Buy The Bubble

Includes: IWM, QQQ, SPY, VT
by: Silent Trader

Many people consider the market overvalued and are scared to stay in the market. At the same time they fear missing out on a continuation of the bull market.

A basic strategy is proposed that offers downward protection, full participation if the bull market continues and the opportunity to lock in gains that the bull market may bring.

Only a one-time investment is needed to participate in the remainder of the bull market.

The strategy can be adapted and enhanced to better fit personal preferences and market views.

The title of this piece is based on the quote of George Soros saying that if he sees a bubble develop he buys. Though for many counter-intuitive, it's a rational approach. In a bubble great gains can be made especially in an extensive buying frenzy that may precede the top.

Despite the rationale of buying the developing bubble many people do the opposite as they feel valuations are getting high. Truth be said, there is a rationale for that too. After all, after a bubble 50%+ declines for the broad market are common. It certainly is not easy to pick the top or to decide which correction is meant to be bought and which correction is the start of a bear market and should be sold.

Now is such a moment that many people claim stocks are overvalued, possibly in bubble territory and a serious correction is in the making. Consequently, investors tend to sell and wait for a correction to re-enter. Instead, for now, they see the bull market continue and miss out on some good profits.

In this article, we'll look at a basic approach to solve this issue and keep you in the market but at the same time limiting the risks. I propose a strategy that limits the losses in case the market goes down, offers full participation in a further bull market and includes a mechanism to lock in those gains. But, as no free lunches are offered, it will lag if the market goes nowhere.

The proposed position

For simplicity sake I assume we have an original portfolio equivalent to the S&P 500 (NYSEARCA:SPY) and use this as the benchmark to compare the strategy to. As the current volatility is low, options are cheap. So, I propose to sell the stock portfolio and buy an equal amount of exposure through options.

To minimize time decay also known as theta, we buy the longest dated options available to us. We will buy at the money option as these offer generally the cheapest market exposure and provides the highest gamma, which is the change in market exposure with a changing price. In this case, we will buy the 245 strike with an expiration on 20 Dec 2019 for $22.50. As we like the same exposure as the S&P 500, we will buy 10 contracts.

At the money options will have a delta of approximately 0.5, which means we need two contracts to have the same market exposure as the stock. With the contract multiplier of 100 per option contract that would give the same exposure as the original SPY portfolio we want to replicate. The investment and maximum loss will be 10 * $22.50 * 100 = $22,500 or 18.5% of the portfolio value.

The remainder of the portfolio value may be invested at the risk free rate. The interest earned may be deducted from the maximum loss as it will be a guaranteed income. For the 2.5 years until expiration, this would be about 2.5%. So, the maximum loss over 2.5 years would be about 16%.


Many people will object to the choice for at the money options and say that by choosing at the money options time decay is maximized. This is true, but it's not as bad as it sounds. As we've chosen LEAPS with the furthest expiration date time decay (theta) is limited. Also important, this theta comes with a benefit called gamma. Gamma is Greek and indicates how fast the market exposure (delta) changes if the market moves. This behavior can be exploited to lock in gains.

In the short term, when time decay is negligible and price moves are small, the portfolio will behave exactly the same as the original investment in SPY. The gamma of the option will however make that with larger price moves, the market exposure changes. If SPY rises, delta, the market exposure will increase and the option portfolio will outperform the original investment.

However, if SPY declines, the market exposure will decrease too and again the option portfolio will outperform the original investment in SPY resulting in a smaller loss. In short, if the market moves, the option portfolio will outperform the original portfolio, it will rise more or decline less. Only when the market does not move, the option portfolio will underperform the original portfolio as the portfolio will be subject to time decay.

Another objection people may have is that the proposal takes on too large a position. The options bought control twice as many stock as the original portfolio. Again, in principle true. That is if we enter the position and leave it as it is until expiration, we will essentially have double the market returns of the original portfolio minus the paid option premium with a maximum loss of the paid option premium. In the short term, with limited price moves, the option portfolio will however perform in line with the original portfolio of SPY.

As explained above, the market exposure is not stable; if we intend to do nothing half the number of option may very well be a better choice. We will however not wait passively until expiration. We will monitor the position and manage it in order to lock in gains while staying in the market and maintaining our market exposure.

Managing the position

The basic position as proposed pretty much does meet our objectives. In case the market tanks, the downside is protected to the paid option premium. If prices go up, then we fully participate and actually the market exposure increases. The increased market exposure is above our objective. As we suspect, a correction may be on the way; we are more after limiting risks than increasing market exposure.

Therefore, after a market rise, we will monetize the increased market exposure in such a way that we maintain the original market exposure and the characteristics of the position but take some profits off the table effectively locking in our profits.

The way we do this is rolling the option contracts up and out. So, periodically or after a certain amount of price rise, we will look at our options. The in the money calls will be sold and at the money calls will be bought. In the process, the slowly increased market exposure will be trimmed back to the original market exposure and we take money off the table that we can add to our cash position.

If in the meantime options with a later expiration date are added, we would also like to roll our options out in order to keep time decay as low as possible. Options further out will have higher option premiums; this means we will take less gains off the table than when just rolling up.

Nevertheless, it's important to roll out if longer dated options are available. It keeps time decay low and makes that we can stay in the market no matter how long the bull market remains. If we would not roll out time decay on our position will keep increasing and become more and more a drag on the performance of the strategy, and at the expiration of the options, we would be left without any market exposure.

An example: If SPY went up 20 points depending on the time it took for this increase to occur options value may have appreciated with $11. So we might sell them for say $33. At the same time, we would buy new at the money options for maybe $19. So we would take $14 per option off the table and lock these gains in by adding them to our cash position. For the entire position that would be $14,000 (10 contracts with multiplier 100 times the premium difference).

Rolling down

If the market goes down, we will initially do nothing. After all, the portfolio is doing what we like it to do; it outperforms our benchmark. Rolling down only because prices have dropped is likely to worsen our performance. The moment we believe a bottom is reached, we can roll down our option positions.

We would sell the options that have become out of the money and buy at the money options. As the goal is to protect principal, we will not add to the position. If the drop has been significant enough, it may be opportune to increase market exposure. The strategy is primarily about protecting principal while still fully participating in the market. Increasing exposure is a separate decision that is outside the scope of the strategy.

If we don't add to the position, this will however mean that we end up with a lower number of contracts, and thus less market exposure as we originally had. If we're right, we ride up with the market again and basically follow the management rules for a rising market. To maintain long-term market exposure, we will limit the gains we take in favor of increasing market exposure until we reach our original market exposure again. We do this by buying more at the money contracts than we sell in the money contracts when rolling up.

An example: If SPY dropped 30 points, the value of our now out of the money options may have dropped to $13. We would sell them and buy new at the money options that might now be at $21. From the proceeds of the option sale, we could only buy 6 contracts instead of the 10 we want. As we don't add to the investment, we stay with 6.

Provided that we're right and the bottom was in, we will profit from the price rise and the increased gamma that came with rolling down. Say SPY rebounds 20 points. Our 6 options may have increased in value to $30. The at the money options may have a value of maybe $19. We would again sell the now in the money options and exchange them for at the money options.

Instead of taking money off the table, we would increase the number of option contracts. The proceeds of the options sold fall short to buy us the desired 10 at the money contracts, but we can buy 9 and pocket a little change. If the market continues to rise the next roll, we will increase the number of contracts to the 10 that we started out with and pocket the remainder of the gains.


In principal, this basic strategy can be used at any time with any asset as long as LEAPS are available. Though a broad market index (SPY, QQQ, IWM, VT) may seem the first choice, it could also be used for narrow sector indexes, commodities or even individual stocks. The present low implied volatility makes now a better time for this basic strategy than other times.

It makes that the investment in the options is relatively low which limits the headwind of time decay. Low volatility will result in a more pronounced expression of gamma than in a higher volatility environment. This makes it easier to lock in gains while maintaining the market exposure. The position also benefits from an increase in implied volatility; consequently, a reversion to the mean would be beneficial.

In a more volatile environment, the basic strategy still works, but the benefits compared to a position in the underlying are less pronounced while the headwind of time decay would have a larger impact. This does not mean the strategy would be bad. The ideas behind it would still be valid. We would however manage it in a different way to limit the negative impact of time decay.


The above is a basic strategy. There are many ways to adapt the strategy to better fit personal preferences and market views. Some obvious examples:

  • Aggressiveness of locking in gains. The moment that positions are rolled are quite arbitrary. By locking in gains more often, the risk of losses are limited, but by waiting longer, you save on trading costs and profit more from the increased market exposure that comes with rising prices.

  • Instead of the risk free rate, one might choose to take more risk with the cash position in the hope of better returns. Some diversification by investing in assets with a low correlation to the stock market is likely to improve the portfolio performance.

  • One might choose shorter-dated options to lower the investment and protecting a larger part of the principal in exchange for higher time decay and a larger part of the principal. As European exchanges and futures have longer-dated options, people that have access to these may go the other way and lower time decay further in exchange for a higher investment by choosing expiration dates further out.

  • Time decay may be (partially) countered by selling shorter-dated calls on (part of) the leaps. This will however limit the upside in case of a strong price move up and might even result in losing the time value in the leaps. In a low volatility environment, you may wonder how option premiums received compensate for the disadvantages. In case of higher volatility, selling shorter-dated options may help to counter the time decay that works against the basic position.

Take away

Many people fear a correction but also fear missing out a possible further rise of the market. The proposed basic option strategy offers a way to protect most of the principal, but at the same time fully participate if the bull market continues. In a moving market, the strategy will outperform a direct investment. There is however no free lunch, and in a consolidating market, the strategy will lag a direct investment.

The strategy requires a one-time investment and will offer downward protection and full participation in the bull market for the remainder of the bull market. That is until an extended period without significant appreciation of the market occurs.

The strategy can be used in all environments for all assets with LEAPS available. The current low implied volatility environment however is ideal as it requires a relatively low investment while gamma, the variability of market exposure, is expressed more strongly resulting in better chance to outperform a direct investment and more opportunity to lock in gains. The strategy can easily be adjusted to better match personal preferences and market view.

Disclosure: I/we 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.

Additional disclosure: The option prices mentioned are just very rough estimates of what prices might be based on June 23 closing prices. The exact prices would depend on many factors and are not that relevant. The goal is to illustrate the mechanics of managing the option position in a way that is likely to yield the best results.