This article will serve as a companion piece to this week's Options 101 article. That Options 101 article discusses a CBOE white paper on employing deep-in-the-money put debit spreads to both predict and hedge against downside movements in certain equities. These put spreads were to serve as an alternative to credit default swaps or CDSs.
Since the other article discussed the theory, I thought perhaps this article might delve into the nitty gritty of the actual option trade being discussed. The option strategy in this white paper on the CBOE's site was given the apt name DOOMs. The CBOE paper detailed several companies on which DOOMs might be appropriate. The requirements were that each company "has a gross notional outstanding of $10 billion or more in the CDS market" and had "not yet experienced severe credit deterioration." Options had to be available, of course, but, moreover, LEAPs more than 18 months into the future had to be available. The lowest strike had to be at least 50 percent out of the money.
Before presenting that list, the white paper had compared how a CDS and a debit spread comprised of deep-out-of-the-money puts might have performed as LEH failed. The example used with LEH was the purchase of a 25-15 put spread in January 2008, when LEH was then trading somewhere between $50.00-$66.00.
Of course, conditions have changed since that paper was released. For example, AZO is one of the companies listed, with AZO currently trading near the same level at which it traded in MAR, 2009, when the white paper was released. Yet the JAN 12 LEAPs, roughly about the same distance out as the JAN 11 LEAPs were in March, 2009, have their lowest strikes at 120.00, well above that 50 percent out-of-the-money requirement. KR, also trading near its March, 2009 level, also did not have JAN 12 LEAPs 50 percent out of the money. I wasn't able to locate any ratings changes since the one in which KR's BBB- rating, however, so that company might still match the requirement that its credit had not yet severely deteriorated.
It turned out that many of the companies on the list included in the CBOE's white paper no longer fit the original requirements set forth in the paper as the strategy was tested. Few had JAN 12 LEAPs with strikes at 50 percent of the current stock price, for example, so it was difficult to find a test equity for the purposes of this article. Perhaps KFT and SPG were two companies that best fit the requirement. SPG, with a close at $77.72 on February 19, 2010, when this article was first roughed out, had JAN 12 LEAP puts all the way down to the 35.00 strike.
Let's imagine that we had 1000 shares of SPG and wanted to protect our investment, being willing to accept some loss but not a catastrophic one. Let's construct a 40/35 put debit spread out of the available options and then look at a chart to see how much protection we're offered.
The total cost for 10 contracts of that put debit spread would theoretically be $780.00 after we'd paid a commission of $1.50 per option contract. That's approximately 1 percent of the value of the 1,000 shares. OptionsOracle calculates that the downside breakeven at expiration for the spread, the point at which the spread would be profitable and protection would begin to kick in at expiration, would be at $39.19.
Expiration Profit/Loss Graph for a SPG JAN 12 40/35 Put Spread:
Hmm, you're probably thinking. Is this really that good a deal? If we owned 1000 shares of SPG, we would have lost $77.72 closing price - $39.19 = $38.53 before that spread's downside BE was even hit and its protection started kicking in. That's 49.58 percent of the share price. That's a $38.53 x 1000 + $780 put spread cost = $39,310 loss before this so-called protection even starts kicking in. And, at its best, at expiration, this returns only a little over $4,000.
Not such good protection, huh?
But wait a minute. Let's look at what happens if share prices drop precipitously well before expiration. What if, by August 16, 2010, SPG's prices have dropped 20 percent, to $62.18?
Profit/Loss Graph for August 16, 2010 for SPG JAN 12 40/35 Put Spread:
The red dot is placed at the spot that marks a 20 percent loss for the SPG share price. Theoretically the debit spread's protection has already begun kicking in. The theoretical profit on the spread itself would have been about $219.00. That's not much, but it's showing that, depending on the time left before expiration, that protection might begin kicking in far sooner than the expiration graph shows.
In fact, that spread's protection may be kicking in even quicker. A drop of that magnitude would presumably pump up volatilities. Let's see how the theoretical curve changes for August 16 if volatilities are higher.
Profit/Loss Chart for August 15, 2010 for SPG JAN 12 40/35 Put Spread When Volatility Is Increased:
Implied volatility was increased only 4 percent, but that change resulted in a theoretical profit on the put spread of about $860.00 at our target $62.18 share price level. Would this $860.00 profit make up for the ($77.72 - $62.18) x 1000 = $15,540 lost on the share price? Of course not. However, perhaps the thinking is that, if one believes in weathering a certain amount of back-and-forth in the markets, this bit of insurance might ease the pain of a 20 percent dip, providing leeway for the investor to then make a hold-or-sell decision on the stock if it drops further than 20 percent.
This isn't the only deep-out-of-the-money debit spread that could have been constructed, of course. Because LEAPs are flexible, it might be possible to balance how much pain one wanted to weather against how much one was willing to pay for such insurance, and buy more contracts or construct a wider or higher spread with a bigger payoff. For example, a trader who was willing to spend about 5 percent of the cost of the share price in order to obtain some degree of protection until JAN 12 could spend about $3,907.50, assuming commissions of $1.50 per contract per side, to construct a 15-contract JAN 12 50/40 put spread. Under the conditions we've outlined previously, with the share price dropping to $62.18 on August 16, and with implied volatilities climbing only 4 percent, the profit would be bigger, theoretically just under $2,590.00.
The CBOE wants you to have even more flexibility. The CBOE has also developed CFLEX, which it describes as "an easy-to-use, internet-based system that allows market participants to customize contract terms like strike prices and maturity dates." Although the CBOE assures customers that trades that are placed through CFLEX "are centrally cleared through the AAA-rated Options Clearing Corporation," I'm not certain that such customized contracts would enjoy the liquidity that we've all come to depend upon in our options trading. It sounds like a souped-up version of the old days when traders used to call their brokers and say they wanted to buy a put for protection, and the broker would go hunting for someone who would offer it, and then there was a dickering over the appropriate price. Again, perhaps this is more appropriate for the institutional crowd, those formerly interested in the CDS market, than it is for us retail traders.
As discussed in this white paper and on the CBOE's site, both CFLEX and the DOOM method appear to be aimed at the institutional investors who were previously using a CDS to protect against adverse market events. I haven't--and wouldn't--use the CFLEX market, if it's even available to retail traders, and I haven't personally tested the pros and cons of the DOOM method in a market crash. Would I employ this DOOM method of protecting my investment if I were long a lot of equities? I'll have to investigate further before I make that decision, as I suggest you do if the CBOE's white paper intrigues you. Compare this strategy with collaring techniques, which are also discussed on the CBOE's pages and in archived articles on this site. Both might have pros and cons that make one preferable to another for a particular investor. For example, a collaring technique would be slightly more active a technique, requiring rolling into new contracts as often as once a month or perhaps less frequently depending on how often calls were sold and puts purchased.
My purpose here was just to graph the way such a DOOMs option position might behave under certain conditions, to further elucidate the information in the accompanying Options 101 article. It wasn't to recommend a particular trade but to provide food for thought.