Q&A
Explore Your Options
Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.
“SPYing” a better option?
After the “flash crash” market price jolt in early May and thinking there’s got to be a safer way to position, I came across the ProShares Ultra S&P 500 (Sso) instrument, which looks to make twice the returns of the Standard & Poor’s 500. At less than one-third the price of the S&P 500 exchange traded fund (Etf) (Spy) and twice the punch, it seems to be a long straddle strategy in which you get more bang for your buck and a stronger way to position. What are the pros and cons?
The reality of this type of product as it relates to option strategies is that the prices are essentially baked in. There are slight nuances with the “Ultras” over time that can affect actual performance in the underlying. But in order to keep things to the point, let’s compare recent front-month and at-the-money (Atm) straddles.
Back on May 11 and a couple days removed from the flash crash incident, shares of Sso closed at 40.86 with the May 41 strike Atm. At the same time, the Spy finished that evening at 115.83. The May 116 straddle was the logical match for our comparison. Using a hypothetical portfolio of $50,000 and just more than 2% risk per position, we came up with the following near-dollar equivalent straddles:
| Position | Price | $Risk | IV | Delta | Gamma | Theta | Vega |
| 4 SSO May 41 C+P | $2.75 | $1,100 | 50.5 | -1.0 | 93 | -$54 | $22 |
| 3 SPY May 116 C+P | $3.87 | $1,161 | 25.3 | -4.0 | 49 | -$58 | $46 |
We can do the breakeven math on the Sso straddle (C+P) and come up with 43.75 and 38.25. Relative to a share price of 40.86, the upside breakeven is 7% and the downside is roughly 6.50%. At the same time, the Spy breakevens of 119.87 and 112.13 represent percentage moves of 3.50% and 3.20%.
Net, net the breakeven relationship between the two straddles reflects a necessitated percentage move that’s in keeping with the Sso being twice as volatile as the Spy. Looking at the other statistics involved, we find implied volatility is a near-perfect double between the two products. That’s also what we’d anticipate seeing, since the Sso is expected to double the performance of the Spy.
Deltas are for all intents and purposes flat for both straddles. Separately, gamma is also close enough to call the difference a double between the two straddles. Again, this matches expectations given the current underlying price and contract relationship.
The theta factors shown are unsurprising. They’re virtually the same, which makes sense as we attempt to keep the dollar outlay as similar as possible. Ultimately, the three Spy straddles would cost a trader about 6% or $60 more.
And finally, the vega component shows the Spy maintaining roughly twice the risk. Since the underlying volatility in that instrument is half that of the Sso, we once again come up with pricing that doesn’t leave much room for exploitation, except for the quants responsible for the flash crash.
A free position
Recently, I got involved in using options for the first time with my portfolio. As a trader who puts a lot of work into his stock selection process, buying a call in lieu of shares makes sense to me and it’s one that I have enjoyed success with. Not long ago, someone told me to create a “free position.” I was embarrassed to ask the specifics of this strategy. Can you explain what this entails?
The “free position” with regards to holding long calls is a bit of a misnomer. What the person was referring to was the ability for you to make an adjustment on an already profitable call position. By making an adjustment of this kind, you allow for increased potential profits on the upside while maintaining some minimum profitability on the downside, even if the stock were to collapse and the call contract go out worthless at expiration.
There are plenty of free positions out there, and they do warrant our attention. The simplest type of free position is to make a “sell to close” adjustment on some portion of your long call contracts, which nets a profit larger than your initial investment. As you can see, that free position required you to do your stockpicking homework first and accurately.
A more secure sale?
Is there anything special about using a cash-secured put strategy versus a straightup put sale?
The cash-secured put strategy sells a put, but the trader sets aside capital equal to the maximum associated loss if assigned and the stock winds up going the way of Enron or Lehman Brothers.
Compared with the naked put sale that might be executed on margin, the trader using the cash-secured put won’t have to worry about the possible rude awakening of forced liquidation if a devastating price move in shares unfolded and account capital proved insufficient.
Neither situation would be pretty, but the cash-secured strategist prevents the trader from losses that are larger than the account can bear. If a put sale is considered attractive, selling a wide bull put vertical that barely cuts into the premium sale of the short contract might be considered as an all-around more efficient means to controlling account risk versus a strategy that might not be so endearing down the road.
Analysis contributed by senior Optionetics strategist Chris Tyler.