At optionsstrategynetwork.com we seek to assist traders and investors in finding the best value for meeting their investment goals. Understanding the dynamics of pricing structure enables you to offset some of your equity exposure through the use of derivatives, specifically Options on the E-mini Futures Contracts or SPY (SPDR S&P 500 ETF). Fortunately, this can be done with good value.
Before getting to the Strategy itself, you should understand the pricing structure of Options on most Stock Indices and specifically the E-mini S&P 500 Futures and SPY (SPDR S&P 500 ETF). They are priced in a manner that the out-of-the money Puts are substantially more expensive in Price and have a significantly higher Implied Volatility than the out-of-the money Calls. This means that if you want to Buy out-of-the money Puts and Sell out-of-the money Calls to Hedge a Long Position, unless the market falls significantly and your timing is very good, it is an expensive way to get Short or Hedge a Long Position. Fortunately, there’s a way to use the Implied Volatility Skew (which shows the ever increasing Implied Volatility of out-of-the money Puts as the Strike Prices get farther away from the current trading price), to build an Options Trading Strategy which produces a Short position with excellent value.
The Strategy involves Selling a Call Spread, out-of-the money and Buying a Put Spread approximately equidistant out-of-the money and taking advantage of the pricing structure of the Options. The Table below shows the Strategy in detail. It this example from Sunday evening, itinvolves Selling the 2110/2160 Call Spread and Buying the 2020/1970 Put Spread. Both are Bearish Strategies. The Strike Prices happen to be equidistant from the E-mini Trading Price of 2065.00. As you can see, by trading the June Options you can establish the Strategy and receive a Credit of 5.50 points. In this particular example, you are risking 44.50 Points to make 55.50 Points. As a comparison, if you were to Buy the 2020 Puts Outright and Sell the 2110 Calls to finance your Short Position, it would cost you more than 10 Points. While the latter position would provide much more profit if the market took a huge fall, the positions would make about the same amount of money with expiration at 1945.
While many of these concepts may be difficult for an Options Trader who is getting started trading, the Table below is clear and concise. It shows that the distance of the Put and Call Spreads from the price of the underlying is 45.00. It provides the prices and Implied Volatilities for each Strike Price involved in the transaction and it shows the Premium Generated if you perform the transaction at the mid-point of the Bids and Offers. It also provides an opportunity to compare the costs of executing a Hedge by simply Purchasing the Puts outright and Selling the Calls as discussed earlier.
Whenever you are executing an Options Transaction, it is essential that you review the Information that was evaluated. Analyzing the Implied Volatility and the Skew provides an opportunity to create a position that meets your risk/reward requirements while getting good value. While the E-mini S&P and SPY are extremely liquid Options Contracts, whenever you are establishing a position make sure that the percentage difference of the Bid/Ask spreads has a low percentage (such as 1-2% if possible). If not, it is difficult to make money in the long run. In addition, always be aware of finding a strategy that provides good value to meet your trading goals. The above example should provide a template for getting short stock indices, but is not a recommendation of any particular trade.
OPTIONS TRADING INVOLVES SIGNIFICANT RISK AND IS NOT SUITABLE FOR EVERY INVESTOR. THE INFORMATION IS OBTAINED FROM SOURCES BELIEVED TO BE RELIABLE, BUT IS IN NO WAY GUARANTEED. PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS.