High Risk/Low Volatility Anomaly Sets Up A 2 Way Option Play

Sep.12.12 | About: SPDR S&P (SPY)

We are at a tipping point where one of two scenarios will soon emerge and impact the stock market in a major way. While the "bad is good" investment strategy is in play at the moment, that strategy won't be in play after tomorrow. That strategy says bad news will force the Federal Reserve to take major monetary expansion initiatives to bolster inflation and keep the market on its upward trajectory. Based on the Fed's decision tomorrow a new strategy will emerge and fuel the markets to new all time highs or propel them back toward post recession lows.

If the Federal Reserve disappoints the market with their FOMC meeting announcement, the "bad is good" strategy will quickly be discarded and the market will return its focus to the underlying fundamental decay that is occurring across the globe. Markets move on expectation of the future and the Fed is going to tell us what in store for the future tomorrow.

One of two scenarios will emerge with greater clarity after tomorrow's announcement. We will discuss each briefly and propose a strategy with an excellent risk/reward ratio that should produce substantial returns in the next few months regardless of market direction.

Making a Case for the Bulls

The bull argument assumes that Fed policy is on the verge of finally creating a massive explosion in money supply and inflation. In a rush to get ahead of the curve corporations, hedge funds, mutual funds and private investors will make the decision to employ cash that has been sidelined for several years.

It is certainly a legitimate scenario as the Fed has set the stage for an explosion of cash being injected into the markets. As I noted in my article "Zero Chance For QE3 - The Feds Job Is Done," the Federal Reserve has flattened the yield curve to historically low levels and injected massive liquidity into the banking system. That liquidity is, at the present time, setting dormant but it could be employed rapidly if sentiment about the future path of the economy occurs.

As Keynesian theory states, the way to reverse a recession or a contraction in an economy is to encourage spending. The theory is that one must not hold dollars as this spending frenzy gets underway. If, in fact, this rush to invest does occur, a number of problems will be solved.

GDP will soar as people borrow and buy now out of fear of inflation making their purchases more costly tomorrow. As GDP accelerates, demand for goods and services will increase. Companies will need to hire more workers to meet the demand and unemployment will drop. These new workers, paychecks in hand, will enter the consumption pool, driving the demand for more goods and services and thereby further increasing the need for new workers.

We will effectively replace the old problem - a stubbornly stagnant economy with a new problem - a race horse that will be hard to stay ahead of - inflation. This is not just conjecture, it is a real possibility and it is the one Ben Bernanke has been trying to create for several years now. In a nutshell, that is the case for the bulls.

Making a Case for the Bears

The bear case is simple. The Fed disappoints and it's back to business as usual. The markets have priced in a good portion of the optimism premium in recent weeks and that premium will rapidly be sucked out of the market if the "bad is good" players are disappointed.

After that optimism premium is taken out of the market, further moves will be dependent on how the underlying fundamentals develop. A best guess on the amount of pre-announcement premium currently priced into the market is about 8% bringing the S&P 500 down about 100 points. That down move will be rapid, at which point the market should pause for a moment and assess a number of issues that threaten to plunge the global economy into recession:

  • Pending fiscal cliff
  • Eurozone recession
  • Possible China hard landing
  • Depression era unemployment levels
  • Flat yield curve discouraging bank lending
  • Fear induced savings that is stifling GDP growth
  • Massive debt to GDP ratios
  • Potential U.S. credit downgrade

That is probably a short list of the headwinds facing the economy at the present. I have written extensively on these issues and will refrain from further elaboration (see "Market Euphoria Continues As We Get Ready To Jump Off The Fiscal Cliff").

Playing the Fed Announcement

Surprisingly market volatility is at extreme lows. This market euphoria has taken on a true risk-on nature. It is probably one of the biggest and most irrational disconnects in the market today. The truth is that there is a huge risk of a major move in the markets in one direction or the other. The purpose here is to present a play that covers both scenarios.

The trade is an option play and for an obvious reason. You can buy a lot of time right now without a huge time or volatility premium cost. Let's take a look at the SPDR S&P 500 (NYSEARCA:SPY). We want some time, so we will go out to the December strike price. We will also want a little leverage, so we will look at out of the money options.

The December 150 call is selling at $1.72 and the December 138 put is selling at $3.46.

If you bought both the put and the call today your cost would be $5.18. The table below establishes the expiration value of these options at various market prices:

Market Price

Put Strike

Call Strike

Option Cost

Profit/Loss

% + or -

138

150

190

0

40.00

5.18

34.82

672%

185

0

35.00

5.18

29.82

576%

180

0

30.00

5.18

24.82

479%

175

0

25.00

5.18

19.82

383%

170

0

20.00

5.18

14.82

286%

165

0

15.00

5.18

9.82

190%

160

0

10.00

5.18

4.82

93%

155

0

5.00

5.18

-.18

-3%

150

0

0

5.18

-5.18

-100%

145

0

0

5.18

-5.18

-100%

140

0

0

5.18

-5.18

-100%

135

3.00

0

5.18

-2.18

-42%

130

8.00

0

5.18

2.82

54%

125

13.00

0

5.18

7.82

151%

120

18.00

0

5.18

12.82

247%

115

23.00

0

5.18

17.82

344%

110

28.00

0

5.18

22.82

441%

105

33.00

0

5.18

27.82

537%

Click to enlarge

This trade assumes a major move of 10% to 20%. It makes no difference which way the market moves as long as it moves. The option cost for both the put and the call total $5.18 which is 3.6% of the current value of SPY. In other words you will break even as a worst case scenario if the price moves up or down by $12.

Let's assume a 10% upside move. The closest price in the table above to a 10% gain is $160.00, producing a gain on invested cash of 93%. Assuming a downside move of 10%, the closest price in the table is $130.00 producing a gain of 54%.

At a 15% move the closest to table values are $165 and $120 respectively. At $165 the gain would be 190% and at $120 the gain would be 247%.

The outside parameters of this trade are probably 20%, at best in either direction and that is what I see as a best case scenario. The table values that most closely represent a 20% move up and down are $175 and $115 respectively. At $175, the gain is 383% and at $115 the gain is 344%.

No trade is without risk and the risk in this instance is that the market stays range bound between $135 and $155 - about 7% from current levels in either direction. Assuming a move in excess of 7% in either direction, the trade will make money.

The profit assumptions above also assume that both sides of the trade will be carried to expiration. Out of the money options will not have any value at expiration. Additionally, in the money options will not reflect time and volatility premiums in the price. To actually carry the trade to expiration would not be the best way to optimize profits.

Notwithstanding the fact that optimum gains are not likely to be maximized by carrying the trades to expiration, it is hard to know how option traders will reflect time and volatility in the option prices as the trade develops. It is simply a matter of monitoring the option premium to market and making a decision to exit the losing side of the trade when it becomes apparent that time and volatility premium relative to option price starts to deteriorate.

A word of caution

For those who don't normally trade options, you need to know that time is a huge consideration in option trading. A second consideration is that options carry a cost that outright stock trades don't have. That cost is the value of time and the risk associated with market volatility. The more volatile, the higher the value of the option relative to its strike and the more time that is left to expiration the higher the price.

Another consideration is the leverage that is afforded a trader in options. That added leverage cuts both ways - you can make huge percent gains trading options but you also put your entire investment at risk. In other words, it is entirely possible that both sides of the trade could expire worthless if the market doesn't move.

That said, you certainly don't want to risk a large amount of money relative to your overall portfolio value. If you have $100,000 to work with and would be willing to risk 10% of it on an outright stock trade, then that is all you should commit to this trade.

Keep in mind that the outer end of the table values above would yield a return on cash in excess of 500%, meaning that a $10,000 investment in this trade would be worth $50,000 producing a return of $40,000 in profit. Assuming a portfolio value of $100,000, that is a 40% gain in value at the outer end of the range reflected above with a risk of just $10,000.

A final word on this strategy - I rarely trade out of the money options nor do I trade both directions. What makes me inclined to think this trade does make sense is the extremely low volatility premium that is built into the option cost today and the fact that I believe we are going to make a dramatic move of 15% to 20% before end of the year. My bias is that the market will move lower and I attach a fairly high probability to that occurring. That said, I attach an even higher probability to the fact that the market is going to move in one direction or the other by at least 15%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.