Investing In A Paranormal Market - March Update

 |  Includes: SPY

In February our hypothetical investor (who is seeking returns consistent with the longer-term market averages while maintaining a portfolio predominantly of cash) sold a 138 call option on SPY with expiration date of March 16.

At the time the call was sold, SPY was trading at $136.41. Our investor was expecting a downward 'reversion to the mean' or, at the least, only modest further growth in SPY.

But of course markets seldom adhere to the short-term logic of the individual investor, and at March options expiration this past Friday SPY closed at $140.30. Our investor was compelled to spend $230 to clear his (now) in-the-money short call position.

C'est la vie ... (or perhaps "C'est la guerre" is more appropriate under Paranormal conditions).

Getting back on point, Table 1 compares our hypothetical investor's "brokerage statement" on February 17 and on March 16.

Table 1
17-Feb-2012 16-Mar-2012
Cash Balance $ 12,451 $12,451
SPY March 146 Call $ 6 $ 0
SPY March 138 Call -$ 131 -$ 230
Total $12,326 $12,221
Click to enlarge

Our investor has given up almost all of the gain achieved in February, and his portfolio valuation (cash position) is now essentially back to his starting point on January 9.

What now?

Like a squirrel foraging for acorns, our investor could give up on his investment thesis of February and look for some other opportunity. Or he could stick with his thesis and adopt the attitude that if SPY was due for a downward reversion to its mean in February, it must be even more so the case here in March.

Our investor decides to continue with his thesis (after all, this article is one of a continuing series about investing under "Paranormal" market conditions).

But before getting into the specifics going forward, let's briefly review the option strategies our investor has utilized up to this point. The first article in this series (January 9) introduced an options strategy sometimes referred to as a "bull put spread." The second article (February 21) illustrated a "bear call spread."

This month we'll utilize a combination of the two strategies that is referred to in the trade by the somewhat arcane name of "long iron condor" (if you look at the graph below you might imagine a large bird flying towards you).

Long iron condors are generally employed when a trader/investor expects that the underlying stock (in this case SPY) will not change significantly over the option holding period.

But, as we'll see below, "significantly" is a relative term depending on the strike price of the options that make up the iron condor.

Our investor decides to execute the following options contracts:

  • Purchase an April 146 Call contract for $0.27, and sell an April 140 Call contract for $2.42 (bear call spread).
  • Purchase an April 130 Put contract for $0.40, and sell an April 136 Put contract for $1.10 (bull put spread).

[Note: all prices are average of the bid and ask price at market close on Friday, March 16, and as such are not indicative of actual transaction prices that may have been realized intra-day.]

The strike prices were selected with the aid of an Excel spreadsheet that generates a P/L (Profit/Loss) diagram at expiration:

The green shaded areas represent +/-2 standard deviations (dark green) and +/-1 standard deviation (light green) from the mean based on historical price movements of SPY.

From this graph we see that the maximum 'portfolio' return is achieved if the underlying ((NYSEARCA:SPY)) declines by about -2% by April expiration. At least modest gains are achieved if the change in SPY is between -5% and +2%. The maximum loss in any event is -2.5%.

Considering that SPY is already up ~10% YTD (gray circle on x-axis), our investor is comfortable with this range of outcomes. In summary, his selection of strike prices reflects his expectation of a market correction in SPY, while still allowing for a bit of further upside gain.

Table 2 shows what our hypothetical investor's "brokerage statement" now looks like just prior to market open on March 19:

Table 2
Cash Balance $ 12,497
SPY April 146 Call $ 27
SPY April 140 Call -$ 242
SPY April 130 Put $ 40
SPY April 136 Put -$ 101
Total $ 12,221
Click to enlarge

I will, of course, be providing an update after April 20 when these options expire. I hope you will continue to follow the progress of our "Paranormal" investor.

One last note. This simplified example does not include the impact of commissions or fees on the return of the 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. Lastly, 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 am long SPY. I hold both long and short positions in SPY.