SP500 volatility and LEAPS

Investment Analysis Clubs Saul’s Investing Discussions
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StockCharts.com Newsletter for August 2nd,

The S&P 500 is locked in a 100 point trading range (2040-2140) since March because of a serious split in sector performance. At less than 5% this is the narrowest range in several years. Note that Bollinger Bandwidth on the weekly chart reached a 20+ year low in July.

This means the Bollinger Bands are at their narrowest in over 20 years. How’s that for a contraction. John Bollinger theorized that a volatility expansion often follows a volatility contraction. Chartists, therefore, should prepare for significant move in the coming weeks or months.

I know little about options but the low volatility suggests that index options should be relatively cheap. LEAPS for protection? Based on stats from Presidential election cycle.Is this actionable?
Any comments from option experts?

Low volatility in indices represents a consensus by investors. Any such consensus is by nature fragile, when some new pieces of information are aded to the equation the move either way is often quite significant.

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John Bollinger theorized that a volatility expansion often follows a volatility contraction.

Hey, John Bollinger: Duh… What else can follow a period of low volatility? If it’s more low volatility it’s still part of the period of low volatility. Eventually it comes to an end and volatility rises. What else can it do? Doesn’t sound like a world shaking observation. Just saying…

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Index options are relatively cheap. Just look at the VIX which is in an all time low range. VIX essentially is a proxy for the price of S&P 500 puts.

But, the options are cheap because the market has been range bound. So why bother paying the time premium to protect against a market decline? You are making the bet that 1) volatility returns before you suffer significant time decay, and 2) that the volatility is to the downside and not the upside.

Also, probably not the best strategy to fight the central bankers and share buybacks and increasing earnings and low interest rates with a long term bet in a wasting asset.

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If you do want to make a play like that, wait for the next bump up to the top of the range and then sell shorter term strikes against it to reduce your cost and create calendar spreads or vertical spreads where you can’t lose once the market trends down to the bottom of the range. That way you don’t get killed on time decay but still can accumulate protection without creating a large a drag on your returns and incurring as much opportunity cost for your money.

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Sorry, that should say wait for the top of the range to start the first leg of the position

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Sorry, that should say wait for the top of the range to start the first leg of the position

If we’ve already topped, if there is no more touching “the top of the range” because we have quietly begun a decline before the major fall, what is your advice?

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I don’t think we have topped at all. We are 2% off of all time highs even with today’s decline.

The broader market (SPY) has been in a range all year mostly between 204 and 212, with the majority of the time spent between 209 & 212. However because it’s not going straight up like it has over the past 6 years, everyone is getting worried. That is a 4% range for most of the year!

As a sidenote, watch the VIX, as it moves inverse, lately in the 12-15 range or so. You mention consensus, but this even means that the premium sellers aren’t even demanding high option prices. As you know most options expire worthless, and the market makers wouldn’t take that risk selling them if they thought a big decline was likely.

Is it possible we get an October like selloff back down to the 200 or 198 level? Yes, of course. And that may even be a good thing that will kickstart the next leg up. Keep in mind that that would still only be a 5% decline from here.

We have gone from a market where everything melts up to a market where rotation into stronger stocks is key as the indexes are flat. My main advice would be to buy quality companies first.

If you want to hedge with LEAP Puts, one option is to go fairly far out of the money, essentially buying insurance against a major market crash, which is probably likely to lose 100%. Even March 2016 175 puts cost about 2.70 today, thats a lot to pay for insurance against a crash. I think this is a bad idea and would be a drag on portfolio returns.

I think a better idea is to go a month or 2 out and find something a few % out of the money that you buy on an upday so you don’t pay a huge time premium, and then sell a lower put strike on a different day to create a vertical spread. That way you have protection to the downside, but you limit your costs and have less of a drag on your portfolio. Of course you should be familiar with spreads first before doing this.

My thoughts are that it’s not worth risking any capital to hedge against a decline right now. Markets are still in the range they have been in all year. After the run we have had, that is to be expected. If you can structure capital light option hedges with spreads, that can help with more peace of mind, but if that’s not your thing, just buy the quality companies, don’t risk money you may need in the immediate future and trust that your analysis on those companies is sound before you invest. Sometimes having the capital to pick them up on the cheap works as well… I think thats called a Texas hedge :wink:

Good luck and hope this post isn’t too off topic for the board

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