Playing Both Sides of the Fence

Two weeks ago, the CBOE Volatility Index (VIX) traded below $20 for the first time since the onset of the coronavirus pandemic (circle in chart below). The VIX is known as the “fear index” since it increases in value when portfolio managers buy a lot of put options on the SPDR S&P 500 ETF Trust (SPY) to guard against a big drop in the stock market.

If you have never traded options before, there are two things you need to know:

  • Put options increase in value when the price of the underlying security goes down.
  • Call options increase in value when the price of the underlying security goes up.

You might infer that the recent price decline in the VIX means fewer put options are being purchased. However, the VIX is a ratio that compares the relative number of put options purchased versus call options. In this case, an increase in the number of call options purchased on the SPY is what has been driving down the VIX lately.

It appears that some portfolio managers may be engaging in an options strategy known as a “long straddle.” A long straddle is designed to make money if the price of the underlying security, in this case the SPY, moves strongly one way or the other. It loses money if the price of the SPY remains close to its current value.

Why would a portfolio manager do that now? Given the stock market’s unexpected surge in November, most portfolio managers should have already earned their performance bonus for 2020. To lock in those gains, they buy put options on the SPY to guard against a December meltdown that could suddenly snatch those bonuses away.

Betting on a Big Move

That makes sense, but why would they also buy call options on the SPY at the same time? If they’ve fully participated in the performance of the S&P 500 Index this year, they should have been up 12% at the end of November.

I’m not so sure that is the case. The S&P 500 Index is cap-weighted, so its performance is strongly influenced by bigger companies such as Apple (NSDQ: AAPL) and (NSDQ: AMZN). On an equal-weight basis, the S&P 500 showed a return of just 7.7% through the first 11 months of this year.

My interpretation of the recent drop in the VIX is that active fund managers are hoping to eke out a couple more percentage points of gain this month. Presumably, their portfolios are not skewed as heavily towards the mega-cap tech stocks that dominate the S&P 500 Index.

Keep in mind, passive index fund managers do not buy put or call options to protect their portfolios. Their only job is to track the performance of the index as closely as possible, not to beat it. Active fund managers buy the put and call options that are tracked by the VIX.

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By using a straddle, those portfolio managers are essentially betting on a big move in either direction. At the start of this week, the cost of buying a 30-day put or call option on the SPY was roughly 2% of its current value. Since they are buying both options, the index must move more than 4% one way or the other for this trade to be profitable.

Reset to Zero

A move of that magnitude could easily happen before the end of this month. December is a notoriously fickle time of the year for the stock market. It is the final month of the final quarter for most businesses. Many of them rely on holiday spending to make their numbers for the year.

This year, December is further complicated by the coronavirus pandemic. Especially now, as COVID-19 surges out of control in many parts of the country. Thus far, the money managers on Wall Street have mostly ignored the economic carnage wreaked by the pandemic.

That may soon change. Portfolio managers got an unexpected bonus last month when the stock market soared to record highs. That gave them extra money to spend on buying call options on the SPY this month. But next month is the start of a new year. All of the year-to-date performance figures for portfolio managers will reset to zero. They will no longer be gambling with the house’s money.

I don’t envy them. They risk being wrong no matter which type of option they buy. For that reason, I’d rather be an options seller in this environment. Options premiums are high. You can make a lot of money these days letting other people pay you to do their worrying for them.

That is precisely how my colleague Jim Fink has been able to produce outstanding results year after year.

Jim Fink is the chief investment strategist of Options for Income, Velocity Trader, and Jim Fink’s Inner Circle. He’s a world-renowned options trader with a proven track record of 85% accuracy.

Jim is now making this bold promise: “Give me nine minutes a week and I’ll show you how to make as much as $67,548 a year.” Want to take him up on his offer? Click here for details.