Investing with SPX Options

Posted on February 4th, 2013

At Buy and Hedge, we write a lot about using ETFs and Indexes as a way of staying exposed to the broad market vs. picking a basket of stocks you expect to outperform. We’ve discussed before the difficulty of picking the winners over time and that most money managers underperform the averages because of it. In our book, we suggest that portfolios have close to 50% exposure to broad-based indexes and outline a few ways to do that; one of them being the use of SPX (S&P 500 Cash Settled Index).
SPX cash index is the calculated average of all 500 stocks that make up the index. It is the broad base index we all know and love (sometimes) and is updated every minute based on the movement and weighting of those included stocks.  Because it is an index, there’s actually nothing to own, so options turn out to be the only way to invest using SPX.  You could buy the S&P500 future if you wanted but it is not exactly the cash settled vehicle because there is a premium worked into the futures. We’ll stay away from the futures for now.
The easiest way to simulate a long position with the SPX is to buy a call and sell a put. This creates a synthetic stock position. The call replicates the index as if you held it as long stock. A synthetic is created by going long an at-the-money call and the selling the put at the same strike.  With the SPX trading at 1500 today, this gives you 150,000 worth of market exposure. Of course the cash necessary to create this position is significantly less because of the option requirement. For example to create a synthetic for the JUN13 expiration at the 1500 level the trade would be long SPX JUN13 1500 Call and short SPX JUN13 1500 Put generating roughly $13 in premium per contract. The requirement for this is calculated by the requirement for a naked put plus the cost of the call. Not a bad use of cash as it will cost you, roughly speaking, the need to use only 25% of the market value in buying power.
The problem for us hedgers with synthetics is they are not hedged. The exposure higher and lower exists just as if you had uncovered stock. So if you want to be protected, you’re now buying a put below the market, say 10% below at the 1350 mark. This adds to the cost of the trade and makes your break even higher. But why go through this whole process when you can just create the same exposure with one single spread.
Spreads are our preferred means of gaining exposure to the indexes.  There are three basic spread types: Vertical, Calendar, and Diagonal. A spread is a two legged trade with one long option and one short option of the same type (call or put). A vertical spread is a long option and a short option of different strikes with the same monthly expiration.  A calendar spread is a long option and short option with the same strike but different expirations. And finally a diagonal is a long option and a short option of different strikes and different expirations.
We use these spreads for different situations, but the most direct way to create simulated long stock exposure is with a vertical call spread that has a net zero hedging cost. That means that the time premium of the long call equals the time premium sold for the short call. The long call will be in-the-money (or below the market) and the short call will be out-of-the-money (or above the market). This will have the investment performance just as if the SPX was held outright as stock (which we already explained you can’t do) AND limit the downside risk. Losses stop if the index crosses below the long call’s strike. Alternatively, gains stop when the index crosses the upper strike of the short call.  However, between the strikes, it will feel like you’re long stock.
The cost of entering a long call spread on SPX is simply the max loss that the spread could endure or the cost of the spread. There is no additional maintenance like there is for the synthetic described in the first section above. While it depends on how wide of a spread you want to create, typically the cost of a net zero or near to net zero cost will be the amount your long call is in the money.  So if your downside limit is 10% (that’s the how far your call is in-the-money) and the spread had a net zero time value or hedging cost, then the trade requirement will be about 10% of the underlying’s asset value; in this case 10% of 150,000 or 15,000. This is the most the trade can lose.
We like this approach because it keeps us in a lot of cash as the trade is what we would call buying power friendly. It forces us to limit our potential losses and stay disciplined to our downside. But there is another advantage which is flexibility. If we want, we can try to sell calls multiple times on the same long option leg. This would happen if the market was to have a pullback where the short call lost almost all of its value and we could sell another call to generate more premium.  Of course the risk is if there is a snap back up and the short call goes in the money and the short call losses value.  This would limit the profit of the long call.
If this is a tactic you’re interested in, you might as well start with diagonals vs. verticals. The concept is the exact same and gives you multiple times of generating call premium vs. just once from the vertical.  Start with the long call of say 6 months and sell 1 call each month or 3 calls every 2 months. This will give you the opportunity to generate more premium over time. This doesn’t always work, however. In times of declining volatility, like we just experience the last few months, you will not be able to sell for enough premium. However, if you’re entering into the long call when volatility is low, you don’t want to lock in your short call at low premiums, so diagonals will work better in a rising volatility environment.
Assignment on SPX options is another benefit. First off SPX options are European style and can only be assigned on the day of expiration. So selling short options means no early assignment. For SPX options, expiration is the Thursday before equity option expiration. The settlement value is calculated at the open of the next trading day. The second assignment benefit is that you won’t actually lose your long call if it has not expired. The short call simply settles as the cash difference between the mark of the open the day after expiration and the strike it was sold for. 
The one downside of SPX as a broad market exposure is that there are no dividends received. ETFs like SPY pay nearly a 2% dividend, but let’s save those for another post. 

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