Election Uncertainty? Use SPY Covered Call Spreads to Navigate the Weeks Ahead

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:

  1. Buy SPY shares, at their current market price.
  2. 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.

pot stock

Pot Stock ‘Blood in the Streets’ Buy Signal Is Here

The cannabis market has been a volatile space in recent years. A wave in legalization, particularly in Canada but also through parts of the United States, led to significant growth

Use Options as Portfolio Insurance in Rocky Times

Since the beginning of September we have seen the main U.S. indices drop. There are a number of possible reasons for the decline, but more importantly I expect the increased

4 Foreign Countries Where You Can Retire On Social Security Alone

Someone once said that retirement is not the end of the road but a highway opening to a new chapter in life. Whoever said that clearly has never experienced a

We’re Beating the Index Off the March Low: Update

The Bulletproof Wealth Report model portfolio is continuing to perform well and is now up 27.4% since the inception of our monthly newsletter on April 13, 2018. Although the value

Terrible Tuesday: Fed’s Powell Says U.S. Faces Slow, Uncertain Recovery

Powell testifies before Congress today. We already know what he's going to say though, as his testimony is pre-released. Not that that will stop the market from acting shocked when

5 Best Online Banks, Highest Savings Rates for Your Buck

Finding an online bank can be difficult. Varying rates, hidden fees and simply having too many choices can cause confusion and make it hard to get started. Set aside some

Hiring a Financial Advisor: What Is a Fiduciary, and Why Should You Care?

“Fiduciary” is a funny word. You may have never heard of it until now, but you may actually have had a fiduciary in your life. More importantly, you may wish

Trading Cryptocurrency Using Limit and Stop Orders

This is the last of a five-part series to help new investors and traders start and grow a cryptocurrency account. In all five articles I’ve been using Bitcoin (BTC) in

3 Cheap ETFs Combine to Create a Powerful Value Stock Opportunity

As I steadily increase my overall equity exposure to a measurable value bias, I do so using just three passive ETFs that are consistently near the top of their respective

Options: This ETF Could Bring a Triple-Digit Gain as the Economy Gains Steam

If we go back to February 19, when the S&P 500 peaked at what was an all-time high at the time, the market has gone through five phases since then.

dividend stock investing

Make Money While You Sleep with Dividend Stock Investing

Famed investor Warren Buffett once said, "If you don't find a way to make money while you sleep, you will work until you die." Dividend stock investing is a exactly

5 Ways to Slash Your Food Spending and Save Money

The average American spends up to 10 percent of their disposable income on food, according to the USDA. Things are likely different due to the coronavirus, but the typical divide