Investing In A Paranormal Market - February Update

Includes: SPY

Last month I suggested a possible strategy for investing under the "New Normal," or even "Paranormal," market conditions put forth by Bill Gross of PIMCO. My strategy was developed for a hypothetical investor who was interested in achieving long-term "market-like" returns while maintaining the safety of cash.

The specific strategy I proposed for the month consisted of a large cash position in combination with a rather simple option strategy known as a "vertical put credit spread," or more commonly as a "bull put spread."

Let's see how the strategy performed after the options expired at last Friday's market close.

Table 1 shows our hypothetical investor's brokerage statement (excluding commissions) on January 9, and February 17. The initial investment of $12,200 has grown to $12,326 over this period because both the long (108 strike) and short (122) put options expired out-of-the-money.

Table 1

9-Jan-2012 17-Feb-2012
Cash Balance $12,326 $12,326
SPY February 108 Put $ 30 $ 0
SPY February 122 Put -$ 156 $ 0
Total $12,200 $12,326

Our investor had a realized gain of slightly over 1%. Annualized, this is roughly a 9.5% return for the 39 days that the options were held. This is in line with achieving a "market-like" return based on the long-term historical performance of the S&P 500 (NYSEARCA:SPY) index.

But now the question is what do we do for an encore performance in the coming month? Our hypothetical investor may have received a tidy 1% return on his portfolio through February 17, but over this same period the S&P 500 increased by more than 6.5%.

Will the S&P 500 continue to rise, or is a correction imminent? If we wish to pursue this same strategy for March expiration, how do we select the striking prices for the new options?

If we target another 1% gain by March expiration, we need a net option revenue of $123.26, or about $1.23 per contract. Following the same strategy as before, this would suggest that we sell the March 134 put at $1.56 and purchase the March 124 put at $0.31, for a net option revenue of $1.25.

But the 134 strike price on the short option doesn't feel right to our hypothetical investor. Following the 6.5% rise in the S&P 500 the prior month, it would take only a small correction of -1.8% off the current price of $136.41 for our short put option to be in-the-money at expiration.

From a macroeconomic standpoint, there doesn't seem to be much in the headlines that would suggest a continued run-up in the S&P 500 index. More central bank stimulus might achieve this, but many pundits are beginning to suggest that continued monetary policy easing is about as helpful as using a cattle prod on a dead steer.

So our hypothetical investor is expecting a reversion to the mean in the coming month (he does, after all, agree with the PIMCO "New Normal" of muted economic growth). This would suggest an expectation of flat to declining growth in the S&P 500 over the coming month as it "reverts" toward an annual growth rate that looks more like what has been achieved over the past month.

Our investor will therefore change his option strategy for March expiration to a "vertical call credit spread," otherwise known as a "bear call spread."

To implement this, he will sell the March 138 call at $1.31 and purchase the March 146 call at $0.06.

At first glance, buying the 146 call may seem like a waste of money; but the call is necessary to limit our investor's risk should SPY increase dramatically between now and March 16. Furthermore, without this option our investor's short position on the 138 call would be "naked" and would quite likely be disallowed by his broker.

So with this risk protection in place let's take a look at the diagram of potential outcomes on March 16:

(Click chart to expand)

The line formed by the small green circles shows how our investor's portfolio valuation will change relative to the change in SPY between February 17 and March 16. The maximum return for the month will be about 1% and will be achieved if SPY closes below $138 a share. If it closes above $138 a share, our return decays to a maximum loss of -5%.

To get an idea of the likelihood of this happening, the light and dark green shaded areas represent a 1 and 2 standard deviation change from the historical mean. This assumes, of course, that returns are normally distributed; many academic studies have shown this not to be the case, so we must not place too much reliance on these probability estimates.

The gray circles indicate what our investor's cumulative return for the year (which includes the gain from last month) will look like. The large gray circle on the x-axis shows how much SPY has changed since we first initiated this strategy on January 7. In combination with the shaded green areas, it gives us a sense of the upside versus downside risk of this investment.

Table 2 now shows what our hypothetical investor's brokerage statement looks like as of close of market on February 17.

Table 2

Cash Balance $12,451
SPY March 146 Call $ 6
SPY March 138 Call -$ 131
Total $12,326

I hope you'll check back after March expiration to see how this strategy worked out. 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 on the return of this hypothetical portfolio. Also, please be aware that investing in options carries certain risks and may not be suitable for all investors. You should consult with your financial adviser prior to initiating any options trades. Finally, the example strategy illustrated in this article is for educational purposes only and may or may not be indicative of options strategies employed by Johnson Harper LLC on behalf of its clients.

Disclosure: I have long and short option positions in SPY.