What options position will yield the highest return if the market corrected by 20% by the end of October?

Question

If I had $100,000 to take on this position, how much profit can I expect?

Answer 1

The assumptions are: the market will drop by 20% from the current value by the end of October, and you would like to use options and $100k to capitalize on your view.

In this case, you would first determine your expected market value at your investment horizon. Say we are using the SP500 index tracking EFT (SPY) as the proxy for “the market”. SPY is currently trading at $147.57 on 2:27 pm July 26, 2007. A 20% downward correction from this price will leave the index at ($147.57)(0.8) = $118.056 at the end of October.

October 07 option expires on the 19th, and the December 07 options expire on the 27th, I’ll work with the December options to give the market the full month of October to realize the correction.

The following transactions will give you close to the maximum return achievable with options and $100k of capital.

1) Short call options that expires in Dec 07 – since you know that these option will expire out of the money, why not sell them now? I read that the Dec 07 SPY option with strike price at $119 is biding at $32.2, given margin limits of 50%, you can sell up to 100k/32.2/100 or 31 contracts for the immediate cash flow of $99.82k

2)Buy at-the-money Dec put options, currently selling for $5.20. Up to 50% of your proceeds from the short sell can be used to satisfy your long margin requirements (broker money rates apply). You can purchase ($100,000 + ($99,820/2)) / $5.2 / 100 = 288 contracts.

Assuming that the market does not adversely move against you(no margin calls), and that the above strategy is successful, not accounting for transaction costs and margin interest expense, you will end up with approximately 288(100)($147 – $118) + $99,820 or $935,020, for a gross return of 935% on the invested capital of $100K.

That being said, remember that risk is return, and return is risk. I have calculated the upper bound of possible gain; I did not calculate the upper bound of possible loss. An investment strategy that yields 935% return carries with it the corresponding level of risk, which is more likely to wipe you out than make you rich.

Answer 2

First let me say I believe the second answer is correct about the problem with the first answer.

In order to come up with a position that ou could say would definatively create the highest return, you would have to give more information such as the future implied volatility of the options.

Assuming that information is not available, I would say an out-of-the-money bearish put spread on the SPX index would likely give you the highest return. The advantage of using the SPX index over the SPY ETF is that favorable tax treatment the SPX index has as a Section 1256 contract.

I would probably go long with the October puts with a 1275 strike and short the October puts with a 1200 strike. (If the October expiration on the 19th, before the end of the month, is a problem for you, you would have to use the December expiration as previously noted.)

Using today's closing quotes, the 1275 puts would cost you no more than $840 per contract, and you would receive no less than $320 for each 1200 contract you sold. That would make the net cost of each pair no more than $520. If the index is 20% lower, each pair will be worth $7,500 at expiration. That would make your profit 1,342%. If you invested $100,000 and made a 1,342% profit you would make $1,342,000.

I hope you understand this would be a very high-risk gamble and you would be more likely to lose your entire investment than make any profit.

Answer 3

one minor problem with the above stratagy. Proceeds from the short sale cannot be used to satisfy your 50% long margin requirment. In fact, if you sell anything short, the broker will require a 50% deposit on the notional value of the underlying shorted security, unless they are covered calls. Therefore the above is waaaaaaaaay off.

Answer 4

Puts on index futures.