Options Corner – 19 September 2020

Last week I presented a number of Option positions that might be used to hedge a portfolio. The only way to “perfectly” hedge a portfolio is to buy a Put Option – but, as we saw ( https://itawealth.com/options-corner-11-september-2020/ ) this can get expensive. A 3-month ATM Put Option on SPY might cost ~$2,000 and this will only cover us for ~$33,400 – so, to protect a $100,000 portfolio (with a Beta of 1.00 relative to SPY) we would need to buy 3 contracts at a cost of  ~$6,000 for 3 months protection – or $24,000 (24%) annually. This is clearly too expensive for “insurance”.

Some of the alternative suggestions that I offered were designed to reduce the cost/risk of buying Option “insurance”. For example, an Out-of-The-Money (OTM) Option could be purchased for ~half the cost – but this has a “deductible” associated with it – i.e. the “breakeven” price is lower and we implicitly accept that we are prepared to accept a defined level of loss/risk.

The Vertical Spread is another way that we can reduce our “insurance” premium – but the trade-off is a limitation of the maximum pay-out that we can recover. From a practical point of view it is not necessary to have 100% protection since our “diversified” portfolio (~equivalent to the 500 stocks in the S&P 500) is not likely to go to zero. However, we do need to have an opinion on what the risk might be – 10%, 20%, 35%, 50% etc. and over what time frame. We can then cap our “insurance” policy and design our hedge.

The “Butterfly” trades presented in last week’s post are just combinations of Vertical Spreads – with the objective of selling premium, or, being the “insurer”. One of our ITA members asked the question as to how I would adjust the positions introduced in last week’s post so as to avoid having to “eat” the premium that we have to pay for a “pure” Put Option. The “simple” answer to this is to sell premium against the Option that we are buying – but exactly how we do this is not all that simple – and will inevitably depend on how much risk we are prepared to take, where we are comfortable holding this risk, and over which time periods. Also, we cannot (or should not) just sell Options since this would introduce unlimited risk – so we must limit this risk by buying other Options, in “spread” combinations such that the spreads are sold for a net credit.

If we take a look at my current “real” hedge position as described in earlier Option Corner posts (here, here and here), my position, after Friday’s expiration of the September 320 Put Option, now looks like this:

that, I think you will see, looks very similar to last week’s illustration of a simple Put Option. But, in this case, the “cost” is significantly less with (assuming no further adjustments) a maximum risk of ~$300. Of course, how I got to this point is not “simple” – but is described in my earlier posts – and I am not finished here, primarily because I now have negative theta (time decay):

I still have this position on for a small ($24) credit and have ~$2,000 maximum risk – well away from current prices:

however, I still don’t like the negative theta. This is my (personal) dislike of the position – although I wouldn’t be too unhappy to hold this, with $300 risk, as a good hedge. But this “position” will evaporate in October, when the October legs of the “position” expire – so I will adjust and prepare to build the position as we move forward.

The first (and simplest) thing that I can do to resolve my “theta allergy” might be to sell the Oct 320 Put Option that I bought, combined with the Sept 320 Put Option that has just expired, as part of a “Calendar” spread i.e. effectively closing down the Calendar spread (more on Calendar spreads later).

Selling the Oct 320 Put Option would leave me with this:

Now I’m feeling better because I have time decay working in my favor (positive theta) i.e. profit increases as we move through the time zones. Selling the Oct 320 Put will also bring in ~ $435 that I can add to my existing $27 to leave me with ~$460 credit.

However, this “position” has a positive Delta and doesn’t satisfy my objective of holding a downside hedge – so I would like to modify this a little by adding a little negative delta to the position. To do this I can add a new Calendar spread using the October and November expirations – and I will move this down $5 (from my initial $320 Calendar) to the $315 strikes. This should leave me with something like this:

This leaves me with a Delta neutral position (little directional risk) – although the greeks are dynamic with respect to time and a “best scenario” case (with ~700 profit) would be for SPY to drift slowly down to $315 at Oct expiration. The danger will be if price moves down fast – but I will just have to be prepared to make an adjustment if price moves to ~$320 too quickly. Placing this new Calendar trade will cost me ~$5 ($500) that will eat up my $460 credit – but it’s still essentially a cost-free (not risk-free) position.

At this point I’ll try to illustrate why I like to include a Put Calendar in the position.

If I place the Oct/Nov $315 strike Put Calendar today (based on Friday’s closing conditions) it will look like this:

i.e. the Calendar will increase in value as price moves down through the central $315 strike price. Maximum profit on this position on 10 Nov (an arbitrary date – white line) is ~$260. However, as I’ve mentioned before, as price drops, or, as we approach elections, or, as concerns over Covid-19 increase, or, we see more uncertainty anywhere, Implied Volatility is likely to increase. Should volatility increase by a very reasonable/probable 5%, the PnL for this position will change to something like this:

Now, with price at $315 on 10 Nov our likely profit increases to ~$400. A 10% increase in IV moves these lines higher to ~$500 profit. The lesson here is that Calendar Spreads are best placed when volatility is low and likely to increase – and volatility generally increases as prices drop. Therefore, an embedded Calendar spread is a good “trade” to include in any hedge position.

To wrap up this Option Corner I will also be looking to add another “Iron Condor” trade to the position to generate another credit that I may need in the future to buy back Option legs that are “in the way” of my downward hedge.

An “Iron Condor” is simply the sale of 2 Vertical Spreads (a Put Spread at lower strikes and a Call Spread at higher strikes) that enables me to be a net seller of premium (the insurer) with limited/defined risk.

My final position might then look something like this:

And my position spreadsheet should look like this:

That should be enough to saturate the brain for this week – I hope it has answered most of Steve’s questions. A PDF file of this post is available at https://www.dropbox.com/s/dag9l3nuwb5zfko/Options%20Corner_200918.pdf?dl=0

Update: 21 September 2020

With SPY opening this morning ~$5 lower than Friday’s close I modified my adjustments slightly by buying an Oct/Nov Calendar Spread at the $310 strike rather than at the $315 strike as described above. All other intended transactions were the same. Here’s what the new “position” looks like at actual fill prices:

In the optionsanalysis software it looks like this:

and is summarized below:

where we see that I am currently holding a credit balance of $233 – that is available in the event that I need to “get out of the way” of a bear 🙂

Here’s what the position spreadsheet looks like:

The only thing that I’m not too happy with is the positive Delta (bullish) – but it’s difficult to get everything working for us – At the moment I’ll rely on the positive Theta to compensate.

Update: 24 September 2020

A GTC (Good ‘Till Cancelled) order to buy back my short October 375 Call Option was filled this morning. This is nothing too remarkable but changes the risk graph as shown below:

This significantly reduces upside risk (at least in the short term) and leaves me with a lottery ticket in the unlikely case of “black swan” upward spike in price. It also allows me a little room to sell more premium (with added risk) should I choose to do so.

The only thing that I don’t like about the current “position” is the positive delta (when I’m looking for a downside hedge with negative delta). However this is partially compensated for by the positive theta (time decay) in the position. I will continue to monitor the position to determine possible adjustments. Possible adjustments that I am considering are a) roll-out of Oct 315 Put Option (probably to 305) and b) Buy-back of Nov 315/310/305 (1/2/1) Butterfly that is embedded in the “position”.

Update: 25 September 2020

After getting filled on my order to roll the short Oct $315 Puts out to the $305 strike my position now looks like this:

… so it looks ok to the October expiration (blue line). As you can see, I have a $500 “sink hole” at the $310 strike for Options expiring in November. There isn’t a big risk or hurry to do anything about this right now but, if I can get filled on a 305/310/315 Put butterfly for 0.15 ($15) I will clear this up – spending $15 to avoid a $500 hole (even if the risk of closing at $310 at the November expiration may be low) seems prudent. I have a GTC order in place – so we’ll see if it gets hit. I also still have a GTC order in to buy back the $365 strike Call Option expiring in October – this may get filled next week as time passes or if price drops a little – again, no hurry or danger – just a clean-up to reduce risk.

I have also been trying to Sell an Iron Condor, expiring in November, to bring in more credit – but, volatility has dropped a little so I have not been filled. I don’t leave this in as a GTC order in case price moves big overnight – in which case I might want to adjust strike prices. I’m looking to try to bring in something like $125 and I will place an order as a day trade on Monday.

The present PnL position looks like this:

Update: 6 October 2020

After today’s “action” the current position (over the next 10 days) looks like this:

with 2 “lottery tickets” in the (unlikely) event of a big move to the upside. The more important thing here is the small risk to the upside.

In tabular format the position looks like this:

where we can see that I have added ~$180 to the credit bank through the sale of premium. Although volatility has creeped up a little it isn’t significantly higher and is still sitting only at the 27% percentile of the 52 week range (although this includes the March correction).

Here’s what the position Spreadsheet looks like:

David