Wednesday, April 15, 2009

Making volatility (the fear of other people) work for you

Despite the fact that there seems to be consensus building around the idea that the financial crisis is over there is still a lot of confusion about whether the economy is in recovery mode or not. There has been a powerful rally in the equity markets since the beginning of March but there still is quite a lot of debate about whether this is a “bear market rally” or the beginning of a real turnaround in the markets. There isn’t really enough data out yet to make a conclusive decision but there is enough to make a credible argument for either side.

The trouble is that as this argument plays itself out in the markets volatility is likely to remain elevated. Volatility, as measured by the CBOEs VIX index has come off quite a lot from its highs back in October but it remains high relative to where it has been for the past several years. It is easy to see why this is. You can think of the level of the S&P 500 as being the product of both its earnings and its PE ratio. Right now there is a lot of uncertainty about both. There is a lot of uncertainty about earnings because it is difficult to estimate what effect the constriction of credit markets and the pullback of consumer spending will have on corporate earnings. The PE is hard to guess as well because even if you believe that a recovery is around the corner the speed of the recovery is hard to gauge.

So is there a way to put all of this uncertainty to work for you? I think there is.

What if I made the following deal with you: If by mid December the S&P 500 was between 590 and 1010 I’ll pay you something and if its outside that range you pay me something? The index as I write this is about 845. More specifically, if the S&P is between $700 and $900 I’ll pay you $110, and I’ll pay you one dollar less per point its outside that range until it gets to 590 or 1010 at which point you have to start paying me? What do you say?

Well you might want to do some thinking about this. Let’s say you’re on the optimistic side of the argument. Let’s say you think that this is not a bear market rally but rather the beginning of a turnaround in the economy and you think that in 2010 the economy will grow at the average rate it has for the past 50 years. That is similar to saying that you agree with the average analyst estimate for S&P earnings and that you think the PE would be about 16, the long run average. According to the S&P website, the average estimate for S&P 500 earnings next year is about $62, multiply that by 16 and you get 992 in the index, with my bet you win $18.

Now let’s imagine that you are in the camp that says this is just a bear market rally and that we are destined to test the lows set back in March. The March closing low on the S&P was 676 set on March 9th. If we went back there you would win $86 with my bet. Let’s say you’re a pessimist and you think that the market will break those lows. Let’s say you think that we’ll go through them as much as we went through the November lows when we hit the March ones, about 10%. That would put the S&P at 609. Under this nightmare scenario you make $19.

So under either a scenario in which this is the end of the recession and the markets fully recover, or we retest the lows and break them you can make money with this deal. Not only can you make money in these extreme events, you stand to make even more money if, in the far more likely event, neither of them is played out fully. As I mentioned, if the S&P is between 700 and 900, you get $110. Or 14% of the average notional of 800, in 8 months for an annualize return around 21%. Sounds pretty good no? The question is, is anyone actually offering this deal? Yes they are.

The options markets on the S&P 500 ETF, the SPY are offering you this deal right now. The SPY is very much like the S&P 500 index divided by 10. What you have to do is sell the 70 Put and the 90 Call to form the equivalent of the 700-900 strangle in the S&P. As I write this that strangle is $11 bid (about $6.5 in the call and about $4.5 in the put, add 'em together and you get $11,) or $110 in S&P terms. If you sell those two options you take in $11 or 110 index points. If on the third Friday of December the S&P 500 is between 700 and 900. You get to keep the money. If it’s above 900 you have to sell the SPY at 90 to whoever bought the option from you but you took in $11 so its like being short from $101. Same thing on the downside, if the S&P is below 700, and thus the SPY is below you have to buy it for $70 but since you took in $11, its like buying it for $59 (or (590 in index terms.) Seems like a pretty good deal to me.

As with most good deals, I think its important to ask why am I getting such a good deal? What’s the catch? How is this possible?

The important thing to realize about what you are doing here is that you are taking advantage of the general level of fear in the markets. Because there has been so much volatility, there is a lot of demand for options. Options are kind of like stock insurance. Take the call for example, the right but not the obligation to buy the SPY for $90 is like owning the S&P above $90 but being insured against any losses below 90. Just like insurance companies charge more or less based on how risky the policy, options markets do the same thing. A house made of matchsticks is harder to insure against fire than a house made of cement for example and similarly options are more expensive when there is a lot of uncertainty.

The large amount of uncertainty in the earnings picture and the larger economy is making options very expensive. It is that fear of uncertainty which enables a thinking person to look at what he thinks the realistic outcomes for the market are over the next few months, recovery or recession, act accordingly, and make money in either case.

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