SPY Has Butterflies?

by Dan February 12, 2016 1:27 pm • Commentary• Trade Ideas

6Last night on CNBC’s Fast Money my friend Carter Worth of Cornerstone Macro Research laid out his technical view on the S&P 500 (SPX). He has been consistent for months, if not quarters that the broad market has been rolling over.  He now believes that the SPX could retest the prior highs from 2000 and 2007, which is about 1575-ish, watch here:

He is fairly convicted that we will see this pull back in 2016, which would be about a 25% peak to trough draw-down.

As one would expect, options prices in the SPY, the etf that tracks the SPX are elevated, with 30 day at the money implied volatility (the price of options, blue line below) are just off of 6 month highs at 23%, which is below the late August high of 32%, but interestingly just a tad above realized volatility (how much the underlying has been moving at about 22%, white line below) making options prices look reasonable on a relative basis:

From Bloomberg
From Bloomberg

On an absolute basis 23% IV for the SPY is very high historically as the on year average has been only about 16%.

One of our last posts of 2015, when U.S. stocks were much higher on Dec 29th was to introduce tactical portfolio hedges in the SPY, QQQ and the IWM (here) siting the fact that in 2015 and 2014 both January and February saw new year sell offs in the major indices. At the time we chose to use straight put spreads, and again when we posted an update on Jan15th (here).   But now, with options prices are were they are, and with the most major indices near their 2014 lows, we think it makes sense for those considering SPY portfolio hedges to be slightly short dated but also look for trade strategies that would help to offset a pull back in options prices. One such strategy is a Butterfly (read about here).

If I were inclined to put portfolio protection on through the end of Q1 I might consider a wide put butterfly, piggy backing off of Carter’s levels, breakdown at 1800, and support near 1600.  

Hypothetical portfolio hedge or outright bearish trade in SPY:

SPY ($185.30) March 31st Quarterly Put Butterfly for $2.70
  • Buy 1 March 31st 180 put for $4.65
  • Sell 2 March 31st 160 puts at 1.10 each or $2.20 total
  • Buy 1 March 31st 140 put for 25 cents

Break-Even on March Expiration:

Profits: gains of up to 17.30 between 177.30 and 142.70, with max gain of 17.30 at 160

Losses: up to 2.70 between 177.30 and 180 and between 140 & 142.70, with max loss of $2.70 below 140 or above 180

BEFORE SHORTING THE MARKET PLAYING FOR A BREAK I WOULD FIRST WAIT TO SEE IF WE GET SOME FOLLOW THROUGH EARLY NEXT WEEK OF TODAY’S RALLY.