Contrarian bet

[indirect]

S&P 500 put premiums are so expensive, while calls are so inexpensive, that it is possible to make an extraordinary wager that equities will rally sharply over the next three months.

 

Selling just one three-month S&P 500 put with a strike price 5% below the market is enough to buy eight S&P 500 calls with identical expirations that are 5% above the market. The funding ratio of puts to calls is at a 10-year high, according to Mandy Xu, a Credit Suisse derivatives strategist. Over the past decade, the average ratio was 2.3 calls for every put.

 

The current setup is either a great trade or a recipe for extraordinary losses. But if you believe the next three months will be strong—and a reader recently emailed that “if” is one of the smallest words in the dictionary, but has the most meaning—getting potentially free upside in return for taking on the risk of a 5% decline is attractive.

 

From today’s Barrons

 

I wonder what the board's thoughts are on this trade. I believe its a good contrarian bet, but not complete conviction.

 

[RichardGibbons]

S&P 500 put premiums are so expensive, while calls are so inexpensive, that it is possible to make an extraordinary wager that equities will rally sharply over the next three months.

 

Selling just one three-month S&P 500 put with a strike price 5% below the market is enough to buy eight S&P 500 calls with identical expirations that are 5% above the market.

 

I'm not quite sure where you're getting your data, but I think the source is incorrect.  Put/Call parity means that, in a liquid, shortable security, puts and calls are typically close to optimally priced relative to each other.

 

(By put/call parity, I mean a call is equivalent to long shares plus a long put, and a put is just short shares plus a long call.)

[cmlber]

S&P 500 put premiums are so expensive, while calls are so inexpensive, that it is possible to make an extraordinary wager that equities will rally sharply over the next three months.

 

Selling just one three-month S&P 500 put with a strike price 5% below the market is enough to buy eight S&P 500 calls with identical expirations that are 5% above the market.

 

I'm not quite sure where you're getting your data, but I think the source is incorrect.  Put/Call parity means that, in a liquid, shortable security, puts and calls are typically close to optimally priced relative to each other.

 

(By put/call parity, I mean a call is equivalent to long shares plus a long put, and a put is just short shares plus a long call.)

 

No thoughts on this trade, but put call parity applies to puts and calls at the same strike price.  The suggestion here is to sell a put and buy a call at a strike 10% higher.

[RichardGibbons]

No thoughts on this trade, but put call parity applies to puts and calls at the same strike price.  The suggestion here is to sell a put and buy a call at a strike 10% higher.

 

Good point.

 

Sorry for misunderstanding your post, indirect.  That is pretty interesting, and is some huge volatility skew.  It would be interesting knowing how often the market's gone up more than 5% in 3 months and what the average gain has been vs. how often it's gone down 5% in 3 months, and the typical loss.  (Not to say that the market today is like the average day in the past 100 years, but rather it would be interesting just knowing that as a starting point for thought.)

 

One other method of exploiting this might be by taking some of that short put money and hedging with some VXX calls (because the trade is probably only a disaster if the S&P 500 crashes, and VXX calls would do well in a crash.) Or changing the short put to a bullish put credit spread to reduce the downside. 

 

Maybe I'm just getting more complex than necessary, but  I just hate getting into positions with potentially huge losses (e.g. a 25% crash like 1987 would cost almost 50 points).

 

 

[no_free_lunch]

It's probably a good trade but I don't like the downside.    Other possibilities would be to just buy the calls but no puts and potentially hold more cash.  Another option, you could sell the 5% put and then both buy calls and a more out of the money put to limit your downside.