Balance Your Portfolio Beta-Exposure With This Easy And Cheap Options Strategy

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Includes: SPY
by: Al Randarevich

Summary

New all time high while earnings fall for 5 consecutive quarters.

3.8% rise per year while having several 5-14% corrections.

Position yourself to profit from both a correction and a simple volatility increase.

Introduction

A recent sobering read of this Market Watch article outlines how more than 90% of the companies that have already reported earnings for Q2 2016 which beat expectations carefully massaged by companies' management through guidance, still look to decline by 3.5% comparing to a previous year. The article analyzes FactSet data, noting this is a fifth consecutive quarter of year-over-year declines, something that hasn't happen since the Great Recession.

The Price-to-Earnings ratio is close to that of 1976, however it is understood that most buying activity is happening due to companies still rushing to buybacks using low interest rates of corporate debt, while institutional and retail investors prefer to refrain and stand aside.

The broad market rises and the S&P 500 is at a new all time high on euphoric risk-loving sentiment. This sentiment has no correlation with earnings or the broad economy, and the market is clearly unable to levitate above previous all time highs for very long before doing a 5-10-15% correction in all recent instances.

There is no technical signal to go short, but a pragmatic investor may look for a way to hedge now and a strategic speculator may consider building a limited risk short exposure via an option strategy described below.

The strategy is intended to be applied at, or close to, all time highs. With a front month option expiration of around one month from the time of entry, one can expect to roll it over once a month for a duration of time, while the original premise outlined above lasts, i.e. 3, 6 or more months.

Thesis & Catalyst For The SPDR S&P 500 Trust ETF (NYSEARCA:SPY)

We can clearly mark the end the QE-fuelled growth period at October 2014. From first $600B injected into the system on November 25th, 2008, till the withdrawal of a last $10B of monthly asset purchase on October 29th, 2014, the S&P 500 had recovered from lows of around 700 to the previous high of October 1st, 2007, to 1576 by April 1st, 2013, and proceeded to climb above 2030. We are talking about a 290% rise in 6 years, or an approximate 48% rise per year.

Snapshot of QE over time provided by RJ O Click to enlarge

Image is courtesy of Commodity and Derivative Advisors Blog

Now we are in August 2016 and the S&P 500 hit a new high of 2185, a rise of just 7% in 22 months, or a measly 3.8% rise per year. While the market is still on a high foot for now, it produced three scary and panic-inducing sell-offs of 9, 14 and 14%, at least four more 5% sell-offs and many more smaller 3% corrections. That's roughly one sell-off of 5% or more every second month on average.

So here is what we are facing: every second month we have a chance to face a sell-off of 3-5-14% as recent history suggests, while expecting a 3.8% rise over the course of the whole year.

SP500 weekly Click to enlarge

SPX500 index chart is available at TradingView.com

In the economy this is called "diminishing returns". The Market keeps experiencing painful draw-downs while its rate of gain constantly slows down.

Anyone with a pair of eyes must have read words of caution from prominent market figures and prodigy investors. There are even outright calls to sell and move to cash due to the rally not being backed by earnings growth nor by economy growth and probably levitating only on buy-backs and expectations of further low rate environment in a world already partially submerged in negative-yielding government debt.

Let us draw a line right here: while there are arguably no fundamental factors supporting higher and higher valuations of the stock market, this has no direct consequence of the market being ready to significantly correct or turn to a bear phase. As Keynes said: "[a] market can stay irrational longer that you can remain solvent." So our argument here is not that we are expecting market to turn bear any time soon, but purely from risk-reward point of view we see more opportunity in a downside than in an upside.

It roughly goes like this: for any 3% of growth above a previous all time high we should expect several smaller sell-offs about 5% and one or a couple of more 12-14% corrections.

This gives us a reward to risk ratio of 3 to 1, which is considered an excellent opportunity. However, going short a wide index for a possibly prolonged period of time (months to quarters perhaps) leaves us with a hefty margin being locked out and exposure to, however unlikely but still possible, surges of risk sentiment driving market up past expected risk boundaries. For example, in case of a sudden move to proclaim an end of the tightening cycle by the FED and perhaps a move to ease, which can happen in case of a major disturbance, a more serious war, etc.

So how can a pragmatic investor or a strategically minded speculator benefit from this thesis? We offer here a solution that might be suitable for some of them by using options. There are three major ways to implement a thesis like this with options:

  1. By selling calls or bear spreads above the market and receiving a credit
  2. By buying puts below the market and profit from the premium increase in case of a rapid sell-off
  3. By doing a combinations trade and calendar spreads

While point 1 can be very advantageous in varying market environments and it is recommended to holders of long biased portfolios to write covered calls and improve an average price by receiving a premium, it hardly makes sense in a very low-volatility environment; currently the VIX is below 12 and SPY being in the lowest percentile of the year. All this means is we will receive very little premium while still bearing a larger risk in the case of a market rise.

VIX daily Click to enlargeVIX chart is available at TradingView.com

Point 2 makes sense and can be implemented with in-the-money puts that give a close break-even point at an expiration. However, providing less non-linear profitability increases in the case of a sell-off, due to its gamma being located on a down-sloping curve and its delta increase constantly slowing as the market moves lower. Out-of-the money options have a further away break-even price, but can provide excellent reward to risk should a sell-off event occur. The only problem with them is that time costs money when buying options and smaller 3% or so moves might not be enough to make waiting for a larger move worth the cost. We cannot predict when a correction will happen and should be prepared to keep rolling our position every 1-2 months, which costs money.

Point 3 is where we stand. While our preferred combination in a more volatile environment would be selling a credit spread slightly above the market and use the received premium to finance an OTM put purchase to profit from a larger move down, in a very low volatility environment, as we are now, it makes a little sense, as premiums for selling options are low and strikes must be kept very close to the market price.

Which brings us home to a combination of a calendar put spread and an Out-of-the-Money long put.

We came up with what we consider a sensible approach with a close break-even point requiring only a small move down in the market at the expiration for the whole construct to become profitable, while still maintaining exposure to receive out-sized gains if market sells-off 7-10% or more.

Below is a bird's eye view on the construction and profitability over the wide range of possible SPY movements.

Click to enlarge

Option analysis screens are courtesy of Interactive Brokers TWS platform

In the image below we can see a more detailed graph for a possible smaller movement and break-even points.

Option analysis screens are courtesy of Interactive Brokers TWS platform

In case of a desire to push more on the short side and increase the bet by sacrificing a bit of close break-even, you just need to do is increase the number of long puts in a back month series. For example, here is a calendar spread plus two long puts.

Click to enlargeOption analysis screens are courtesy of Interactive Brokers TWS platform

Going long two puts per one calendar increases our premium and moves the break-even point away to 2% below the market at the time of expiration, but we stand to receive significantly more on the upside should the market sell-off strongly.

Practical application

So enough of this gibberish, how can a real life investor with a net long portfolio use this strategy to protect against a possible correction?

In the example above, each set of options taken consists of one short put with its strike slightly below the current market price and with a front month expiration (3rd Friday of the next month), one long put with the same strike and a back month expiration (3rd Friday of the month next after the next) and one long put with further out of the money strike and a back month expiration.

Investor should look to enter one set of options described to protect each 100 shares of SPY he or she is net long, or an equivalent of roughly $22000 worth of stock net long with a beta of 1.0. Alternatively, if he or she holds stock with low beta of 0.5, this amount goes to $44000 exposure for one option construct described above opened.

For an investor with a more speculative approach and a desire to gain exposure to an adverse market move, simple rules of money management and capital preservation should be used.

One should keep in mind that the risk in this trade is the premium paid and trade should be closed right before the front month expiration when the sold put option due to expire.

Should an investor decide to continue with the approach and the basic premises listed in the introduction, he or she should enter a new trade once a previous one closed, with the front month expiration being a monthly expiration in a next month (3rd Friday of a month) and a back month expiration - one month after that.

In both cases investors should clearly realize the risk of this strategy being a premium paid to enter the trade once a month and a worst case scenario being expiring out of the money and losing an entire premium.

Variant View

What could go wrong? The market stays in low-volatility mode and keeps climbing. We lose the premiums paid, which should never exceed your predetermined risk, by the expiration of the short put options and we roll the whole construct into a new series 1-2 months away. Rinse and repeat.

There are different cases for reducing the loss in that situation. For example by entering into a calendar call spread, which includes selling close series and buying next series calls and receive a premium increase as we move up by the front month expiration, but this is a whole new topic for another post.

This article is not a trading recommendation and is presented for information and education purposes only.

Data points provided above are courtesy of MarketWatch, FRED, FactSet and RJ O'Brien through their respective publicly available information resources. Charts provided above are courtesy of TradingView and taken as screen shots from their web application, option analysis screens are courtesy of Interactive Brokers TWS platform and taken as screen shots.

All other data and conclusions are derived directly from the data available from the information sources listed above.

Disclosure: I am/we are short SPY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am currently legging in into the trade presented and looking to add more as highs bust and market goes below the previous all time high.