Most investors are struggling to make sense of today's market. On one hand, there has been a rapid 10% correction and volatility is relatively high. This usually signals a buying opportunity. On the other hand, the macro issues that questioned the November-April rally in the first place, remain, and may have even degraded.
I have written numerous articles detailing portfolio protection techniques and hedges and stand committed to them. This article will bring some of those basic principles together and offer a "Cautious Bull" strategy. That is, I will look to take advantage of what would normally be construed as a buying opportunity, but, at the same time, keep one foot near the brake pedal -- just in case things sour.
The SPDR S+P 500 ETF (SPY) is, in most cases, the ideal product for cautious bull option plays. With few exceptions [such as some MLPs and Apple (AAPL)] I find it easier to deal with "Where do I think we're headed?" than "Where do I think we're headed AND who will lead the way?"
SPY options are also very liquid, priced fairly and the strike intervals make "fine tuning" easy.
When volatility is high, selling options is favored over simply buying them. As a result, an effective strategy must include selling some options. This cannot be done without increasing risk.
Taking these into account, here's what I see as a reasonable, but cautious, strategy.
1) Buy a March 2013, slightly OTM put on SPY. SPY is trading at $128, so the $125 strike fits just fine. This costs $11.08. I buy a slightly OTM put as a "Bull" play, but an ATM strike could be employed for the more cautious.
2) Sell an OTM March 2013 put to "convert" to a Bear Put Spread. This component compromises my downside protection, so some risk has to be accepted. Selling the $105 strike seems far enough OTM and still credits a reasonable $5.00+. So, the cost of the Bear Put Spread nets out at around $6.00.
Step 2 is employed, primarily, as an offset to a potential decrease in volatility. When volatility decreases, the benefit to the lower strike will help offset the loss to the higher strike.
3) Sell weekly put options on SPY. The hard part is to determine if they should be sold ITM, ATM or OTM. The "market timers" can make this decision each week, as they please. For me, I'll take a more fundamental view.
When volatility is high extrinsic is also high. The most extrinsic can be captured ATM. Moving ITM gives up this extrinsic and defeats the whole purpose of benefiting from hi-vol. Setting the strike OTM is a bearish stance, and though it is appropriate at times, this article pre-supposes a "cautious bull." Therefore, I will go with ATM.
There is also another reason to go ATM. The sale of the $105 put compromised my downward protection in exchange for protecting against a reduction in volatility. This tempers my willingness to be too aggressive and go ITM.
I write this article on Tuesday and there are only a few days left till the June 8th expiry. SPY is trading around $128.55 and the $128 strike still has 91 cents in extrinsic value and the $129 $1.36. Depending upon my assessment, I will go either $129; $128 or split 50/50.
With the next weeks expiry at June 16th and the Greek elections scheduled for June 17th I would probably go slightly OTM, just in case.
There is also one additional "play" for the weeklies ...
The $128 credits 91 cents. The $127 credits 60 cents. So, instead of selling,say ten $128s, I could sell fifteen $127s. If SPY closes at or above $128 ... 90 cents is gained, either way.
What happens if SPY falls? IF spy closes at $127 ... the $128 strike would have lost 10 cents, whereas the $127 still gains the full 90 cents.
If SPY closes at $126, the $128 has lost $1.10 whereas the $127 has lost 60 cents. The $127 has actually only lost 40 cents (the $1.00 drop minus the 60 cent credit) but there are 150% of them. So, comparatively, it has lost 60 cents.
I'll leave it up to the reader to continue the analysis, but the "break-even" is at SPY=$125.
Now, I think, it's Tuesday, SPY is trading at $128.50 and it would have to drop $3.50 (over 2.5%) in just a few days for the "One at $128" to be better than "1.5 at 127." Could happen, but considering all the places SPY could land between $125 and $128, it looks pretty good.
Conclusion: Though there is still a lot of uncertainty in the markets the investor need not just sit on the sidelines. The option strategy put forth here looks for gains but takes a cautious stance. It is not without downside risk (SPY<$105) but the downside risk is probably far enough away to allow ample time to adjust the weeklies to meet this risk.
Disclosure: I am long AAPL. I buy and sell options on SPY
