Options

More Bull Market Strategies

Russ Allen
Instructor

For the last couple of weeks I’ve been talking about investors’ strategies for markets that just keep marching to new all-time highs, and I’ll continue with that this week.

These are the times when the folks who buy stocks and hold them for the long haul have big smiles on their faces. They finally look as though they were right all along. Yet even they secretly worry about just when the market will turn. Anyone who was alive in 1987, 2000 or 2008 knows better than to believe that “it’s different this time,” and that markets will never have another significant drop.

I first took some interest in the stock market when I was in high school in the late 1960’s. I remember being taught in school at that time that a stock market crash could never happen again. At the time, the great crash of 1929 was still well within living memory. The regulations that were made in the 1930’s, along with the Federal Reserve’s benign management, were supposed to make another crash impossible.

Of course, we know that’s not true. The Federal Reserve, after all, has been in business since 1913. They were on the job during every stock market crash since then, including the crash of 2008. In fact, since comprehensive stock market records began being kept in the 1870’s, 18 out the 20 biggest percentage losing days ever, have happened since the Fed began operations.

Clearly, the gentlemen of the Federal Reserve are not infallible magicians. (By the way, if you ever hear that the Fed has retained Penn & Teller as consultants, I suggest you leave the country immediately).

So we know that this bull market will not last forever. Making that happen is beyond even the considerable power of the Fed.

BUT – in the meantime, we have to decide what to do to while waiting for the inevitable reversal.

I discussed one alternative in last week’s article, which you can read here. That is to hold onto our stocks and buy Put options as insurance. That comes at a cost, but it does allow us to continue to profit if the market continues even higher. I mentioned that there are not many times when this is a worthwhile strategy, but that this might be one of them, due to the low current prices of options.

Today let’s look at a closely related alternative: What about selling our stocks now, while we have a big profit in them, to lock it in; and then using a little of that cash to buy call options. That way we stay in the game, while putting most of our money in our pockets. Could such a thing make sense? Actually, yes, it could.

As I described in my article of March 26, which you can read here, owning a call option alone is equivalent to owning stock together with a protective put. In fact, the stock-plus-put combination is also referred to as a synthetic call option. Either way, your loss is limited in case price drops; and your profit is unlimited as price moves up.

Last week we looked at SPY, which was then at $165.45. The August 157-strike Puts were at $1.70. I selected the 157 strike price because there was a strong demand zone below that, so that it would coincide with the price where a long-term trader might put a stop-loss order. This happened to be about 5% below the $165.42 price.

Buying these 157 puts while holding on to our SPY would mean that our worst outcome would be where SPY moved below the $157 put strike, and remained there until expiration of the puts. In that case, from the peak our SPY stock would have lost [$165.42 - $157.00] = $8.42. From that $157 SPY price on down to zero, any additional losses on SPY would be exactly paid back by gains on the Put.  Adding in the $1.70 price of the puts, that loss would amount to $10.12 total. This would represent 6.1% of the SPY value of $165.42. That 6.1 % is a little more than we would lose by simply putting a stop at the $157 level. But we would not have to worry about gap openings, or anything else that might cause us not to get out in a crash exactly at our stop price.

With the puts as insurance, if SPY did anything other than drop below $157, our situation would be better; if it increased by $1.70, to $167.12, then we would have recouped the cost of our Put option. At any price beyond that, we would resume making increased profits, with no upper limit.

Let’s now compare that stock-plus-put combo, to selling the stock and buying Call options.

Let’s use that same $157 strike price. As of May 23, SPY at $165.42 was above the strike price of the 157 calls by $8.42. This amount was their intrinsic value. The calls were selling at a price of $10.17. The part of this price which represented the excess over their intrinsic value, ($10.17 – $8.42 = $1.75) therefore was their time value. Note that this $1.75 time value was very close to the price of the 157 Puts, which were at $1.70. Since the puts were OTM, that entire $1.70 represented time value.

Even though the 157 Puts were out of the money, and the 157 Calls were in the money, the time value component of their prices was virtually identical. This is no coincidence. Time value is a measure of the uncertainty of an option’s finishing on the other side of the strike price, given the stock’s current price. The time value in both the 157 put and the 157 call were measuring the same thing – how likely it was that price would move from $165.42 to $157 – so they should be the same.  And they were. This is another aspect of the concept of put-call parity.

Comparing key elements of the two position shows us:

Element Stock plus Put

Call

Position Cost

167.12

10.17

Underlying price for Max Loss

Below 157

Below 157

Maximum Loss

10.12

10.17

Breakeven price

167.12

167.17

Max gain

Unlimited

Unlimited

Everything is virtually the same here except for the position cost. For the Stock plus Put (AKA synthetic Call), we keep our $165.42 invested in the SPY, and we lay out another $1.70 for the Put, for a total of $167.12 in the game. With the actual Call, we keep all of that money in our pocket, except for the $10.17 cost of the call.  Either way, we have the same risk and reward.

Either of these will be profitable in case the rally continues. For most people, it’s not a hard choice between the real call option and the synthetic call option.

Next week we’ll explore further alternatives, looking at ways to reduce the cost of this bullish trade.

For comments or questions on this article, contact me at rallen@tradingacademy.com.

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.