in case of a catastrophic decline in SPY. Worse case? Well, if SPY went "bankrupt" prior to Feb 17, we would be forced to buy 100 worthless shares at a price of$122 each. Our loss would be $12,200, or 98.8% of our original investment. (Small consolation; we get to keep the $156 made on the put sale).

Now I could point out that the "portfolio" (cash + short put option) consistently outperforms SPY on the downside. The diagonal dashed line shows what the portfolio would return if it consisted only of SPY shares instead of the cash and option position. When the blue dots are above this diagonal line, then the portfolio has outperformed SPY; when the blue dots are below, SPY has outperformed the portfolio.

In fact, SPY could decline by as much as ~6% between now and Feb 17 and our portfolio would be at least at the breakeven point.

All of this notwithstanding, however, many investors would likely not want to take on this position. Looking at the graph, they see the potential downside could be as much as -98.8%, with the upside gain limited to only 1.3%. A cash-secured put (like its covered call equivalent), has far greater downside risk than upside reward.

And such an investment would be particularly worrisome under the bimodal scenario that Bill Gross has laid out. A "fat tail" event on the downside could result in significant pain for the investor concerned with preserving capital (such as in an IRA account).

So let's modify the portfolio slightly by simultaneously purchasing a put option (expiring on Feb 17) having a strike price of 108 at the same time that we sell the 122 put. Based on Friday's ask price at the close, the 108 will cost us $0.30 a share. This new position is generically referred to as a "credit spread" because we receive a net cash amount -- in this case $1.56 (revenue from short put) - $0.30 (cost of long put) = $1.26 per share, or $126 for 1 contract.

A diagram of the potential outcomes on Feb 17 for this "revised" portfolio looks something like this:

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Even though, strictly speaking, we are no longer required to deposit the full $12,200 with the broker to secure this option spread (we only need deposit the difference in strike prices times 100, which is $1,400 in this case) we're going to keep the $12,200 on account anyway. Keeping this extra cash limits the overall loss (as we can see from the chart above) to a maximum of about -10% regardless of how much the price of SPY might decline between now and Feb 17.

To be sure, we've sacrificed a bit of upside gain by initiating this spread; we're now limited to a maximum return of $126 / $12,200, or a little over 1% for the 6-week period.

The downside risk (-10%) is much better compared to the cash-secured put example, but still doesn't look great compared to the relatively modest (1%) upside potential. The question now, however, is how likely is either outcome?

To get a sense of this, we can look at the average 6-week change in SPY over the period from January 29, 1993 (fund inception date) to the present. Looking at historical price data for SPY, we can determine that the average change for all 6-week periods since inception is 0.8%, with a standard deviation (assuming a normal distribution of returns) of 5.9%.

The probability distribution is illustrated by the green regions below:

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The light green area spans +/- 1 standard deviation, and the darker green area spans +/- 2 standard deviations. This would suggest (again, assuming normally distributed 6-week changes in SPY price) that there is roughly an 85% probability that this position will yield a positive return by Feb 17. And there is only about a 2% probability that any losses will be greater than -5% (with a zero probability of losses in excess of -10%).

It's important, however, not to get too hung up over calculating risk-adjusted returns, because probabilities (normal or otherwise) cannot realistically be calculated for one-off events such as what will happen between now and Feb 17.

Suffice it to say that, if historical price movements are any indication, this position has a good chance of yielding a positive return by Feb 17.

Additionally, an investor that is not quite ready to re-invest in the equity markets can potentially generate an "equity-like" return while keeping the bulk of his or her portfolio in cash. Holding an excess of cash (as though it had actually been invested in the underlying ETF) against this option spread position also helps to prevent an investor from taking on excessive leverage in the form of initiating additional contracts in the position ... In the bimodal world of Bill Gross, over-leveraging option positions can be disastrous if the "low probability" event actually occurs.

Finally, regardless of what the closing price of SPY is on Feb 17, we still have to make a decision about how to invest our portfolio after this date ... But we can only cross that bridge when we come to it.

I'll tell you what. We'll revisit this strategy sometime during the 3rd week in February when these options are set to expire. If you select the "Follow" button below my photo in the upper left of this page, you'll be able to easily see when I've posted the next article in this series.

One last note. This example does not include the impact of commissions or fees, and investing in options may not be suitable for your particular circumstances. You should consult your financial advisor prior to initiating option trades. Furthermore, the example strategy illustrated in this article may or may not be indicative of options strategies employed by Johnson Harper LLC on behalf of its clients.

Disclosure: I am long SPY. I have both long and short positions in SPY.