As Market Volatility Picks Up, Sell Puts

This article was written with Oliver Pursche, the Co-Portfolio Manager of the GMG Defensive Beta Fund. It was part of a series of articles developed under an agreement with to work with a variety of contributors and assist them in delivering actionable investment ideas each week.

Cost matters in just about everything, especially when making investment decisions.

Up until last week, I was advocating buying September and December puts and writing some covered calls to help hedge portfolio downside risk.

Well, those puts have gotten very expensive, and writing covered calls generates next to no premium. So, why not turn the trade upside down and sell puts, a strategy that is typically associated with being bullish?

On Monday, after another volatile day in the market, the State Street S&P 500 ETF (SPY) closed just above $156. The December 145 puts on SPY are trading at $5 per contract, about 3% of the value of the ETF — making it very expensive, or a great deal for the seller.

I’m generally bullish on the market and believe that equity prices will be 5% to 10% above current levels within a year. As such, I certainly don’t mind being “put” the S&P 500 ETF 7% below current levels and being paid 3% to do so.

This trade results has three effects:

– If the markets decline by more than 7% and I’m “put” the ETF, I still benefit from the 3% premium I collected and own SPY 10% lower than anyone who bought today.
– The market stabilizes and trades in a tighter range. I get to keep the 3% premium and am slightly ahead.
– The market rallies. Same outcome as #2.

This strategy can also be executed on individual stocks which are not as volatile as the broader market (beta below 1). Investors sentiment has turned so negative that demand for portfolio protection has spiked, causing some mispricing and thereby some opportunities for astute investors.

Verizon’s (VZ) April 2014 option was just made available. With fewer than 300 days until expiration the contract represents an opportunity to achieve a higher premium than one with a closer expiration. One of the contracts has a $47 strike price and is currently being bid at $3.60. The sell-to-open put would collect the premium.

Procter & Gamble (PG) and Pfizer (PFE) also saw trading start in new options with expirations of September 21 and October 19, respectively. One PG contract has a $72.50 strike price representing a roughly 4% discount to the current trading price; PFE also has an attractive $27 strike price contract also trading at a 4% discount.

The key is to look for mispricings, which appear most prevalent in longer dated options.

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