Equities are frothy but you’re not ready to go short. How do you prepare for a reversal without missing out?
Markets can remain frothy for some time so use these options strategies to protect yourself.
The simplest solution would be to just buy a put on one of the various stock index futures. Let’s look at the most popular stock index, the Standard & Poor’s 500 Index. The September S&P 500 (CME:SPU14) is currently (July 2) trading at 1968.00. On this date, the September 1900 put is trading at $19.50, a real value worth $975.00. This should afford you the right to be short the S&Ps at 1900.00 at a cost of $950.00 plus commissions. Should the market trade below 1880.50 (1900.00 minus the 19.50 premium paid for the option) before the expiration on Sept.19, you should make a profit equivalent to the amount of the difference between the futures price and the strike price minus the premium paid.
Another alternative would be a put spread. This involves buying one strike and selling another strike priced below the one purchased. At relatively the same cost as the previous example, you can buy the September 1950 put and sell the September 1865 put for about $20.00 or $1,000.00, plus commissions. There are advantages and disadvantages to this strategy. One advantage is that this strategy brings you closer to the money, i.e., the market will not need to make as large a move to make a profit. The disadvantage is that being closer to the money, you are giving up unlimited profit potential. Your profit should be limited to the difference in the strike prices.
Another alternative, one which carries a bit more risk, would be to sell futures and buy enough out of the money calls to be delta neutral, which should limit your exposure on the long side of the market. As an example (these prices are just for illustration purposes), you can sell the September S&P futures at 1968.00 and purchase 3 September 2005 calls at 18.00 each (total of $2,700). The advantage of this is that if the market continues to rally, you can capitalize as the calls increase in both value and delta (delta being the percentage of gain as a derivative of the underlying future).
As the delta value increases you would have to monitor this position and manage the position accordingly to stay delta neutral. For example, if the original delta is 33% and climbs to 50%, you would need to alter the amount of calls from 3 to 2. The disadvantage to this strategy is that by purchasing the options, you have in effect lowered your basis of where your breakeven point is, should the market decline. This is the price you pay for limiting risk.
Let’s take a closer look at delta. Delta is one of the risk measures used by traders to measure the degree of price movement to which an option is exposed in relation to the underlying asset, in this case the S&P futures. The value will range from 0.0 to 1.00. An in-the-money call (a call with a strike price below the futures price) will have a higher delta than a call away from the money (above the futures price). An option in the money with a delta of 0.75 will be expected to move approximately 75% of the underlying futures price on an up day. An option with a delta of 0.40 will move 40% and so on (see “Measuring options,” above). Delta tends to increase the closer you get to expiration for near and at the money options and will consequently decrease the further the option is out of the money. Delta is not a constant and will change based on a number of variables such as underlying price change, volatility and time.
Delta is a vitally important measure to understand. Too often traders make decisions on a cost basis. They want to get long, but a certain strike is expensive, so they go a bit further out-of-the-money. Then they get upset when their option does not appreciate despite a strong move in the underlying. They chose to give up that profit for a cheaper strike by choosing a lower delta option. That is fine if you understand and are doing it for a specific reason. Options are precise tools and traders need to understand delta along with theta, the rate of premium decline that grows steeper the closer you get to expiration, to be able to understand how and why prices are moving.
Marc Nemenoff is a senior broker and analyst with the Price Futures Group. In 1976 he became a member of the CME as an independent trader in the live cattle pit. Marc has worked as a broker, trader, lecturer and is author of the Nemenoff Report.