If you don't know who Jeff Augen is and you are an option trader, you need to ask yourself this: "Am I really and option trader?" The man knows his stuff and is one of the most insightful and interesting traders I have met. Everytime he and I speak I feel like I have walked away a better trader. He is always going to be someone that will bring a new twist to any idea. I hope you enjoy his guest blog. if you havent read one of his books, you should change that (there is a reason I put him on my reading list).
The Current Mess
The recent debt ceiling crisis represents the beginning of a new era that will undoubtedly leave permanent scars on the U.S. economy. Several new dynamics are in play. Most importantly is the recoupling of stock market performance to the economy. For the past two years, since the housing bubble collapse, the stock market has enjoyed an unprecedented rally fueled by free money in various forms with familiar names like TARP and Quantitative Easing. Earnings have also been strong because companies refinanced their books with money they borrowed at nearly 0% interest. The realities of the economy and the performance of the stock market have been connected by 10 mile long rubber band.
But that’s all about to end. Whatever the final solution, one thing is certain – the U.S. government is about to reverse course and launch an austerity program that will eclipse the free money initiatives of the past two years. President Obama was very succinct when he referred to “the lowest level of annual domestic spending since Dwight Eisenhower was President.” Exactly what that means is anyone’s guess, but one thing is clear – the rate of government spending is going to be sharply cut with the goal of eliminating at least $1.00 of spending for every new dollar that is borrowed. Anything short of that would remove all meaning from the recent political theater that seems to have finally reached its final act.
As always there are going to be winners and losers. So far most discussions have centered around the potential effects on specific groups who receive government subsidies such as social security recipients and Medicare beneficiaries. But it is easy to forget that the U.S. government is a major customer of almost every large corporation.
Consider the computer industry. Cisco receives 20% of their total revenue from public sector projects; IBM is in a similar boat with 15% of their revenue at risk. The budget cuts that are about to commence could potentially impact everything from supercomputing projects at national labs to data center management and software development projects. The Obama administration already announced on July 20 that it intends to shut down 178 data centers in 2012, which would bring the total of closed centers to 373 by the end of next year. That kind of news can be devastating and it doesn’t take into account cuts at the state and local level that will result from cutbacks in federal aid.
Companies like IBM have additional exposure to rising interest rates because they rely heavily on their ability to issue massive amounts of debt. IBM has a strong balance sheet but part of that balance sheet includes nearly $30 billion of debt. Cisco has less than half IBM’s revenue and more than $12 billion of long term debt. In an economic environment where the cornerstones are reduced government spending and rising interest rates, these dynamics are more of a liability than an asset. Companies like Cisco and IBM will need to learn to live on much less government revenue and much less low interest debt.
Capitalizing on the New Dynamics
Most serious investors prefer bearish environments for one simple reason – stocks crash down not up. The options market accommodates this difference with an implied volatility skew. Knowing how to trade the skew provides a tremendous advantage.
The goal is to capitalize on a steep skew and overpriced out-of-the-money puts to structure positions that benefit from a price decline while being hedged against surprise increases. In this regard, “slow-burn” and “go nowhere” markets are a huge advantage over highly volatile collapsing environments like the NASDAQ and housing bubble crashes. Those markets, although weak, were characterized by sharp upward corrections that triggered the emergence of unusual symmetrical skews that are more appropriate for commodities.
Short Collars Have a Volatility Advantage
One approach to profiting from the catastrophe is to identify companies like Cisco and IBM that are likely to be affected, and to structure short positions that are heavily hedged. Short collars are the most conservative choice and they have a structural advantage over long collars that might be a good choice in a bull market.
A long collar is composed of long stock surrounded by short calls and long puts. If, for example, you were bullish on a $100 stock you might buy the stock, sell $105 calls, and buy $95 puts. Call revenue pays for the puts in return for a cap on the maximum gain of the trade. The long put side of the trade caps the maximum loss. But the problem with long collars is that the implied volatility skew tends to make the puts more expensive that the calls, so the option part of the trade will usually have a slight debit. If the stock goes nowhere the trade will lose money. This slow decay coupled with regression to the mean creates an ongoing expense for long collars that is similar to time decay.
Short collars are the exact opposite. The equivalent short trade would contain short stock, long $105 calls, and short $95 puts. This structure has an advantage because the implied volatility skew makes the put side – the short side of the trade - more expensive. The profit cap side can be wider than the loss cap or, if the sides are symmetric, the puts more than pay for the calls. In addition, because short stock margin requirements are just a fraction of the cost of long stock, short collars are much less expensive than long collars.
Monday evening when these words were being written, IBM closed at $180.75. Approximately equally spaced $10 out-of-the-money puts and calls traded at dramatically different implied volatilities. September $170 puts were priced at $1.93 (24% imp. vol.) while $190 calls were only worth $1.36 (16% imp. vol.) despite being slightly closer to the spot price. The trade would, therefore, be short stock / short $170 puts / long $190 calls for a $0.57 credit.
These dynamics are even more extreme at the broad market level. SPY, for example, closed Monday at $128.78. A simple trade would be to short the ETF, sell September $120 puts for $1.54, and buy September $137 calls for $0.44. The trade, therefore, would produce a net credit of $1.10. The steep skew allows us to buy 15% implied volatility and sell 26%.
Collars are the most conservative way to structure a directional position. They are also one of the few valuable option trades approved for IRA accounts. If the market falls sharply, the implied volatility skew will continue to steepen and the size of the credit will grow. The trades will, therefore, generate significant profit even when the stock price remains unchanged. All things considered, this approach is the most conservative way to trade in a bear market.
Whether or not we are entering a bear market is unclear. A more reasonable description would probably be “flat” or “not up.” But one thing is clear: the driving force behind the rally was free money and that dynamic is changing quickly.
Jeff Augen
Jeff Augen is the Author of six books on options trading: Microsoft Excel for Stock and Option Traders, Trading Realities, Day Trading Options, Trading Options at Expiration, The Option Trader’s Workbook, and The Volatility Edge in Options Trading. He currently teaches option trading classes at the New York Institute of Finance and writes a weekly column for Stocks, Futures and Options magazine. More information is available at Pearson Education’s site:
http://www.ftpress.com/authors/bio.aspx?a=5CF29120-3FB9-4E98-A0B4-C8F9FEAD85E3
