Stocks made all-time highs on Thursday with shorts caught off-guard, again. Since Brexit, the market is up well in excess of 7%. Given that the risk-free return is practically nothing; those who have sought excess returns through investments in equities are quite pleased. Amazon (AMZN), Google (GOOGL), IBM and Walmart (WMT) all participated by setting new highs for the year. The question remains, will this trend continue through the election, or is the stock market, as represented by the SPY (SPDR S&P 500 ETF Trust), topping out. For those that want to participate in the market through options trading, there are bullish and bearish strategies which provide a statistical Black Scholes advantage if held for a significant portion of the vehicle’s trading period.
For example, SPY provides liquid (small differences between the bid and ask prices) options on the S&P 500 Index. It provides the investor an opportunity to trade an ETF (Exchange Traded Fund) that essentially equates the movement of all of the components of the S&P 500. It provides diversification and the investor can trade one item (SPY) and her returns over time will replicate those of the S&P 500. (There will be a slight tracking error due to the cost of trading the ETF; it is a very small error). Therefore, buyers can both buy and hold the ETF or trade options contracts on the ETF with little expense.
If one chooses to trade options on the ETF, then there is the opportunity to design positions which are either bullish or bearish, but either can potentially provide good value. The first position to be discussed is for bullish traders. It is the long fence. The long fence (shown below and priced early on Thursday) involves buying an out-of-the money call and selling out-of-the money put. The key feature of the trade is that SPY’s puts, like those in most stock indices, are far more expensive in absolute price than a call with a strike price equidistant to the current trading price. In terms of Implied Volatility, the out-of-the money puts have significantly higher Implied Volatilities than the equidistant out-of-the money calls. In the example below you can see that while the out-of-the money put is much farther from the current trading price, it is still more expensive than the call we are buying. Keep in mind that because you are selling a naked put this is a bullish strategy with unlimited risk.
Should one want to get short the SPY or hedge their long positions since SPY and the S&P 500 are trading at all-time highs, the following strategy (also priced early on Thursday) provides the opportunity to get short with good value. It involves selling a call spread and buying a put spread. Each transaction provides an implied volatility advantage and despite the fact that the call spread and the put spread are approximately equidistant from the current trading price, you can establish the trade with a credit. This means you can risk less and make more for a strategy which gets you short with limited risk. If either of the strategies is unclear: Contact Us.
Options trading provide tremendous opportunities to establish positions to meet your risk/reward requirements. They enable traders to utilize significant leverage and if the trader’s timing is good, can provide the environment for significant returns. Our Options Guide PDF provides material for review. Consider that a $300 investment in LinkedIn turned into more than $6,000. For the buyer of that call option, it was a true blessing, but for the sellers, it may have been disastrous. Before trading options, be sure you have an understanding of the following topics: 1) liquidity, 2) in and out of the money options, 3) synthetic options, 4) spread valuation, 5) implied and historical volatility, 6) the Implied Volatility Skew, 7) options trading strategies and 8) risk management. Understanding these concepts will greatly increase your chances of profitability when trading options.
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.