Last night on CNBC’s Fast Money I took a look at the implied move in the S&P 500 between now and September expiration, which will include the highly anticipated FOMC rate decision on Sept 17th:
For those of you who hear the term implied move, and are not exactly sure what that means, let me break it down for you. With the SPY trading $196, both the Sept 196 puts and the Sept 196 calls are offered at 3.75. Buy both and you own a Sept 196 straddle for 7.50. With the etf at 196, both options are at the money and their values are pure extrinsic premium. If we could turned the clock ahead to Sept 18th expiration at 4pm, both options would expire worthless (with SPY pinned at 196). So if you were to buy the SPY Sept 196 straddle because you thought the SPY could move greater than the $7.50 implied move (or ~4%) you would need a move above $203.50 on the upside, or below $188.50 on the downside to break-even. And if you got no move, the entire straddle would be worthless.
What’s interesting about this mental exercise is that prior to the 12% decline in S&P500 (that started in mid August) the implied move two weeks out into an expiration that included an FOMC meeting was a little less than 2%. The one year chart (below) of 30 day at the money implied volatility (blue) vs 30 day realized (white – how much the SPY has moved) shows IV having overshot realized in the latest sell off, but with implied vols settling a bit, realized now higher than implieds.
What that means is while the all out panic from those seeking protection might have subsided, the SPY is still moving around at unprecedented levels for 2015:
So what to do now for those seeking portfolio protection or merely looking to make an outright bearish bet on the SPY? Long premium directional strategies could be a hard way to make money if the broad market were to settle into a new range here. Implied vol can collapse quickly once traders want/need to sell out of elevated index etf option premiums.
Back on Aug 12th, prior to the market decline, we took a look at SPY options as a potential portfolio hedge:
The lack of movement in the index, despite some massive moves in large components like AAPL, DIS, GOOGL & XOM has caused only a mild uptick in both realized (how much the index has been moving) and implied volatility (option prices) on the index. The one year chart of both for the SPY shows the recent uptick in both, but well below recent highs into the Greek debt deal, and down nearly 50% from the 52 week highs in implieds:
Intra-day movement like today will keep options prices decently bid, while a cooling off would cause a collapse, likely to new lows. If you are of the mindset, as we are, that the volatility in almost every other risk asset class, and most other equity index’s around the globe (the German DAX closed down 3.25% overnight) is likely to adversely affect the SPX in the coming months then you may want to look at what we would call relatively cheap index option protection over the next few months. If we can agree that 2050 is the line in the sand for the SPX (205 in the SPY) then in our minds thats where you want to target for disaster protection against a portfolio of large cap U.S. stocks.
At the time, SPY options looked and felt cheap, relative to the movement in other risk asset classes. This is an important point. Often times you will hear peeps on tv say buy protection when you can, while it’s cheap. While that makes sense, it only makes sense at perceived inflection points. For the better part of the last couple years, index etf options appeared very cheap, but for a reason. The recent vol spike is the first time since early 2012 that 30 day realized vol in the SPY has been above 20:
For those buying options premium right now, either for hedging or trading purposes, it’s imperative to spread with out of the money strikes against long near the money strikes you may own to help offset decay. And during times of panic implied vols comes opportunity in selling far out of the money options in ratios versus closer at the money options due to skew.
Stay tuned, we will detail a zero cost way to use out of the money ratio spreads to slap on crash protection.