Catching A Falling Knife With Put Options On SPY

Mar. 26, 2018 7:08 PM ETSPDR S&P 500 Trust ETF (SPY)47 Comments
Denis Atamanov profile picture
Denis Atamanov


  • The recent sell-off in equities opens an opportunity to exploit the "oversold" regime.
  • Trying to catch a "falling knife" with a pure directional bet is possible but quite risky.
  • Options market usually overreacts to the downward moves and lifts put option prices unreasonably high, above their fair values.
  • Put options provide an opportunity to exploit both directional and inflated implied volatility factors in oversold markets.

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Various pieces of evidence exist confirming that put options on wide equity indices are permanently overpriced by the market. The excess demand for the long portfolio protection is believed to be the main reason for that. For more about systematic puts overpricing, please see here.

During the market sell-offs, that overpricing is even more staggering: The options market lifts prices of put options hugely above their fair values, which are equal to the probability of the in-the-money expiration times the expected option value is that case. You can find this approach to the fair value calculation in this Seeking Alpha blog post: "What Is The Fair Price Of An Option You Buy Or Sell?"

Below, we will use the Relative Strength Index - RSI(14) - as a filter to calculate the fair values of, say, put options on SPY with expiration on April 13, 2018 (a three-week period). We consider RSI(14) below 40 as an oversold market signal; at the time of writing, March 23, 2018, it is around 35.

ChartSPY data by YCharts

Here is the mispricing chart comparing the current market prices (green line) of our options with their fair values (blue line), which have been calculated based on the dates in SPY history when its RSI was around 35 and VIX was around its current level of 22 (300 data points):

For more information about the filtering logic, please see here. We have also filtered out the recessionary environment when the half-year rate-of-change of the Conference Board Leading Economic Index was below -2% (we only consider healthy economic periods).

Obviously, the difference between the fair and market prices is huge - it actually constitutes the expected profit of a seller and the expected loss of a buyer (see the lower diagram). It is not guaranteed, of course, and the market can continue its way down and entail a loss for an option seller ("buying the dip" does not work out in 100% of cases).

However, on the basis of historical data, it is very unlikely. After some number of trades, the result should converge to its mathematical expectancy. In practice, the sum of premiums received by selling of these overpriced puts should eventually exceed the losses of all in-the-money expirations.

Avoiding the Total Crash With Spreads

Of course, this is an extremely risky strategy and selling naked puts is a sure way to lose everything. No matter how huge the expected profit is, if you have a non-zero probability of ruining the portfolio, it will happen eventually in the case of a catastrophic event. Therefore, the tail risk hedging is essential with, say, buying a farther OTM put and, hence, converting that naked put strategy into a credit put spread. Yes, that hedging long put is also overpriced but the expected loss of buying it will be less than the expected profit of the short leg. The overall expected profit is still positive.

Here is an expected profit of the credit put spread (96/90) for the SPY options from the example above (all values are presented as a % of current SPY price - $263.93):

Leg/strategy Fair Value Market Price Overpricing
Short leg - 96 moneyness 0.22% 0.73% 0.51%
Long Leg - 90 moneyness 0.03% 0.27% 0.24%
Credit Put Spread 0.19% 0.46% 0.27%

Fair value is a multiplication of the ITM expiration probability and expected value in the case of such expiration: FV(96) = 10.7%*2.1%=0.22%, FV(90) = 1%*2.8%=0.03%.

So, we have the expected profit of 0.51% ( $263.93 * 0.51%*100 = $135) per option in the short leg, and expected loss of -0.24% ( $263.93 * -0.24%*100 = -$63) per option in the long leg. In total, it is 0.27% ( $263.93 * 0.27%*100 = $72) expected profit per strategy. In other words, we expect to give up $63 as a loss of ITM expirations per each $135 of the credit received, on average.

Importantly, since this strategy inevitably entails substantial drawdowns at times, it is also crucial to adhere to the strict money management rules and properly select the position sizing to avoid overbetting (e.g., after losing 50% you will need to earn 100% to break even).

Why It's Better With Options

Of course, it is possible to exploit such an "oversold" market with just the underlying security. Why not simply buy SPY if it is expected to bounce back with high probability (after all, the average SPY return in our three-week period is 1.22%, or 22% annualized, in our historical sample)?

Yes, it is possible. But with options, we can have two sources of profit at once: not only the expected upcoming move but also the market's overestimation of the probability of going further down (overstated implied volatility, in other words). If the former factor does not work out and SPY goes further down harming the long (delta) position, you still will be able to make a profit from the latter one. Simply put, the underlying may continue sliding but if your short put is far OTM enough, you have some wiggle room for SPY until it hits your breakeven point.

Another advantage of options in these cases is that it is possible to fine tune your strategy with varying the strike and selecting the probability of success that suits your risk appetite and/or other portfolio holdings. You can choose higher probability trade with a lower expected profit of a trade with higher profit expectation, but with lower probability.

Make Your Portfolio Hedge Smart

Besides the pure speculative trades that can be done based on this analysis, the big positive expected profit of option strategies can be also used to lower the cost of the long-term portfolio hedging. For instance, it's well-known how expensive a protection with the outright put options is. The simple puts buying will eat up the major part of your portfolio returns (various research papers confirm that).

However, if we combine the long-term protection (with, say, LEAP put options) with the exploiting of the short-term market mispricing like the one described above (and many others), we can substantially decrease the total cost of hedging. We just need to make some number of such trades to force the probabilities and expected values to realize in practice.

Disclaimer: The information provided in this article is for informational purposes only and should not be considered as an investment advice. Investing in options involves risk of potential loss exceeding the whole amount of money invested. I use the approach of the options fair value estimation and finding the market mispricing in my daily trading.

This article was written by

Denis Atamanov profile picture
I am an investment advisor and option trader.Before 2014, I worked in the pension industry for 7 years being responsible for the asset management function as a Vice President on Investments of a private pension fund (around $1 billion AuM). Since 2014, I have been working as an investment advisor with my own private practice focusing on the long-term portfolio management with index ETFs and hedging with options. The other part of my professional life is options trading. I have been familiar with it for the last decade, and now I trade them on a daily basis using options to build trading strategies or as a hedge for the long-term equity positions in my portfolios and portfolios of my clients. In 2017, I decided to open to the public my software that I had been developing and using for myself for several years. I called it OptionSmie - It is an online analytical software platform calculating the options Fair Value on the basis of the historical distribution of the underlying security. It identifies market misprising and discovers trading opportunities in different market regimes and helps in building options trading or hedging strategies. Since it is a by-product of my own trading that I use every day, I decided to make the access free because the incremental cost for making it public is not material for me. What is more valuable is the feedback that I’m receiving to my approach, which is somewhat unusual and is not widely used among option traders.

Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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