Investing In A Paranormal Market: June Update

| About: SPDR S&P (SPY)

SPY closed at $134.14 on Friday, and thus our hypothetical investor's option positions that were established last month (see Investing In A Paranormal Market: May Update) expired worthless.

This was, of course, the desired outcome and results in the current "brokerage statement" shown in Table 1:

Table 1

18-May-2012 15-June-2012
Cash Balance $ 12,293 $ 12,293
SPY Jun 142 Call $ 8 $ 0
SPY Jun 138 Call -$ 25 $ 0
SPY Jun 119 Put $ 86 $ 0
SPY Jun 123 Put -$ 143 $ 0
Total $ 12,219 $ 12,293
Click to enlarge

Our investor now has a cash balance of $12,293 compared to an initial (January 6, 2012) balance of $12,200. The YTD gain of 0.75% lags significantly behind the gain in SPY over the same period (6.04% including the $0.688 quarterly dividend posted on Friday).

But the modest gain is a consequence of our conservative credit spread strategy for this investor, which included a cap on downside loss of -2.5%.

Given the ongoing uncertainty about how the European debt crisis (and our own fiscal and monetary challenges) will impact the U.S. markets, a cap on downside loss seems prudent for our investor who is interested in conservative option strategies as a potential way to generate income.

Looking forward into July, there continues to be reason to believe that market volatility and uncertainty will not abate.

In fact, at the time I'm writing this, elections in Greece will be held tomorrow (Sunday) and much of the news this past week has focused on possible contagion issues with Spain and Italy.

So we will, again, establish 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 then glance at each subsequent monthly update.

To select the strike price boundaries for July expiration, our investor starts by making a rough assessment of the probabilities of a range of outcomes for the price of SPY on July 20 (expiration date).

There are 24 trading days between market close on Friday, June 15, and market close on Friday, July 20. Looking at all of the 24-trading day price changes of SPY from January 29, 1993 (earliest available data for download from Yahoo! Finance), through the present, the mean 24-day price change is 0.67% with a standard deviation (assuming a normal distribution of price changes) of 5.05%.

Let's take a closer look at these numbers, especially since they may suggest a much higher degree of accuracy (and usefulness) than is actually the case.

First of all, I listed the mean and standard deviation numbers to two decimal places only as an aid to anyone who cares to try to duplicate these calculations using their own download of the Yahoo! Finance data. If you get 0.67% and 5.05% as well, then at least you know that your method of calculation is the same as mine.

...But getting the same numbers (or not) shouldn't be construed that either of us actually knows any more about what the market will do than we did prior to making the calculations.

If market prices follow a normal distribution (which they don't), and if past history is a predictor of future price movements (which it isn't), then one could say there is a 68.2% probability that the price change in SPY between last Friday and July 20 will be between -4.4% and +5.7%. You could also say that there is a 95.4% probability that the price change in SPY would be between -9.4% and +10.8%. These numbers represent +/- 1 and +/- 2 standard deviations, respectively, from the mean and are represented in Figure 1 below by the light green (+/- 1 standard deviation) and dark green (+/- 2 standard deviations) areas.

But if market prices don't follow a normal distribution and past history isn't a predictor of future price movements, what value is there in calculating and displaying mean and standard deviation numbers?

Well, another way of looking at these numbers is to say (again, if market prices follow a normal distribution) that if the change in SPY is outside the range of -4.4% and +5.7% on July 20, this will be an event that happened only 31.8% of the time since March 9, 1993 (the first 24-trading day period after January 29,1993). And if the change in SPY is outside the range of -9.4% and +10.8% on July 20, this will be an event that happened only 4.6% of the time since March 9, 1993.

Actually, by my tally, the change in SPY over 24-trading day periods was outside the range of +/- 1 standard deviation from the mean only 24.6% of the time, and was outside the range of +/- 2 standard deviations 5.0% of the time. This difference is due to the relatively small sample periods in combination with the non-normal distribution of price returns.

But I maintain that this is still close enough for the mean and standard deviation to be at least somewhat useful in selecting the striking prices for the July options.

The subtle, but important, difference between predicting a probability and observing the number of times that potential changes were outside of an historic range helps our hypothetical investor in establishing risk/reward trade-offs.

More specifically, if our hypothetical investor wants to select strike prices on options with the goal of receiving a near-constant positive return across a range of outcomes that occurred 68% of the time over the past 19 years, then the following credit spreads may be suitable for this purpose:

  • Purchase a July 146 Call contract for $0.07, and sell a July 142 Call contract for $0.27 (bear call spread).
  • Purchase a July 123 Put contract for $0.76, and sell a July 127 Put contract for $1.23 (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, June 15, as reported on the Yahoo! Finance website. 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 superimposes the proforma P/L (Profit/Loss) diagram at expiration with the mean and standard deviation values:

Figure 1

Click to enlarge

The green circles illustrate how the value of the cash+options portfolio will change relative to the change in the price of SPY between June 15 and July 20 (option expiration dates). The gray circles show how the value of the portfolio will have changed between January 6 (when the portfolio was initiated) and July 20 based on the change in SPY between June 15 and July 20. This is useful to get a sense of whether we are making gains as the year progresses.

Figure 1 shows that the greatest return will be achieved if SPY closes on July 20 at a price between roughly +/- 1 standard deviation from it's long term price change over 24 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.

Thus, the cash+options 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 0.5%.

However, our investor will realize a modest 0.5% gain in his portfolio if the change in SPY is within the +/- 1 standard deviation range.

These potential outcomes are satisfactory for our hypothetical investor. In the best case, the investor will achieve a realized gain for the month of about 0.5%, or roughly 6% annualized. In the worst case, he will realize a loss of about -2.7% for the month, or -2% YTD.

Summarizing for this month, then, Table 2 shows what our hypothetical investor's "brokerage statement" now looks like just prior to market open on June 18:

Table 2

18-May-2012
Cash Balance $ 12,360
SPY Jul 146 Call $ 7
SPY Jul 142 Call -$ 27
SPY Jul 123 Put $ 76
SPY Jul 127 Put -$ 123
Total $ 12,293
Click to enlarge

The next update to this series will be shortly after July 20 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 hold both long and short positions in SPY.