Insurance Is Still Cheap

Now, before you do anything else I need you to first read Scott’s equities related perspectives which he graciously posted earlier this morning. It’s spot on and I could not agree more. As it so happens however I have quite a bit of material to add today – you may want to grab a cup of coffee or your favorite tea.

A little caveat before you read on: None of the below suggests that we are switching into bearish mode (just yet). Whenever you look at long term charts remember that they are just that – LONG term charts and that means that price usually takes weeks, if not months, to produce conclusive evidence suggesting that the ongoing trend has been broken. Effectively Scott is saying that we’ve come a long long way since the last correction and it’s not wise to overstay your welcome on the long side given that we are in a low volatility melt-up that could easily turn out to be an exhaustion spike. So what does that all mean then? Well, that is exactly what I’d like to address this morning:

Let’s start at the daily panel on the spoos which earlier in today’s session was dangerously close to testing 1965. That is where the 25-day SMA and our daily NLSL stand right now and a breach below would mean we probably drop toward 1910 or lower.

The S&P cash is of course our final guide and the hourly has thus far managed to hold its 100-day SMA. That’s good news but at the same time it’s not been able to launch a counter response all last week which is a big negative. A drop through SPX 1975 could launch a long covering frenzy during the low participation summer season and thus easily drop price toward SPX 1960 or lower.

But frankly, although I use the SPX/ES as my price gauges I wouldn’t trade either one. If you’re a sub then you’ll find two separate (and very juicy) setups at the end of this post. But first things first:

Let’s assume we really do proceed lower from here – perhaps today or maybe in a week or two from now. Looking at the monthly I see a pretty solid first support line in the form of a diagonal which currently meets price at around ES 1934. If that one should give (very doubtful at this point) then I think that our monthly NLSL at ES 1854.5 would offer support for at least a week or two.

So now that we have established two reasonable price support zones let’s talk about buying insurance. If you’re holding equity related instruments in any form or shape (most likely stocks or ETFs) then this is not a bad time to put yourself in a beta neutral situation.

Why? Because insurance is still very cheap – the VIX  has been spiking a bit lately but last Friday it has settled back near the 13 mark. Volatility of volatility however has remained elevated and either equities proceed higher from here or we are in for the brunt of the storm.

Here’s Friday’s option chain on the Spiders – we are looking at the September put options which still have over 50 days to go. I very rarely hold (hedging) options beyond 30 days to expiration as theta burn really really starts to kick in at that point. The two puts I have highlighted would put us in the money (ITM) at each respective inflection point I talked about above. The respective premiums on Friday for the 195 was $290 – the 187 is about $123. That’s not a horrible spread on both but consider that you are effectively losing $30 and $20 instantly when purchasing these.

Now for some reason I made a mistake and used the 196 when I put it on the simulator but for the purpose of this exercise it really doesn’t matter. This shows us the profit and loss of our put option based on where we are heading from here. Obviously if we are heading higher than you can kiss your premium goodbye – your put will expire worthless as the majority of options usually – especially out of the money (OTM) options. If we cross another bullish inflection point and you’re quick enough you may still be able to re-sell them before they lose all their remaining premium.

But if we drop lower then you see that we’d be banking some very nice coin. I have spiced this one up a little by adding four volatility extensions – basically it’s simulating what would happen if volatility would raise by 10% increments from here. I think the most we can expect at this point is perhaps a push to 23% before we hit support – the other increments are nothing but science fiction at this point.

In essence this shows us what a huge impact an explosion in option vega can have on option premiums (puts and calls alike by the way). IF we actually drop toward our first price support zone near SPY 194 (i.e. ~SPX 1940) and IV hits 23% then we would bank $477.52 in profits – not bad at all. Given that we spent $323 on the premium that’s an acceptable risk given where we are – but it’s nothing to really write home about. However as we are still near the all time highs it’s reasonable to assume you would be able to sell this one back for over $200, which makes it a decent play.

Now here I have taken the same simulation and aligned my cursor at the 186 price slice – we are now near at a profit of $983 but that’s still at 23% IV which is unrealistic. I think if we really drop this low then we’d be a lot closer to 33% resulting in over $1200 of profit.

Of course much of this may just be mental masturbation to you so I decided to borrow Stewie’s time machine and travel back to January 22nd when we were very near where we are right now on the Spider volatility side.

As you can see the option chain I picked is the March 2014 contract month which at that day at 58 days to expiration. Perfect – near our current 53 day number on the September contract. The put I highlighted is the 183 – very similar to the near the money 196 today – and it would have cost us $312. Actually since I’m already there let me buy a few of those for myself and a handful for Stewie’s World Domination fund.

Now I just traveled forward in time when equities were scraping new lows in early February. Out of fairness I did not pick February 4th, when the VIX was painting a high – instead we’re using the Friday session where it seems clear that we may have spiked. What’s our volatility today? It jumped to 20.26% – that’s not bad but shy of the 10% increment we were simulating. Nevertheless our premium has pushed to $935 banking us a juicy profit of $635. Let’s sell those suckers and laugh all the way to the bank.

But wait – not so fast – what I forgot to mention is that I also loaded up on a few OTM puts – the 177 strike price is about the same distance to the strike price in January as we are now to out lower support zone of ES 1854. We were able to afford two of those suckers for the price of one near the money put and they have banked us $772.

Of course making money with OTM options is very very rare and quite frankly OTM options should always be considered either lottery tickets or pure hedge-your-ass-for-the-rupture luxury trades.

Alright – before I go let me show you how I would handle today’s price action. Please grab your decoder ring and meet me in our air conditioned luxury lair:

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You have been briefed – now have fun but keep it frosty.

Cheers,