The stock market continues its multi-year bull run with the S&P 500 has hit new highs. Investors are showing little fear of market decline to a point of unhealthy complacency. One measure of investors perception of market risk is the prices they will pay for options hedging against market changes. For large capitalization stocks the best indicator is the S&P100 volatility index. The index measures the implied level of anticipated pricing changes exhibited in short term options prices. Looking at the below the index is sitting near a five year low.
We recommend a strategy to take advantage of these low levels through the purchase of an option straddle. An option straddle is the simultaneous purchase of a put and a call with the same strike price. Investors can profit if the market moves either up or down by more than the premiums paid.
Another strategy is to buy or sell the underlying index regularly to bring the position back to delta neutral. The investor will gain from any market movement regardless of direction. Any gains will be offset by the time decay inherent in options. In essence the investor gains if the market move in either direction is large enough to overcome the loss in time decay.
Let's look at an example to demonstrate the delta neutral strategy, where the investor an realize a gain even in the event the index closes at the straddle strike price.
- An investor purchases an OEX straddle a put and call at $5.20 and $5.85. OEX options are 100 times the index and there fore have a market value of $520 and $585 respectively.
- Looking at the second day the index closes at 820 with the put and call at $1.08 and $16.08 respectively. The next step is to calculate the delta neutral position. This is done by taking the sum of the call delta and put delta from the Black-Scholes pricing model and multiplying by the index value (100x time the index value in the case of the above options) In the example below this creates a short exposure of $57,564. The investor would then execute a transaction offsetting this exposure by purchasing 70.2 units of the index. For the OEX investors can purchase shares of the S&P100 ETF (NYSEARCA:OEF) or use the market value equivalent of the S&P500 (NYSEARCA:SPY) This results in a long exposure of $57,564 in the ETF. Therefore the investor is now in a delta neutral position. The profit and loss for the day is the change in market value of the options plus the change in value of the beginning of day ETF position. Since the investors held no shares in the ETF at the beginning of the day the P&L is zero for the index but a gain of $611 overall.
- On the third day the index value returns to 835, a value that would be harmful if there was no daily adjustment to a delta neutral position. Repeating the same exercise in day two the investor will notice their long position in the index increase in value along with their call option offset by losses in the put option generating a positive profit and loss of $421. Note without delta adjusting the investor would incur a loss of $100. The investor must once again recalculate their delta adjusted options exposure. In this case the options have a long market exposure of $542. To offset the exposure the investor requires a short position of 0.64 index units meaning they would sell 70.82 units at the closing price. (Long 70.2 units day prior to a now short position of 0.64 units)
This process is repeated each day until the options expire. Note that the days in which the profit loss are negative the day to day change in index value is small either positive or negative. On days the index change is large the portfolio gains regardless of direction.
In the below example we returned the index value to the straddle strike price at expiration. In this case the options both expire worthless and without delta adjusting the investor would have realized the maximum loss on a straddle. But because the positions were delta adjusted each day the portfolio showed an overall gain.
|Day||OEX Value||Call Value||Put Value||Call Market Value||Put Market Value||Call Delta||Put Delta||Options Delta Adj Market Value||Index Position||Index Market Value||Call Gain/Loss||Put Gain Loss||Index Shares Gain Loss||Total P&L|
|C X 100||D X 100||(G + H) X 100||(I / B) X -1||J X B||CHANGE IN E||CHANGE IN F||CHANGE IN INDEX X PRIOR DAY J|
The delta adjusting strategy with options allows investors to profit or loss from purchasing (or selling if the above were reversed entirely) volatility. In the current market environment volatility is at multi-year lows and should the actual market volatility be greater than that implied investors can use the above strategy to profit from regardless of the overall market direction.
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.