Preparing For Options Expiry

As we head toward the expiration date for August options this Friday, we are faced with a decision as to whether we should be assigned shares of the SPDR S&P 500 ETF (SPY) and the iShares Russell 2000 Index (IWM) or buy back the options to avoid being short.

We will explain the mechanics and risks of each transaction. However, we also want to discuss the current market environment and our point of view.

There are several factors that can be used to assess the equity markets, and all of them point to a less-than-rosy picture. Let’s take a brief look at some of them.

Valuations — During the last several quarters, we have seen declining corporate earnings. It could be argued that earnings, margins and revenues all peaked in 2014 and have declined since then. Yet despite this decline, the equity markets continued to climb higher purely on multiple expansion, which pushed the S&P 500 to trade at a frothy 19x price-to-earnings (P/E) ratio. To put this number in perspective, a P/E of 19x is in the 90th percentile of the S&P’s historical range. While this P/E level does not mean that a correction is going to happen right now, it does give one reason for pause.

Seasonality — As seasoned traders know, September and October have historically been volatile months for the equity markets, as market participants are all returning from summer activities. In fact, while the S&P has posted lofty gains over the last five years, the month of September for three of those years actually posted a loss, with an average return of negative 1.19% over all five years. It may not seem like a huge loss, but within the context of the S&P 500 gaining 62% over that same five-year period, it doesn’t bode well for the months ahead.

Complacency and Sentiment — In this central bank-driven environment, there clearly is no alternative to equities. With treasury yields near historical lows and negative in many countries, investors are essentially forced into equities in search of good returns. Investors are buying equities aggressively during mild market dips to create V-shaped bottoms, as well as when markets rise on light volume. Simply put, light buying demand into a supply source that is not selling created a one-directional market and led to investor complacency. Indeed, investors are holding equity positions because there is no alternative, and the market grinding higher only has led to sentiment that the market will never go lower. This complacency and misplaced positive sentiment creates, in our opinion, the potential for a dangerous outcome.

All of these factors, taken into consideration, give investors reason to be cautious. While we don’t expect a deep and sustained correction, we do believe volatility is on the horizon.

Returning to Friday’s options expiration, we have sold calls on IWM and SPY, and both of them are in the money. There are two possible actions to take here. Either we buy back the options or get assigned the shares.

If we buy back the options, we avoid share assignment. However, we would have to pay a premium to buy the options again.

Alternatively, we could let the options expire and be assigned the shares. Being assigned call options means we would be forced to sell, short in this case, the shares of IWM or SPY. For example, if we sold one contract of the IWM August $116 call, on Monday you would short 100 shares (1 contract = 100 shares) of IWM at a cost basis of $117.32 (Strike price of $116 + $1.32 premium received = $117.32) assuming you received our pricing. If you sold one contract of the SPY August $215 calls, then you would be forced to sell 100 shares of SPY with a cost basis of $216.39. The strike price of $215 would be added to $1.39 premium previously received by collecting $2.14 on the May 11 sale of SPY calls and paying a premium of $0.75 on the SPY calls that we bought on the same day. At this point in time, you would be receiving proceeds from the IWM and SPY short sales.

Depending on your brokerage account, no cash outlay may be required. However, should you decide, after being assigned shares, that being short the market is not your desired positioning, then your cash outlay would be the amount of shares you are short multiplied by the current market price of the shares. For example, if you had sold one call option of IWM, you would be short 100 shares. To close the position, you would be required to buy back the 100 shares at the market price. Using the close on Tuesday, that purchase would amount to $11,732 (100 shares X $117.32).

Given the headwinds in the market place that were previously mentioned, we recommend waiting and getting assigned shares to take short positions in both IWM and SPY. We believe the market is susceptible to a pullback in the short term. What that situation means is that we believe we will be able to buy back our shares at prices lower than where we sold them. We would be taking a short position in IWM at $117.32, about 4% away from Tuesday’s closing price of $122.40.  A short position on SPY at $216.39 would be less than 1% away from the closing price of $217.96. The weeks ahead should provide us with a good opportunity to cover the short shares at a profit and thus close out the trades completely.

The markets may display some volatility before Friday’s expiration, but we will be watching it closely and will advise you if another course of action should be taken. In the meantime, we intend to take action on another one of our options before then so be on the lookout for a special alert.

Sincerely,


Doug and Tom