Investing In A Paranormal Market: April Update

Apr.23.12 | About: SPDR S&P (SPY)

With SPY closing at $137.95 this past Friday, the April option positions held by our hypothetical investor expired worthless. This is, of course, the desired outcome (see "Investing In A Paranormal Market - March Update" for the reasons why), and consequently our investor has an overall realized gain on cash of 2.4% year to date.

Table 1 compares our hypothetical investor's "brokerage statement" on April 20 against that of March 16.

Table 1

16-Mar-2012 20-Apr-2012
Cash Balance $ 12,497 $ 12,497
SPY April 146 Call $ 27 $ 0
SPY April 140 Call -$ 242 $ 0
SPY April 130 Put $ 40 $ 0
SPY April 136 Put -$ 101 $ 0
Total $ 12,221 $ 12,497
Click to enlarge

Our investor now has a cash balance of $12,497 compared to an initial (January 6, 2012) balance of $12,200.

Continuing forward into May, we will stick with our original "paranormal" investment thesis of zero-bound interest rates, muted growth, volatility higher than historical averages, and potentially bimodal outcomes as suggested by Bill Gross of PIMCO (read his January, 2012, article here).

In such an environment, our hypothetical investor wants to keep his portfolio primarily in cash, with some opportunity to achieve a return in 2012 that is typical of long-term market averages (let's say, roughly 8%).

By way of a short review, 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." And in April (see link at the beginning of this article) we utilized a combination of these two strategies that is often referred to in options textbooks as a "long iron condor."

The long iron condor strategy is particularly suitable to our assumed "paranormal" market conditions because it generates the highest return if the underlying (in this case SPY) closes at expiration at a price between the strike prices of the short put and short call options.

To illustrate how an investor might select the option strike prices, let's assume our hypothetical investor believes that the growth in SPY over the coming month will remain "muted" over the range of about -2% to +2%.

Our investor decides to execute the following options contracts:

  • Purchase a May 146 Call contract for $0.09, and sell a May 142 Call contract for $0.62 (bear call spread).
  • Purchase a May 131 Put contract for $0.70, and sell an April 135 Put contract for $1.39 (bull put spread).

[Note: prices are based on the bid price for short options and the ask price for long options at market close on Friday, April 20. As such, the prices in this example may not be indicative of actual transaction prices that would have been realized intraday.]

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

Click to enlarge
Figure 1 (Click to enlarge)

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.

The green circles illustrate how the value of the cash+options portfolio will change relative to the change in the price of SPY between April 20 and May 18 (options expiration dates). The gray circles show how the value of the portfolio will change between January 6 (when the portfolio was initiated) and May 18 based on the change in SPY between April 20 and May 18. This is useful to get a sense of whether we are making gains as the year progresses.

You can see from Figure 1 that the greatest return will be achieved if SPY closes on May 18 at a price between roughly +/- 1 standard deviation from it's long term price change over 21 trading days.

The dashed line from the lower left to upper right of the graph illustrates how a portfolio consisting entirely of SPY would change compared to a change in SPY. The relevance of this line is that it illustrates the extent to which the portfolio will outperform SPY at expiration. The portfolio will outperform SPY for those outcomes where the circles are above the dashed line. We see that for the coming month (green circles), the portfolio of cash and options will outperform SPY if the change in SPY is less than 1%. For the year to date (gray circles), the options portfolio will outperform SPY if the change in SPY between April 20 and May 18 is less than 3.2%.

This range of outcomes is satisfactory for our hypothetical investor. In the best case, the investor will achieved a realized gain YTD of 3.5%, or roughly 9% annualized. In the worst case, he will achieve a realized YTD gain of 0.2%, or just about breakeven for the year so far.

Table 2 shows what our hypothetical investor's "brokerage statement" now looks like just prior to market open on April 23:

Table 2

20-Apr-2012
Cash Balance $ 12,619
SPY May 146 Call $ 9
SPY May 142 Call -$ 62
SPY May 131 Put $ 70
SPY May 135 Put -$ 139
Total $ 12,497
Click to enlarge

The next update to this series will be shortly after May 18 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 on SPY.