Option Ideas

As I watch the markets and the news, I come back to the basic idea that the politicians may well deal the markets a major blow over the next few months, so I want a hedge.

In the December time frame, I put on a hedge by buying calls on SDS, the ironically named Exchange Traded Fund (ETF) that amounts to a 2x levered bet against America.  When the S&P hit 1430 on the way up, I took my lumps and got out.

Now I’m just getting started thinking about buying a call option on pure volatility — the VIX.

We’ve got three ginned-up “crises” coming over the next few months, and the most serious, the debt ceiling, is even being suggested as a monthly serial drama that would put 1930’s Hollywood serial dramas to shame.

Threatening not to pay our already existing debt every single month (when we could) is a strategy that would most certainly keep any sane investor or employer from making new long-term commitments.  I’d hazard a guess that playing with the credit rating of the United States for the foreseeable future would dwarf the negative effect of virtually any spending or taxing policy.

Resolving the debt ceiling, once and for all, would probably result in the biggest boost to the economy we’ve seen since the Oil Embargo ended in the 1970’s.

That said, the risk is far more to the downside, given the size and dedication of the financial terrorist caucus in Congress.

Since markets move down (generally) twice as fast as they move up, we should expect that an actual or near default will result in the VIX volatility index shooting up well over 20 from its current levels just below 14.  For comparison sake, the VIX hit an all-time high near 90 during the 2008 financial crisis, and averaged around 19 from 1990 up through that crisis high in October of 2008.

The key dates for all the excitement are the return of the “fiscal cliff” spending cuts on March 1st, the lapse of the Federal Budget continuing resolution Mrch 27th (government shutdown), or the Big Casino, default on the full faith and credit of the US Government, which could happen as early as February 15th if tax receipts aren’t large enough to roll over the Treasury debt that matures that day.

I find it particularly disconcerting that several highly-placed elected officials who are part of the process have already tried to dismiss the default as a “partial shutdown” of the government, grotesquely understating what it is.  If they really believe what they’re saying, then we may be headed for big time trouble.

So, I’ll be looking at call options on the VIX, probably with strike prices in the 18 to 25 neighborhood, with expirations in March or April.

On that happy bearish note, let me at least offer one thing that could produce pretty good risk-adjusted returns, something I’m doing.

With some of my Arena stock, I just wrote January 2014 $10 calls.  The stock is now trading at $9.66 and the options are (mid-market) at $2.44.  If you did a buy-write (and if you don’t understand the phrase, you shouldn’t be doing it), you would pay $9.66 for the stock, collect $2.44 for the options, and live with the potential of having the stock bought from you for $10 some time in the next 372 days.

Assuming a net commission cost on the options and the stock of five cents a share, you would be agreeing to take “only” $2.73 in profit on a $7.27 investment in one week more than a year. or north of 37% profit.  Not a bad year (for that money, at least)… On the other hand, the company’s stock went down today and yesterday while they were presenting at the JPMorgan biotech conference, and analysts are projecting a loss around 40 cents a share for the year.  But this is a weight-loss pill that works, especially for diabetes patients, and the $2 billion company may well end up with tens of millions of people taking their drug.

Looking at the downside, I think owning the stock at a net cost of $7.27 won’t be so bad for those with patience.  And there’s always the option of selling calls again next year on these shares if they don’t get called away.

hh

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9 Responses to Option Ideas

  1. Jesse Livermore says:

    I like the idea of buying VIX calls ahead of the debt ceiling debate, so I checked them out. Have you seen the premiums on the March calls?? Enormous. Conversely, the puts seem to offer free money. VIX is at 13.49 right now. You can buy a March 27 put for $10.00. If the VIX were a stock, you could buy at $13.49 and sell at a net of $17.00 for an easy arbitrage.

    Obviously the VIX isn’t a stock, but there must be some way to take advantage of this. Futures, ETFs?

  2. hhill51 says:

    That’s an interesting angle.

    As I said, I’m just starting to think about this one. I’ll have to look at the index options (on the S&P) to see how the put seller can offer such a “cheap” put. Could that have been a stale price? I’ll be looking at the entire series tomorrow.

    At the very least, the VIX call buyers and the deep in the money put sellers expect this sucker to fly…. maybe my “guesstimate” of high 20’s as the rhetoric heats up and the deadline(s) come is even low….

    hh

  3. Jesse Livermore says:

    I did a little more research about this. The actual VIX is a derivative calculated by combining in a complicated way a bunch of out-of-the-money options on S&P stocks. VIX is traded on the futures exchanges like S&P futures or cash-settled commodities futures. That is, essentially you can bet that the actual VIX at the end of the month will be up or down. If you hold the contract to completion it gets settled like any other futures contract. There are different contracts for different months.

    Here’s the key point: The prices on the futures market (i.e., the market’s estimate of where VIX will end up for that month) are not identical to the VIX’s current value. Not unlike how natural gas futures are higher for winter and summer months (because of higher demand for heating and electricity for air conditioning) compared to spring and fall. So the higher expected volatility around the debt ceiling is priced in already. We just can’t see it because the easily available VIX quotes are for the actual current value of the VIX, not the expected value some months hence.

    This means that VIX ETFs, which hold VIX futures contracts, trade in relation to those futures, not the actual current VIX. In the same way that natural gas ETFs do not fluctuate seasonally with the natural gas spot price, VIX ETFs will not necessarily capture the change in VIX associated with a widely known event. (In fact they may leak value over time because VIX futures are generally in contango.) Now, you can argue that the markets are not correctly pricing in how disruptive the debt ceiling debate is going to be, but it’s no longer a no-brainer.

    • hhill51 says:

      Excellent work! You got there before me. I figured there had to be something like this at work, but had not looked into the calculation of the VIX yet. There may be more money to be made on the eventual collapse if they come to their senses and get rid of the debt ceiling than can be made now by betting on it rising. Still, I can’t dismiss those Senators blithely saying “a partial shutdown of the US government” as if it won’t even be as bad as the Clinton/Gingrich shutdown in the 90s, which many of us remember as a minor inconvenience with national parks closed. Do they really think choosing to default is no big deal?

      • Jesse Livermore says:

        Here’s my prediction for the debt ceiling “debate.”
        1. Everybody sits around for about a month doing nothing. Because Congress, like a lazy teenager, can never seem to start its homework before the last minute.
        2. Boehner is sick of being the guy who hashes out a deal with Obama and then fails to sell it to his own guys. McConnell is going to take the lead on the Republican side.
        3. McConnell is actually kind of a dove as far as the debt ceiling goes. Last time around he laid out a plan that would have traded away the debt ceiling leverage in return for forcing the Democrats to vote a couple times to increase the ceiling. http://www.pbs.org/newshour/rundown/2011/07/mcconnell-presents-plan-to-put-debt-limit-hike-burden-on-obama.html
        Conservatives rejected that almost immediately. This time around he and Obama/Biden will probably negotiate another bargain that pisses off Paul Krugman and enrages conservatives, but looks like it might pass.
        4. Everyone breathes a sigh of relief.
        5. House conservatives blow it up and Boehner refuses to schedule a vote. Because it doesn’t cut spending enough, or raises taxes, or generally because Obama has agreed to it so it must be bad.

        I’m not sure what happens after that (though crappy can-kicking last-minute compromise is always a good bet). But the time to buy VIX is on step 4. It might even be a good short play before then.

      • hhill51 says:

        I think you’ve nailed it. I probably won’t be committing now, given the time decay implied in the underlying, which then gets compounded daily.

        I’ll look again, especially if we hit your #4 point in the time line. At that point, I may play in the ETFs or 2x ETFs rather than the options.

  4. Robin says:

    Clicked here to warn about contango on vix options but that looks to be well covered. You might, however, consider trading the VIX directly, based purely on technicals.

    More debt ceiling action ahead but the impact looks to be more muted since no one expects the U.S. to default, given the outcome of the latest game of chicken.

    Have really enjoyed your discussions of REITs and wondering if you have insights or recommendations now that these have pulled back. I started nibbling at TWO, considering building up a substantial position on this one now that I’ve exited (or soon to exit) most of my other contrarian bets.

    • hhill51 says:

      hey, robin….

      sorry to take so long to respond (holidays)… right now, the best combination (IMHO) of management talent and discount to book value is probably MITT, though TWO is close… the straight agency MREITs have a lot of extension risk they can’t afford to hedge

      • Robin says:

        Thanks for the reply! I’d never heard of MITT. Looks like they missed the boat rather badly in Q2. I do appreciate that they were up front about that though. I don’t understand the nuances of moving to a whole-loan strategy well enough to evaluate it. Book value is declining, so I’m also not sure how to value their current p/b. Will start following this one and seek to understand it better.

        Best wishes for a great holiday season!

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