The election cycle is heating up, bringing increased uncertainty and volatility. The strategy below for the SPDR S&P 500 ETF Trust (SPY) can be used to navigate the upcoming weeks.
A long position in the ETF is combined with a bear call spread, reducing downside risk while preserving upside potential. Advantage is taken of relative option prices for different strikes.
Similar strategies can be implemented for other index tracking ETFs, such as the SPDR Dow Jones Industrial Average ETF Trust (DIA) and the Invesco QQQ Trust Series I (QQQ).
Market environment
US equity indexes are setting new all-time records almost every day. Strong equity markets are underpinned by:
- A rotation towards technology and growth sectors, resilient during the current crisis
- Quick recovery expectations
- Accommodative monetary and fiscal policies
Some downside risks
- Uncertainty from the elections in early November and potential delays in results due to increased voting by mail
- Lofty equity valuations entering earnings season, at peak political campaign time
- Assumptions for a quick recovery from the current crisis not being met
Some upside factors
- A strong and quick economic recovery
- Successful development of treatments and vaccines for the Covid-19 virus
- Current stock prices momentum
- Release of cash on the sidelines as uncertainty subsides
- Earnings outperformance relative to expectations
Pricing rationale
Within equity indexes, single stock price moves partially cancel each other, resulting in lower index than individual stock volatility.
During market selloffs, most stocks move downwards simultaneously at increased speeds, dampening diversification and increasing index volatility.
As a result, same-expiration low-strike equity index options are more expensive than higher-strike options. Stock indexes are “skewed” towards lower strikes. Further discussion of option skews can be seen at the Chicago Board Options Exchange website.
A simple way of thinking about implications of skews for index options is that 10% out of the money calls (with strikes above the market) usually cost less than 10% out of the money puts (with strikes below the market), despite both being struck at a similar distance to current market prices.
Options relative premiums can be exploited by selling low strike expensive options, while buying cheaper high strike options.
The resulting payouts have reduced volatility and attractive risk reward profiles.
Example
At current market prices the following strategy can be implemented:
- Buy SPY shares, at their current market price.
- Initiate a bear call spread, for the same units of SPY, expiring November 20, 2020.
The bear call spread is built using two options:
- A short 10% in the money call sold at a 12% premium. Note that a put with the same strike, currently has a 2% premium, reflecting the pure time value of the option.
- A long 4% out of the money call, bought in current market conditions at a 2% premium.
The above bear call spread will generate a credit (cash received by the investor) of 10% of the SPY price, equal to the net intrinsic value of the options.
The two options in the spread have equal time values. Key to the strategy, their strikes can be set at different distances to SPY market prices.
The low strike is about 10% below the current SPY price, and the high strike is nearly 4% above. Upside scenarios at expiration are closer than downside scenarios, capitalizing on the relative value of index option premiums
When held to expiration the strategy will produce gains for SPY price increases above 4%. Losses will be incurred for SPY price decreases of more than 10%.
Market risk is reduced around the current SPY price with an attractive risk/reward without paying any premium for the time value of the options in the spread.
Variations of the strategy will work for different strikes if index options struck below the current market price have higher time values than index options struck above current market prices.
Time value of options can be easily checked for any expiration by looking at call prices for strikes above the at the money and put prices for strikes below the at the money.
Payout summary
| (a) SPY expiration | (b) Long 4% OTM call | (c) Short 10% ITM call | (d) Premium | (e) Strategy |
| 120% | 16% | 30% | +10% | 16% |
| 110% | 6% | 20% | +10% | 6% |
| 100% | 0 | 10% | +10% | 0% |
| 90% | 0 | 0 | +10% | 0% |
| 80% | 0 | 0 | +10% | -10% |
The strategy payout (e) is calculated by subtracting the ETF cost of 100% from (a) + (b) –(c) + (d). “OTM” stands for out of the money. “ITM” stands for in the money.
Disclosure: I hold SPY and option spreads in a net long position.
