With the S&P 500 (NYSEARCA:SPY) 25% above its October 4, 2011 low, the VIX near 17, down from 46.88 just four months ago, and trailing 12-month earnings for the S&P 500 (NYSEARCA:IVV) at an all-time high, investors inclined to bet on a pullback should consider buying puts now, especially considering how cheap they currently appear. Here are three ideas:
1. For a contrarian investor wanting to bet on a one-third retracement of the October 4, 2011 to February 3, 2012 rally in the S&P 500, taking the index to an area roughly around where we started the year (1257.60) and roughly where the 200-day moving average currently sits (1257.47), SPY September 22, 2012 $145 puts leave plenty of room for profit at a modest cost. These puts are currently bidding $14.67 and asking $15.00. If I were to enter a buy-to-open order on these puts, I would search for hidden liquidity around $14.90.
A fill at $14.90 would mean the investor would realize intrinsic value profits below a level of $130.10 ($145 minus $14.90 ex-commissions) on expiration day. Prior to expiration, there would still be time value left in the option, leaving the option's price open to other considerations. Any SPY move down to $126 would leave the buyer of the September 22, 2012 $145 puts with a profit of $4.10 per contract plus any remaining time value. This would mean a minimum 27.5% gain on the position. For investors interested in buying puts on other S&P 500 ETFs, the IVV and VOO are two other choices. However, it should be noted that the option chains for these ETFs are generally much less liquid than SPY's and offer far fewer choices than SPY in terms of months and strike prices.
2. Given that the Dow Jones Industrial Average (NYSEARCA:DIA) is now bumping up against its 2011 high, perhaps DIA September 22, 2012 puts are more enticing than SPY puts. A one-third retracement of the October 4, 2011 to February 3, 2012 rally would take the DIA to the $120 region, right around where its 200-day moving average currently sits. At these levels, the DIA would be down slightly for the year. DIA options are generally less liquid than SPY options, and it is often more difficult to find narrow spreads. At the moment, the DIA September 22, 2012 $130 puts have a spread of only 15 cents, bidding $8.85 and asking $9.00. Given the wide spreads at other strike prices, if I were to purchase these puts, I would not attempt to find hidden liquidity; I would instead take the $9.00 asking price.
A fill at $9.00 would mean the investor would realize intrinsic value profits below a level of $121.00 ($130 minus $9.00 ex-commissions) on expiration day. Prior to expiration, there would still be time value left in the option, thus leaving the option's price open to other considerations. Any DIA move down to $120 would leave the buyer of the September 22, 2012 $130 puts with a profit of $1.00 per contract plus any remaining time value. This would mean a minimum 11.11% gain on the position. Naturally, given the small amount of intrinsic value profits that would be left upon expiration after a move to $120, the put buyer would want the move to $120 to happen well before September in order to realize higher profits on the trade.
3. The iShares MSCI EAFE Index Fund (NYSEARCA:EFA) has more than 22% exposure to financials and large exposure to European based companies. Therefore, buying puts on EFA would be one possibility for the investor betting that Europe will be the reason for a pullback in equity markets. EFA is currently bumping up against its 200-day moving average, so any firm breakout above this level would be reason enough to close a long put position on this ETF. Given the real possibility for a near-term breakout above the 200-day moving average or the possibility of resistance holding, the put buyer would be keen to purchase a put with plenty of time value remaining but not purchase a put so far in-the-money that an ultra-high delta crushes the value of the puts upon a breakout above the 200-day. The September 22, 2012 at-the-money $54 puts seem like an acceptable medium.
If I were to purchase these puts, which are currently bidding $4.55 and asking $4.70, I would briefly search for hidden liquidity at $4.65. If I had no luck within a few seconds, I would take the $4.70, thereby creating a position that would realize intrinsic value profits below $49.30 ($54 minus $4.70 ex-commissions) on expiration day. Prior to expiration, there would still be time value left in the option, thus leaving the option's price open to other considerations. Any EFA move down to 2010 and 2011 support levels in the $46 region would leave the buyer of the September 22, 2012 $54 puts with a profit of roughly $3.30 per contract plus any remaining time value. This would mean a minimum 70.21% gain on the position. However, any quick pullback to just the $49 to $50 region, which has also acted as short-term support during the past two years, would also likely result in a significant profit for the put buyer.
Disclaimer: Please be aware that any potential trades/ideas mentioned in this article are not intended to serve as financial advice. When buying put options, investors should keep in mind that 100% of the amount of money allocated to the puts could be lost. Each investor must decide for him or herself the suitability of purchasing puts for his or her portfolio. When purchasing puts, be sure to have an exit strategy. Option prices can fluctuate wildly, and any profits not realized by closing the position can quickly disappear.