The CBOE Volatility Index (INDEXCBOE:VIX) closed yesterday at 9.43, up 7 cents from Friday’s close of 9.36. This marked the third lowest close ever for the VIX with only last Friday’s aforementioned close of 9.36 and the all-time low of 9.31 from Dec. 22, 1993 coming in lower.
The VIX is calculated using option prices on the S&P 500 Index, so an extremely low VIX means extremely cheap options on the S&P 500. The SPDR S&P 500 ETF Trust (NYSEARCA:SPY), which tracks the S&P 500, closed at $246.82 which is a mere 28 cents (or 0.12%) off the all-time high of $247.10.
With stocks basically at record highs — the S&P 500 just hit a new intraday high of 2,479.87 in Tuesday’s trade — and option prices at record lows, now is an opportune time to consider adding some SPY puts to the portfolio.
SPY is trading at virtually an all-time high on a price standpoint, but also more importantly on a valuation basis as well. Using a price to sales (P/S) methodology factors out much of the financial engineering inherent in the more widely followed price to earnings (P/E) ratio. The P/S ratio on the S&P 500 now stands at 2.15, by far the highest level over the past 15 years.
Click to Enlarge The IMF just cut their 2017 and 2018 growth forecasts for the U.S. to 2.1% (versus a previous 2.3% and 2.5%) with expectations of dampened growth prospects over the coming two years.
The combination of slowing growth and rich valuations is usually a harbinger of trouble for stock prices.
SPY is also looking tired from a technical perspective, failing to break out to new highs after reaching an overbought reading on a 9 day RSI basis. Given the sharp 2.7% gain in just 10 days from the the July 6 low of $240.55 to the all-time high of $247.10 on July 20, a pullback certainly would not be unwarranted-and may actually be welcomed.
Click to Enlarge Most importantly, option prices are at dirt cheap levels. As I stated earlier, the VIX is derived from the option prices of the S&P 500. Lower VIX means lower option prices. Super low VIX, as we most assuredly have now (third lowest reading EVER), mean super low option prices.
Super low option prices mean you lose less if you are wrong and make more if the market heads your way … and I like risking less to make bigger profits.
So with the SPY at highs on both price and valuation and looking tired from a technical standpoint, positioning for a pullback using dirt cheap put options makes probabilistic sense.
How to Trade the SPY
Buy to open SPY Aug $247 puts for $1.85. Maximum risk on the trade is the premium paid of $185 per contract. Downside breakeven at August expiration is $245.15, just 0.67% below the closing $246.82 closing price of SPY.
A mere 1% pullback from current levels would essentially double the price of these puts.
As of this writing, Tim Biggam did not hold a position in any of the aforementioned securities. Anyone interested in finding out more about option-based strategies or for a free trial of the Delta Desk Research Report can email Tim at deltaderivatives@gmail.com.
