Investing In A Paranormal Market: May Update

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 |  Includes: SPY
by: JHLLC

With SPY closing at $129.74 this past Friday, the May put option positions held by our hypothetical investor were both in-the-money, while both call options expired worthless.

This means that our investor received $126 for his long May 131 put (the good news), but had to spend $526 to clear his short May 135 put.

Table 1 compares our investor's "brokerage statement" on May 18 against that of April 20.

Table 1

20-Apr-2012 18-May-2012
Cash Balance $ 12,619 $ 12,619
SPY May 146 Call $ 9 $ 0
SPY May 142 Call -$ 62 $ 0
SPY May 131 Put $ 70 $ 126
SPY May 135 Put -$ 139 -$ 526
Total $ 12,497 $ 12,219
Click to enlarge

Our investor now has a cash balance of $12,219 compared to an initial (January 6, 2012) balance of $12,200. Which means that with almost 5 months of the year behind us, he is only up by $19, or about 0.16%.

Certainly nothing to write home about, but on the other hand over the period from April 20 to May 18 the S&P 500 on which the underlying is based declined by 6% while our investor's portfolio declined by only 2.2%.

In April (see Investing In A Paranormal Market: April Update) we deliberately established our option positions to limit our loss to a maximum of 2.2% in case of a dramatic market move in either direction, which in fact did occur.

Continuing forward into June, there seems to be little reason to believe that the current level of volatility and uncertainty will not continue.

So we will stick with our approach of establishing put and call credit spreads on either side of the current price of SPY. To review the rationale behind this, you might want to go back to the first article in this series (January 9) and read each subsequent monthly update.

This month our investor believes that there is roughly a 68% probability that the change in the price of SPY will be between -4% and +6%. He wants to maximize his return over this range, while still limiting his downside loss.

Our investor decides to execute the following options contracts:

  • Purchase a June 142 Call contract for $0.08, and sell a June 138 Call contract for $0.25 (bear call spread).
  • Purchase a June 119 Put contract for $0.86, and sell a June 123 Put contract for $1.43 (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, May 18. 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 proforma P/L (Profit/Loss) diagram at expiration:

Figure 1

Click to enlarge
(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 May 18 and June 15 (options expiration dates). The gray circles show how the value of the portfolio will have changed between January 6 (when the portfolio was initiated) and June 15 based on the change in SPY between May 18 and June 15. 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 June 15 at a price between roughly +/- 1 standard deviation from it's long term price change over 20 trading day periods.

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%.

This range of outcomes is satisfactory for our hypothetical investor. In the best case, the investor will achieve a realized gain for the month of about 0.8%, or roughly 9.6% annualized. In the worst case, he will realize a loss of about -2.5%. Based on historical price changes in SPY, however, such a loss is assigned only about a 5% probability.

Before summarizing the trades for this month, I would like to respond to a comment made last month by a reader. He wanted to know why I didn't "tighten" the option spreads by setting the strike price difference to only $1, and then entering into 4 contracts each. He pointed out that the margin requirements (cash needed to secure the spreads) are exactly the same in both cases, but the return on the cash margin is much higher.

The answer has to do with personal preference and position sizing.

To illustrate this, consider Figure 2 below. It shows the profit/loss outcome at expiration on June 15 for our (large) cash position in combination with 4 put credit spreads having strikes of 123 "short" and 119 "long" and 4 call credit spreads having strikes of 138 "short" and 142 "long."

At first glance it looks a lot like Figure 1 above. But on closer inspection you can see that the maximum return (while somewhat lower in Figure 1) is achieved over a slightly broader range of price change at expiration of the underlying . Also, the decline in returns between 1 and 2 standard deviations on either side (dark green areas) is slightly less steep in Figure 1 compared to Figure 2.

In Figure 1, for example, a positive return (or at least breakeven) occurs if the change in SPY at expiration is between -5.5% and +7%. In Figure 2 (with the tighter spreads) a positive return is achieved if the change in SPY is between -4.5% and +6%.

A subtle difference, perhaps, but one that gives our hypothetical investor a bit more cushion in these volatile times.

Figure 2

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(Click to enlarge)

Summarizing for this month, then, Table 2 shows what our hypothetical investor's "brokerage statement" now looks like just prior to market open on May 21:

Table 2

18-May-2012
Cash Balance $ 12,293
SPY Jun 142 Call $ 8
SPY Jun 138 Call -$ 25
SPY Jun 119 Put $ 86
SPY Jun 123 Put -$ 143
Total $ 12,219
Click to enlarge

The next update to this series will be shortly after June 15 when these options expire. I hope you will continue to follow the progress of our "Paranormal" investor (to be alerted of the next update simply select the "Follow" button under my picture in the upper left of this page).

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.