2017 continues to be a year of easy money. There is a complete disconnect between earnings growth/valuations and the price trends within this bull market. Markets are incredibly expensive, but does that mean to sell? It is just a simple reality that to participate in this market you must speculate. You must speculate that there will continue to be new waves of buyers willing to bid the markets even further. You must speculate that no geopolitical or macro event negatively shifts the resilient animal spirits. But if you did sell, what would you buy? Everything is expensive.
Everything except implied volatility.
I will argue that this is a gift. Now I am not suggesting investors go buy long VIX futures or a long volatility ETF which implicitly have a big negative carry built into them. But rather, it is translating to relatively cheap option pricing. A cheap option does not mean you cannot lose money, but it does mean that at very few points in market history have you been able to buy call options at a relatively cheaper cost to be used as a trading tool to express your bullish themes.
WHERE IS THE OPPORTUNITY FOR YOU?
Investing and trading are the continuous process of redefining the risk/reward propositions of being invested. How much upside is there? How much risk? In today’s market, the rise higher has been parabolic and has not been tested with a correction. The key to being invested is to find a way to continue to participate on the upside of this bull market, but have a very clearly defined maximum risk. With call options being so cheap, there have been very few times it was cheaper to continue to express the bullish upside of the market with so little risk.
So, what am I doing?
I am strategically selling my stock and ETF positions and replacing them with call options. Here is an example.
Our investor has a $1,000,000 portfolio that is fully invested in the market. A part of that investment is a $258,000 position (1000 shares at $258.00) in the S&P500 ETF (SPY) for their US equity exposure, which is up +15.20% on the year.
- Our investor sells the $258,000 SPY position for a capital gain and keeps the $258,000 as a cash reserve to reduce the volatility of the portfolio.
- Our investor buys 10 contracts of the SPY January $258.00 call options for $4.00.
- The 10 call options are synthetically controlling the same 1,000 shares they owned.
- Our investor needs to outlay $4,000 for the calls ($4.00 x 1000 shares)
What has our investor created? A perfect binary outcome.
Scenario 1 - The market continues to rally. The call option is giving the investor full participation to the upside less the cost of the calls.
Scenario 2 – The market has a 10% or $26.00 correction lower on the SPY. In this situation the investor loses the $4,000.00 they paid for the calls. More importantly, they did not lose the $26,000 the would have been drawn down on if they still owned the original 1000 shares of the stock. Not only did our investor on lose $26,000, but is now free to reinvest the money and buy the dip.
The Bottom Line:
The market can continue to rally, but inevitably the market will have a correction. You can act. There are choices beyond just selling everything and moving to sidelines. Consider that options today offer a unique situation that may be a valuable way for you to reposition.