An options strategy is all about assessing the probabilities of future outcomes. For that matter, all of investing is predicated on placing probabilities on events yet to occur.What is the Fed likely to say next month? Is XYZ Company likely to exceed earnings estimates next quarter? How likely is an XYZ March 2014 call option to expire in the money? Each answer has some probability attached to it. Luckily for the markets, there are ways to express one’s view based on these probabilities.
This month we hone in on a topic that is raising questions lately: What happens when interest rates rise? And what probabilities should be placed on certain outcomes if and when they do?
From an options perspective, these questions set the table for a discussion of the relative opportunities portfolio managers face in today’s environment. Specifically, many capital allocators have grown accustomed to placing a large segment of their portfolios in fixed income securities. However, given the potential risks associated with a changing rate environment and an increasing interest in options-based strategies, a change of the guard could be upon us.
Back to our probability analysis for 2014. Let’s begin with fixed income. In the assumptions below we generate a range of return outcomes for two commonly held ETFs:
At first glance, the results come as no surprise. In a rising rate environment, bond prices fall, and in a falling rate environment, returns look somewhat attractive, all things being equal. But when we ascribe probabilities (feel free to place values as you see fit) to each of the returns, the fixed income portion of a portfolio doesn’t look very appealing.
To combat this rather lackluster set of outcomes, we present an options probability matrix that demonstrates the expected value of a set of trades using option pricing on the S&P 500 Index (using the SPY ETF) as of 12/20/2013.
The three examples in this table are representative of basic trades that an investor could put on to express different levels of risk aversion in the equity markets. The first trade is a standard buy-write where the investor is long the SPY and writes a 50-delta at-the-money call (defined as the Dec 2014 182 call). In this example, we are buffered on the downside by the written call, but capped out on the long position at 7%. In a strong market rally, this trade will lag the market.
A second common trade is the collar. Typically, investors look to transact in a “zero-cost” collar, whereby one writes a 5% out-of-the-money call option and purchases a put option in the same expiry such that he is not paying or collecting the option premium. At the onset, this trade’s expected value at expiration is 5.0% assuming no change in the level of the S&P 500. As the market moves, the position is fully capped on both the downside and upside at -11% and 5%, respectively.
In the third trade example, we take a different position using a cash protected put with a strike price 5% beneath current levels. Here, our upside is capped at roughly 5%, but our downside profile is more attractive. In a market down 10% in 2014, the position can expect to lose only approximately 30bps.
The outcomes displayed in the preceding tables depict the challenge of the strategic allocation decision. On one hand you are at risk of a rising rate environment eroding away principal, and on the other, you are constructing a skew profile that limits your upside, but protects your equity portfolio from outsized losses. In a market on the heels of the sustained bull run since the lows of March 2009, this could be a potentially valuable trade. If we assume a scenario where the U.S. creates a modicum of GDP growth in the early part of 2014, driving the 10 year up to 4%, and the equity market merely trades flat, these basic option strategies will have many opportunities to outperform.
This is outlined not to advocate any one strategy or asset allocation, only to provide a probabilistic viewpoint to the investing climate today. As one considers a move into options strategies from a fixed income portfolio, it is worth examining the breakeven scenario. As we touched on earlier, if the 10-year yield rose to 4%, bonds prices will fall. In our example, LQD could see 4% depreciation, while GVI potentially returns -2.3%. For the three said option strategies to generate similar performance, the equity market would have to return -10% in the ATM buy write, -6% using the zero cost collar and -14% in the 5% OTM cash secured put.
Essentially, unless the equity markets tumble severely, these options strategies will provide fixed-income-like volatility and a return stream correlated to the equity market, but with a fair amount of downside buffering or even outright protection.
If rate increases put the brakes on what has been a 30-year bull market in credit, this seems like a logical alternative.