A great way to hedge downside risk in equities or to speculate on a major market decline is to buy deep out-of-the-money put time spreads, a simple but very powerful trading strategy that gets you long volatility and short delta without too much risk. This article discusses the setup for the trade, the option strategy and the projected profit/loss scenarios given different assumptions about changes in implied volatility and movement of the underlying.

The Setup
Let's assume there is currently a bear market rally that began a few months ago and that it is not the last. What if the next swing lower will be the biggest in a final washout of the longs? How could we capitalize on such a scenario without risking too much capital? One way is to buy deep out-of-the-money put spreads. There are two necessary market conditions to make such a trade worth the risk.

The first condition is low implied volatility, and we use the VIX (S&P 100 Implied Volatility Index) as a proxy for overall equity-market implied volatility. When it is low, investors are complacent, and put options are "cheap". When it is high, put option premiums go sky-high as investors and money managers buy up puts in a panic to protect stock positions. Put options give the owner the right but not obligation to sell stock at a specific price (known as a strike price) within a certain time frame.

We want options to be cheap in terms of the implied volatility pricing because the trading strategy explained below is actually long vega (a measure of risk exposure to changes in implied volatility), which means it will profit from a rise in implied volatility. If VIX rises with a sharp sell-off, the position will gain from any associated rise in volatility. And if it is net short delta (a measure of risk exposure to changes in the price of the underlying), a fall in price will yield further gains.

The second condition we need is of course an overbought market. Here we can use contrary sentiment indicators to tell when to enter this type of trade. When the level of bullish investor and trader sentiment gets too high, suggesting that the majority of market participants are bullish, almost inevitably the market reverses direction and catches the longs in a squeeze. When the majority of traders are long, they are usually wrong, especially when there is heavy volume.

The Strategy
This bearish strategy is simple to implement. It is actually a calendar spread (also known as a time spread), but instead of its usual placing at the money, it is placed deep out of the money. At-the-money time spreads are usually placed when the trader expects sideways movement of the underlying. Since it is a put time spread, it will be placed well below the market place, assuming we have a bearish outlook of course.

In June 2003, the S&P 500 was trading just above 990. At such a time we'd want to place our put time spreads down below the latest significant lows, which means below the lows of the last March (787-8). Ideally we would want the market to go all the way down to the strike price we'd select for this trade, but profit would arise even with a less severe drop in the S&P 500, as you will see below. Meanwhile, even if the market moves higher in the short term, the potential for profit remains until the third Friday of September.

A long calendar, or time spread, involves selling a short-dated option and buying a long-dated option, both at the same strike price. Since the long-dated option has more time premium than the short-dated one, the spread generates a debit to your trading account. You are buying the more expensive and selling the cheaper for a debit. So this is actually a net buying strategy. Let's take a look at how the pieces of this strategy fit together with some actual prices.

Figure 1 below presents settlement prices taken at the close of trading June 4, 2003:


Figure 1: Deep-out-of-the money December/Mar S&P put time spread. Delta and vega values are taken from the OptionVue 5 Options Analysis Software S&P futures options.

The settlement price of the September S&P futures on June 4, 2003, was 985.1. December S&P 500 futures settled at 983.40. The September option is priced according to the level of the September futures, and the December option is priced based on the level of the December futures contract.

When initiating such a position, we would be selling the September S&P 700 put for $1.10 and buying the December S&P 700 put for $3.60. This generates a debit of $2.50 in premium. S&P options are valued just like the S&P futures, $250 per 100 basis points, or one premium point. The maximum risk, therefore, is $625. This is the amount of money, moreover, that would be required by the exchange to initiate this trade. The risk is measured by the size of the spread (2.5). If the spread widens, the position profits. If it narrows, the position loses.

The nice feature about this trading strategy is that the spread can only go to zero, meaning you can only lose $625. The spread would narrow if the market rallied higher. Should the market trend lower between the time of this trade and September expiration, a huge profit potential exists. Figure 2 below presents a profit/loss snapshot of this trade based on the assumption that there will be no change in implied volatility. After we take a look at this scenario, we will relax the no-change-in-volatility assumption, permitting a 10% jump in volatility, which is conservative if we expect that the S&P might break new lows.


Figure 2 - September/December S&P deep out-of-the-money put time spread profit/loss. No change in volatility. Created using OptionVue 5 Options Analysis Software. This example excludes commissions and fees, which can vary from broker to broker.

As can be seen in Figure 2, the position has some nice profit potential should the S&P 500 get down to new lows before September expiration, with maximum profit at the level of 700, totaling $15,750. This example excludes commissions and fees, which can vary from broker to broker. As indicated below in the profit/loss chart, the delta gets shorter and shorter until we reach 700, where it reaches a maximum. Meanwhile, the vega remains positive, so if volatility increases from such a fall in the equity markets, the position gains. Figure 3 below shows the profit/loss functions resulting from a 10% jump in implied volatility of S&P 500 options, where we have now relaxed our assumption.


Figure 3 - September/December S&P deep out-of-the-money put time spread profit/loss. Ten-percentage-point rise in volatility. Created using OptionVue5 Options Analysis Software. This example excludes commissions and fees, which can vary from broker to broker.

With a ten-percentage-point increase in implied volatility, the at-expiration level has increased to $19,180. One of the best features about this trade is the potential for profit at levels well above 700 level at September expiration. For example, at 879-80 levels, we show a profit of $3,025 with the assumed change in volatility, and $975 with no change in volatility. The actual profit would lie somewhere between the two. This strategy can be applied in longer time frames as well, such as March/December, and shorter-term selling strategies can be employed to offset the cost of these bear market/crash protection trades should the anticipated move not materialize.

In the case presented in this article, we used just a one-lot position. A trader should scale position size according to risk tolerance and available capital. Be aware that this trade requires closing the long December put option at expiration of the September put option. The profit/loss scenario changes should you chose to hold the long December put option.

The Bottom Line
Deep out-of-the-money put spreads require low volatility and potential for big downside moves to be profitable. Risk is limited to the initial debit so there is no need to make panic-driven decisions during the life of the trade. By selling a short-dated deep out-of-the-money put option and buying a long-dated option at the same strike, we are long the time spread, and the account is debited to enter the strategy. An explosive move lower at any time before September expiration (third Friday of the month) will likely produce a profit. If you want to protect an equity position, or speculate on another bear market decline, this might be your best approach in terms of risk/reward.

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