We have alternated our writing to encompass both the behind the scenes reasons for market movement as well as how to navigate and trade the market’s movement. We clearly stated that the debt ceiling rally should have been sold and further strengthened those comments by our suggestion that the risk in the stock market may be more than a buy the rumor, sell the news event in the debt ceiling negotiations. Therefore, people should take a genuine look at hedging their portfolios for something deeper and more structural. Did we expect the S&P to sell off 13% in a little more than two weeks? Of course we didn’t.The newscasts are full of contradictory reports and editorials. Some of their points are valid while others are simply for shock value. I think there are a couple of key points remember as we navigate our way through this. First of all, this is not a repeat of 2008 here in the U.S. The major sub prime, deleveraging and balance sheet issues of our, “too big to fails,” have begun to be addressed. In other words, here in the U.S. the fumigation process has begun.
Overseas, they’ve just begun to turn on the kitchen lights. They’re no longer able to assume that the only roach they see is the only roach they have. As a result of their shared economy, we’re watching the blame game while they assess responsibility for their problems. This is most clearly seen in the Societe General liquidity rumors of Wednesday’s trading followed by the instant questioning of the rest of the Euro Zone’s banking heavy hitters like RBS, Deutchebank and Barclays. Does this remind anyone of Shearson, Goldman, AIG, etc?
Traders choosing to participate in these markets may want to participate in the options market rather than directly in the equities or futures arenas. Options allow market participants to trade a general idea, rather than actual chart points. Being able to trade the idea allows us to withstand a higher degree of volatility while still maintaining our general investment thesis.
The two primary variables in an options price are time to expiration and volatility. Time to expiration is obviously a linear component. The more time there is to expiration, the greater the opportunity there is for that option to pay off, thus a higher premium must be paid. Thinking in insurance terms, a policy written for 12 months would have twice the probability of a claim written for 6 months.
The non-linear variable in the option pricing equation is volatility. The more a market moves, the more volatile it is, thus more likely an option is to end up in the money. Insurance terms say a policy sold to someone with an excellent driving record is less likely to require a payout than a policy sold to someone with a history of moving violations. The unpredictability of the second driver is the same as option volatility.
Option trading as it equates to insurance can be seen in two ways. A trader can write the policy, which is a calculated assumption that the policy or option won’t be collected on or, the policy or option can be purchased because a trader feels that there is a good chance to observe a collectible incident. The option buyer expects the driver to have another accident while the option seller expects the driver to be on their best behavior.
Volatility increases the option premium which makes the policy more lucrative to sell and more expensive to purchase. I have been focusing on selling the options as we’ve declined dramatically and I feel that we are more likely to rebound than we are to decline another 20% in the next couple of weeks. In other words, I expect the market to shape up its act rather than behave as wildly as it has.
The math works like this. September S&P options expire on September 16th. I can sell an option and collect $450 on a $4,000 investment per contract based on the notion that the S&P will still be above 900 in one month. Depending on when you look, this is another 20% lower than where we are today and more than 33% from the July highs. Finally, should the market rally, I can always offset the position prior to expiration for a smaller profit and if the market does tank, there are trading methodologies that can be employed to hedge my risk on the way down just like the re-insurance markets that the big boys use on their policies.
This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.
