In my last article I wrote about the “Santa Claus Rally”. One way to play is to buy a stock index mutual fund or ETF. Another is to trade using options. Let’s explore this avenue a little more closely.
On 11/21/2014 (the Friday before Thanksgiving week – i.e. the start of the Santa Claus Rally period) a trader wishing to play the Santa Claus Rally might have:
*Bought 100 shares of ticker SPY at $206.68 for $20,668
*Bought 1 January 206 call option at $3.62 for $362
The good news with buying a stock index fund or ETF is that once you buy it, if the index goes up 1% you make 1%. If you bought say an at-the-money call option and the index went up 1% you might actually lose money on the option due to time decay. Of course the fact that one trade costs $20,000+ to enter while the other costs only $362 is also an interesting trade off.
So let’s consider an alternative strategy and compare it to simply buying shares of SPY.
For this experiment, Trader A will buy a bull call spread using SPY options and Trader B will buy a “delta equivalent” position in SPY shares. OK, a little explanation is clearly in order.
“Delta” is a Greek symbol used in options. For our purposes, the delta of an option tells you roughly the equivalent position in stock shares. For example, if a particular call option has a delta of 50 that means that buying one call option will give you a position that will behave like a position buying 50 shares of stock. The big difference is cost, as you will see in a moment.
Jay’s Santa Claus Rally Option Strategy
At the close on the Friday before Thanksgiving:
*Buy the January SPY call option with a Delta closest to 80
*Sell the January SPY call option with a Delta closest to 15
*Exit the trade at the close of the last trading day of the year.
Example of Strategy compared to buying shares of SPY
At the close on the Friday before Thanksgiving:
Trader A:
*Buy the January SPY call option with a Delta closest to 80
*Sell the January SPY call option with a Delta closest to 15
Trader B:
*Will buy a number of SPY shares equal to the delta on Trader A’s option trade above.
For example, if Trader A bought a call option with a delta of exactly 80 and sold an option with a delta of exactly 15, then the net delta for the option trade would be 65 (80-15). Thus, for comparative purposes, Trader B would buy 65 shares of SPY.
*The trades will be exited at the close on the last trading day of the year.
Example Trades from 2010
Trader A:
*Bought 1 Jan 2011 SPY 112 call @ 9.28
*Sold 1 Jan SPY 127 call @ 0.58
*Cost = $870; Delta = 64
Trader B:
*Bought 64 shares of SPY @ 120.29
*Cost = $7,699; Delta = 64
Both Trader A and Trader B have a position with a Delta of 64 (i.e., if SPY goes up $1 in price both positions should gain $64). However Trader B put up $7,699 to buy the shares while Trader A put up only $870 to trade the options.
On 12/31/2010:
*SPY closed at 127.39
*Jan 2011 SPY 112 call closed at 14.04
*Jan 2011 SPY 127 call closed at 1.31
Trader A:
*Bought the 112 call at 9.28 and sold it at 14.04
*Sold the 127 call at 0.58 and bought it back at 1.31
*Net gain = $403
*Original cost = $870
*% gain/loss = +46.3% (i.e., $403/$870)
Trader B:
*Bought 65 shares of SPY at $120.29 and sold the shares at $127.39
*Net gain = $349
*Original cost = $7,699
*% gain/loss = +4.5% (i.e., $349/$7,699)
So in this one example, Trader A:
*Made more money ($403 versus $349)
*Committed 88% less capital ($870 versus $7,699)
*Earned a higher % return on capital (+46.3% versus +4.5%)
Does it always work out this way? Not a chance. But you get the idea – i.e., commit far less capital for a roughly equivalent position.
2014 Trade
Figure 1 – Santa Claus Option Trade on 11/21/14 (Courtesy www.OptionsAnalysis.com)
2010 through 2014 Comparative Results
For those who are interested the results of this strategy from 2010 through 2014 appear below for illustrative purposes.
Figure 2 – The Santa Claus Option Trade versus buying shares of SPY
For the record all back testing was done with the software that I use for all of my option strategy analysis, www.OptionsAnalysis.com
Summary
The stock market has shown a pretty strong tendency to gain ground between the week ending before Thanksgiving and the end of the year. The option strategy I have detailed here is nothing more than an idea regarding “one way to play” – a way that allows a trader to commit a significantly smaller amount of capital than would be required to buy shares of a mutual fund or ETF, while still enjoying roughly the same upside potential.
Please note that this information is printed for educational purposes only and there is no guarantee that this idea will generate a profit between 11/20/2015 and 12/31/2015.
Jay Kaeppel
