The Striking Price column in this weekend’s Barron’s features John Marshall from Goldman, who suggests an “opportunity to buy volatility” in the S&P Materials sector via the tracking ETF (XLB). He makes the bearish case for XLB, arguing: 1) that the materials sector is particularly vulnerable to any slowdown in global growth, 2) that the ETF components include some less resilient names, and don’t feature the best of breed like POT and MOS, and 3) that hedge funds are relatively overweighted in materials, such that underperformance in the sector or any increased redemptions in the funds themselves could exacerbate any downward move.
These are all fine points. So what options strategy does The Striking Price suggest we use to take advantage of this downside?
The next few weeks could be just as interesting as investors decipher what earnings reports, oil-price moves and inflation data mean for global growth. Buying puts and calls risks the entire premium, but it provides potentially rewarding exposure to a big move in either direction.
This is pretty unsatisfying, and a tag misleading. Flat-out buying puts and calls is, after all, rarely the best approach to anything. Some thoughts:
- If by “potentially rewarding exposure” Marshall is referring to the leverage inherent in options, well that’s a trivially true claim you can make about any options trade. If, on the other hand, he’s making a substantive claim about the likelihood of the options rewarding you for “a big move in either direction,” well’s that just false. If XLB makes a big upside move, the already-elevated volatility in the options will get crushed, leaving you at best significantly underwhelmed. This is always the problem with buying naked calls - you’re effectively fighting three enemies at once, namely time, volatility, and price. Getting price right is great, but call buyers often still end up losing even if they’re great stock-pickers.
- The whole premise of this piece doesn’t make much sense to us, either. Implied volatility is already on the high end in XLB: the 35 area, where most of the XLB options are trading, is exceptional. Besides the January and March 2008 selloffs, XLB options haven’t seen this kind of sustained IV since late 2002. Now, while high premiums can always go higher, it certainly doesn’t make much sense to be a net buyer of volatility here. You’re paying a steeper price than normal for options on a sector that has already been beaten down pretty well.
- The fundamental analysis this trade relies on may need plenty of time to play out. That means you’ll either need to prepare to keep having your contacts expire worthless month after month while you wait around for the big payday (a gloomy strategy, to be sure); or you’ll have to pay up for some serious time in addition to that pricey implied volatility, and paying up now to lock in historically high IV for the next 6-12 months sounds a bit like taking out a 30 year mortgage at 10% at the height of a Greenspan chairmanship. In either case, you’d better be prepared to refinance.
If you really want to get short XLB, and don’t want to pay through the nose (either in terms of theta or vega), a simple put diagonal spread will act a lot kinder to you. For example, you could sell the August 37 XLB puts and buy the September 40 XLB puts for a debit of about $1.80, and a trade like that would have positive time decay (from the short front month options) and have positive vega, enabling you to participate if volatility increases from here.
We understand that The Striking Price isn’t intended to be a column for advanced and experienced options traders, but just telling readers to go out and buy puts and calls isn’t particularly helpful advice. Frankly, replacing that advice with “buying calendar and diagonal spreads provides potentially rewarding exposure” would make a world of difference.