Trade in Groups

The bearish outlook given yesterday was based off a combination of general economic data (fundamental) as well as a handful of indicators about market internals (technical). The underlying theme here is that the leaders into this crisis – namely, real estate and financials – have not yet hit a bottom (or at least need to re-test lows).

The themed bets here are that it will be profitable to be short REITs and financials, as well as oil due to demand destruction, to be long volatility via options on the VIX, and have a covered call on the Gold ETF (ticker: GLD).

Typically, there has been an emphasis on trading long/short, and although this group of trades has a blend of longs and shorts, it is hardly uncorrelated. Below is a one month chart showing the performance of the UltraShort Real Estate ETF (ticker: SRS, blue), the UltraShort Financials ETF (ticker: SKF, orange), the S&P Volatility Index (the VIX, green), and the United States Oil Fund (ticker: USO, red). The first three have tended to increase together, while oil has declined – meaning being long SRS, SKF, and VIX calls with a short position in USO is not exactly hedged.

Purchasing out-of-the-money call options is normally one strategy used by beginning options traders because the options seem “cheap” – that is, they are inexpensive. And they are, because out-of-the-money options tend to expire worthless. For our purposes, we are using the February call with a strike 5% above the underlying’s opening price (or 5% below for USO puts) on Friday (1-30-2009), rounded down (up for the put position).

Part of this exercise is to compare the performance of a simple portfolio of ETFs against a portfolio with leverage from options, and the other is to add time pressure because of option value decaying. With that, the underlying positions, their opening price on Friday, and the percentage change:

UltraShort Real Estate (SRS): $54.86, +6.50%

UltraShort Financials (SKF): $133.66, +4.77%

CBOE S&P Volatility (VIX)*: 42.63, +5.18%

United States Oil (USO): $30.02, -2.66%

*There is no way to own the VIX directly, it must be done using options

Because we are short USO, all of these positions went in our favor on Friday. The average percentage change was +4.78%. Now on to the options positions, again with the opening price on Friday and the day’s percentage change:

UltraShort Real Estate $57 Call (SRSBE): $7.20, +34.72%

UltraShort Financials $140 Call (SKFBJ): $16.20, +43.83%

VIX $42.50 Call (VIXBV): $5.70, +5.26%

USO $29 Put (UBONC): $1.70, +17.65%

All of these options positions went in our favor, some substantially. The average position return was +25.365%, which shows how the leverage from options impacts returns. Initiating 100 share positions on the underlying would have cost roughly $26,000 (again, remembering one cannot “buy” the VIX), while buying one of each option contract could have been done for about $3,100.

One day does not do much to validate a trade idea, so we will revisit this occasionally between now and options expiration. Hopefully for now, however, it will suffice to say that buying out-of-the-money options is a strategy with value for the aggressive bettor, and not just the choice of inexperienced options traders.