Saturday, July 16, 2016

Best Deal I'm Seeing Now Is a Macro Trade: SPY Put Combos

Update 8/4/2016

Looking at this post from a couple weeks ago, I seemed to be making the assumption that low VIX = low option prices. That is a naive view. I have learned a little more since this post and I will try to share here.

1) VIX only covers front month contracts, so options 6 months out are not necessarily cheap just because VIX is low. To get a sense of how expensive options are further out, you can look at VIX futures curve. In this case the VIX futures curve is actually quite steep, showing that options 6 month - 1yr out is reasonable but not super cheap.

2) Ok, so volatility is cheap, but is it calls or puts?  For that you can look at "skew". Barrons is a good source here. For a longer term view, you can look at the CBOE SKEW index. This shows that while demand for puts have came down from earlier in the year, it is about normal relative to recent history.

3) low VIX also benefits from low implied correlation. If the individual stocks in S&P500 are going to go opposite directions in prices, that would balance out index prices and dampen the overall index volatility. We're in the middle of the earning season so the low expected correlation makes sense.

So my post below is incomplete. However, the risk/rewards of the below trades are still what they are. Numbers don't change just because my understanding is flawed. They may not be as cheap as the low VIX would suggest, but I still find them attractive.  

Original Post:

Once in a while a good deal comes your way. That can happen in the single stock universe or in the macro world. At the moment I see one in the latter.

Right now, SP500 put combos offer a high probability trade with 4.5-to-1 upside/downside ratio.

Option prices are based on volatility and that is clearly at the lower end of historical range. Below is the historical chart of the VIX index from 1990. The red line is the latest VIX reading of 12.8 and green line is the 10th percentile level of 12.2.

While the VIX can go lower, any drops below 12-13 level tend to be followed by sharp bounces upwards within a few months. A 6 month option should be long enough.

With the VIX below 13 and SP500 at all time high, this is a good time to buy some SPY puts. Here’s a combo I was able to buy last week (all puts expire Jan 20, 2017).

The payoff diagram at expiration is as follows:

This combo goes in-the-money with SPY at $214 - the chances of SPY falling more than 1% from its current $216 level seems pretty high to me! It's not like the world has no problems! Peaks profitability comes if SPY falls to $203 by Jan 2017. Maximum upside is 4.5x the downside.

More importantly, you spend $2.54 to control a $216 position. That leverage allows you to hedge your entire portfolio with an 1.2% option position.

I started accumulating this last week. If the stock market continues to go up, I plan to take profit and plow it back into more of these trades as they become available. The plan is to be very aggressive if VIX falls to low 12’s or even lower.

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