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.