Introduction
As the world keeps changing, the capital markets reflect this dynamic ebb and flow. In 2023, while the U.S. equity indexes have shown remarkable resilience, there’s an underlying truth that remains unshaken: “Buy protection when you can, not when you’re forced to.” As we step towards the close of 2023, it’s imperative to reevaluate your investment strategy, especially concerning index options.
The Cost of Protection: Understanding the Basics
In the world of options, the cost of protection is often overlooked when the markets are calm. The catch is that as soon as an adverse event strikes, the need for coverage increases non-linearly, leading to costly premiums. It’s a bit like a crowded room with few exits when panic sets in.
The reality is that it’s far more economical to buy options when implied volatility levels are relatively low, and there is little apparent concern in the market. Let’s explore how this applies to index options, specifically focusing on the Nasdaq-100® Index (NDX).
Implied Volatility (IV) on the NDX: A Historical Perspective
Looking at the past five years, the range for mid-term (six-month) and longer-term (one-year) NDX ATM (at-the-money) IV has fluctuated between ~33% and ~17%. This historical data is critical for understanding potential trends and planning our strategy for the rest of 2023.
Interestingly, the concept of protection goes beyond traditional markets. The recent headlines about UFOs and the underwriting of Alien Abduction insurance policies offer a playful yet profound analogy about protection and the unpredictability of markets.
Index Options Strategies: What to Consider
1. Buying Longer-Dated Index Protection
Currently, longer-dated index volatility expectations are at or near the low end of the range. Since longer-dated option values have a greater sensitivity to changes in implied volatility estimates, they change in value more dramatically than shorter-dated options. It could be a strategic move to buy this protection now, when it is relatively cheap.
Example:
The table below highlights how longer-dated NDX ATM options with various maturities show a more considerable percentage change in value. Utilizing this information can help investors to strategically choose when to buy protection.
2. Utilizing Index Collars
For investors concerned about the downside risk but wanting to maintain some upside potential, index collars can be an effective strategy. This involves buying out-of-the-money (OTM) put options while simultaneously writing an equal number of OTM call options.
Example:
Investors could consider setting up a collar on the NDX, offering protection if the index falls significantly while allowing for some upside if it continues to rise.
3. Implementing Vertical Spreads
Vertical spreads, consisting of buying and selling options of the same type but different strike prices, offer a way to reduce the cost of buying protection. It limits both the potential loss and gain but could provide a balanced approach for the uncertain rest of 2023.
Example:
A bear put spread on the NDX could be implemented by purchasing ATM puts and selling further OTM puts at a lower strike price. This strategy could provide protection if the NDX declines, without requiring a significant upfront premium.
Conclusion: Adapting to Change
The rest of 2023 presents a mix of opportunities and uncertainties, from global pandemics to interest rate volatility, and even unexpected events like the recent Fitch downgrade of U.S. debt. The proactive use of index options strategies could be the key to navigating this unpredictable landscape.
While we may laugh at the idea of Alien Abduction insurance, the lesson rings true for investors: we don’t know what we don’t know. Markets are forward-looking, dynamic, and ever-changing. Implementing a well-thought-out index options strategy can offer that much-needed protection, aligning with the timeless trading wisdom: “Buy protection when you can, not when you have to!”
As we approach the end of 2023, let’s take a proactive stance and use the available tools and strategies to insulate our portfolios from potential uncertainty. After all, in both life and capital markets, “every ending has a beginning.”
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