The prevailing theme among institutional money managers is to buy on a dip, which probably explains why pullbacks have been minor in nature and short in duration. This thinking also probably sets the stage for money flows throughout the summer, which means you can watch from the sidelines or hedge your way into the game. To that end, there are a couple of low-risk option strategies that fit well within the “buy on a dip” mindset.
The first of these strategies involves selling cash-secured puts, which allows your clients to capture stocks on a dip; the other strategy is to buy calls as a stock substitute, effectively limiting your clients’ exposure during pullbacks.
Both of these strategies are bullish in nature, which means that you should have a positive longer-term view. The choice of whether to “sell premium” (i.e., write cash-secured puts) or pay up (i.e., buy calls) comes down to whether you believe options are expensive or cheap.
For that assessment, you should look at the volatility indices in North America. In Canada, you have the S&P/TSX volatility index (VIXC); in the U.S., you can look at the Chicago Board Options Exchange‘s volatility index (VIX). At the time of writing, the VIX was close to normal levels, as defined by its 200-day moving average. Premiums above the 200-day moving average are considered relatively expensive, and those that are below the 200-day moving average are considered relatively cheap.
In terms of strategy selection, buying (going long) calls makes more sense if you believe premiums are low and volatility is likely to increase. Writing cash-secured puts makes more sense if you believe that volatility is likely to remain the same or decline.
In a Goldilocks environment, in which premiums are not cheap but also are not expensive, strategy selection comes down to your client’s preferences: limited risk with a cash outlay, which is the “long call + cash” strategy; or an initial credit with an obligation to purchase, which is the cash-secured put strategy. This column will look at both approaches using a couple of recent examples.
To that end, suppose you like the prospects for the S&P 500 depositary receipts (SPY), which represents exposure to the S&P 500 composite index. At the time of writing, SPY was trading at US$164 a share, which translates into a value of 1640 on the S&P 500 composite index. The SPY September 164 calls were trading at US$4.70 a share with an implied volatility of 15.5%, which is slightly above its 200-day moving average of 15%.
The long call + cash strategy is an alternative to buying SPY outright. The math is relatively straightforward: to buy 100 shares of SPY would cost US$16,400; to buy one SPY September 164 call costs US$470, which is your maximum exposure. The remaining US$15,930 that would have been used to buy SPY outright is used to purchase, for example, a short-term, high-quality certificate of deposit.
It’s granted you make very little on the cash. But, because it is a riskless asset, you will lose less if the market were to sell off as a result of a sentiment shift. This combination of cash plus the call option represents a low-cost synthetic convertible debenture that carries less risk than the outright purchase of SPY.
The sale of cash-secured puts represents an obligation to buy shares on a dip. In this case, the sale of the put obligates you to buy the underlying security at the strike price of the put. Consider shares of Microsoft Corp., which have rallied throughout 2013. But even with the rally, the dividend represents a 2.6% yield well above the average for S&P 500 companies.
At the time of writing, Microsoft shares were trading at US$35.40 and the Microsoft October 35 puts were trading at US$1.70. When you sell puts, your client is obligated to buy Microsoft at US$35 a share until the October expiration. However, should the put be assigned, your actual cost will be US$35 a share minus the US$1.70 premium received, resulting in a net cost of US$33.30.
The cash-secured nomenclature assumes that you maintain a minimum US$3,500 in cash to purchase 100 shares per written put, which represents the classic strategy of buying on a dip.
Maybe the U.S. financial markets are the leading indicator that everyone imagines and the heightened valuations reflect a changing global landscape. Maybe ultra-low interest rates create excess liquidity and benign inflation will continue to be a recipe for more of the same with “buy on a dip” sentiment providing short-term support for share prices.
Even with that, it would be wise to recognize that markets are priced for perfection. It’s the things we don’t know that are fodder for the risk-reduction metrics inherent in specific options strategies – whether buying calls as a stock substitute or selling puts to take advantage of dips.IE
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