What a difference an expiration cycle makes!

The close of the June expiration cycle, back on the 17th, marked the low set in 2022. The SPDR S&P 500 ETF (SPY) hit an intraday low of 362.17 before rallying to close the June expiration cycle at 365.86.

Who knew that was just the beginning of what would become a historic short-term rally? Since then, the market has rallied an astounding 16.7%.

Cabot Options Institute – Fundamentals Issue: August 15, 2022

What a difference an expiration cycle makes!

The close of the June expiration cycle, back on the 17^th, marked the low set in 2022. The SPDR S&P 500 ETF (SPY) hit an intraday low of 362.17 before rallying to close the June expiration cycle at 365.86.

Who knew that was just the beginning of what would become a historic short-term rally? Since then, the market has rallied an astounding 16.7%.

For the year the S&P 500 (SPY) is down 10.2%, while the tech-heavy Nasdaq 100 (QQQ) and small-cap Russell 2000 (IWM) indexes are lower by 16.6% and 11.7%, respectively.

Volatility has pushed back significantly over the past two expiration cycles, but the CBOE Volatility Index (VIX) continues to hover above 20, which marks a historically elevated level. And nothing has really changed. Yes, the bulls have managed to rally the market and in turn, push levels of volatility lower, but until fears subside on a potential recession, rising inflation and ongoing geopolitical turmoil, I expect to see volatility remain at heightened levels.

Last week, the market was in a particularly forgiving mood when both CPI (consumer price index) and PPI (producer price index) inflation data for the month of July moved slightly lower. But remember, the July inflation data came after a surprising leap to the upside the prior month and there is no hiding that inflation remains at historically elevated levels. So while we did see a temporary peak in inflation data, there is nothing that should deter the Federal Reserve from continuing rate hikes.

I still expect to see bouts of volatility going forward, potentially leading the market lower. I would like to say that most of the weakness is behind us, but unfortunately, I don’t have a crystal ball. Although, I will say that barring any real setbacks in inflation data, or ongoing geopolitical concerns, I expect the market to hold the 2022 lows and potentially rally from here, particularly if inflation data subsides.

But as I stated in my last issue, during times of market extremes, I’ve learned to take a more cautious approach. Trading is about patience. It’s certainly not about the number of trades you place during a given timeframe. It’s about the quality of trades and understanding there is an ebb and flow to trading frequency. We still have a lot of trades to place as we begin to build out each one of our Fundamentals portfolios.

My intent is to slowly start building out our active portfolios while, of course, continuing to manage our passive portfolios. With August expiration coming this Friday, we now have a few positions in our active portfolios and our passive portfolios that are humming along.

Since we initiated our passive portfolios, when the S&P was trading for roughly 412.40, only 3.5% lower than the index trading now, we’ve seen an incredibly volatile market. And both our passive portfolios endured the volatility with flying colors. Now our All-Weather Portfolio stands 13.7%. higher, while our Yale Endowment Portfolio has returned an incredible 23.6%.

As always, if you have any questions, please do not hesitate to email me at andy@cabotwealth.com.

Current Positions

Click here to access the “Portfolios” section to view each portfolio’s respective positions.

Options Education

Today we are going to start our journey into learning the basics of the Greeks.

First of all, don’t be frightened.

The options Greeks should not scare you away. Quite the opposite. For those serious about trading options, the Greeks will give you far greater insights into your position, portfolio, etc., while allowing you to manage risk on the fly.

I’m not going to cover everything today. I plan on taking a more methodical approach. I only want to do a quick summary today and will follow up with a more detailed discussion on each Greek over the next few issues.

Delta

Of the four predominant Greeks used in options trading, delta is probably the most important Greek as it can be used in a variety of different ways.

The first way that I use delta is by thinking about probabilities.

For instance, if you buy a stock, the probability of a stock moving higher is 50% (actually 1% to 2% higher if you include the risk-free rate). In the world of options, this type of situation would be equivalent to buying an at-the-money call or put option.

The S&P 500 (SPY) is currently trading for roughly 427. As a result, the at-the-money strike is 427 and, as seen below, the associated delta of the 469 call is just over 50% at 0.51. The probability of success is 51.29%. What does that tell us? It tells us that there is a 51.29% chance that SPY will close above the 427 call strike at expiration in 32 days. Essentially a coin flip.

So, the first way delta is used by options traders is to find out what the probabilities are on the trade. Since we are typically selling options, we want to use a delta that is typically lower than 0.50. For example, if I sell an option with a delta of 0.20, my probability of success on the trade will be roughly 80%.

You can see an example of this below. By choosing the 445 call strike our delta is 0.20, which means our probability of success is 81.47%. So again, the delta essentially tells us what the probability of success is on the trade at expiration. By knowing this we can alter our strike to bring in more/less premium and simultaneously decrease/increase our probability of success on our prospective trade.

But that’s not all delta tells us.

Delta also represents the change in price of an option contract for a $1 move in the underlying asset. For example, if you have a SPY option worth $1 with a delta of 0.60 and the underlying ETF moves $1 higher, all things being equal, the options contract now has a value of $1.60.

If we look at the same image above, the 445 call strike with a delta of 0.20 is worth roughly $2.19. If SPY were to move $1 higher, all things being equal, the 445 call contract would now be worth roughly $2.39.

Essentially, delta provides insight into how options premium will respond as your underlying stock of choice moves up or down. Knowing this information gives you a good idea of how much money you stand to make, or lose, based on a specific move in the underlying stock.

But the real beauty of delta is that it tells you exactly, in real time, what the market anticipates for a specific price being reached at expiration. No technical or fundamental data required, just hard statistics which is always a quantitative trader’s preference. The market sets the probabilities based on a variety of factors. Just know that the foundations of these probabilities are based on how real money is being traded, not conjecture.

No speculating on geopolitical concerns, inflation rates or upcoming Fed speak. Everything is already priced into the option, based on supply/demand in real time.

As I said before, I will be delving even deeper into delta over the coming weeks. Until then you should have a good base knowledge on why delta should be the anchor of all of your options trading, especially when using options selling strategies like poor man’s covered calls.

Portfolio Discussion

All-Weather Portfolio
The All-Weather portfolio is up 13.7% since it was initiated back on June 3. The overall market is up 3.5% over the same time.

As has been the case from the beginning, the commodities portion of the portfolio has been the laggard that has held back the portfolio, with DBC and GLD both seeing declines. However, the losses in DBC and GLD have been met with positive gains in our bond positions (TLT, IEF) and our total market exposure in VTI.

I’m incredibly pleased with the performance of the overall portfolio so far as it’s outperforming its benchmark index by almost 4x.

As I said before, the historic volatility that has impacted the overall market hasn’t put a dent in our All-Weather portfolio. And that should give us all great confidence about how this portfolio will perform in good times and bad going forward.

We’ve managed to roll all of our August positions into September and October expiration cycles, so now we only have to concern ourselves with managing our deltas just in case an underlying position pushes through its short call strike or happens to decline.

Yale Endowment Portfolio
The Yale Endowment portfolio is up 23.6% since it was initiated back on June 22. The S&P 500 is up 12.9% over the same time frame.

Like the more conservative All-Weather portfolio, I continue to be pleased with the performance of our Yale Endowment portfolio. We managed our deltas appropriately, which has led to some tremendous gains. And remember, this is during one of the most volatile periods we’ve seen in the market.

Dogs (and Small Dogs) of the Dow
No positions at the moment. I will be adding at the onset of 2023.

Warren Buffett’s Patient Investor Portfolio
Last week we finally began to build out our Patient Investor portfolio by adding market stalwart, Apple (AAPL) to the mix. We paid $54.20 for our LEAPS contract, which certainly beats paying over $17k if we were to purchase 100 shares of the stock.

I will be building out the portfolio to a minimum of five positions over the coming two expiration cycles and remember, because this is an active portfolio, we will be rebalancing every month around expiration.

James O’Shaughnessy’s Growth/Value Portfolio
Last week we initiated our first position, with plans on at least four to seven more trades coming over the next two expiration cycles.

Our first trade was in Chevron (CVX), as my screen led me to a few energy stocks. I expect that I will be adding at least one more position this week, of course, if Mr. Market gives us the opportunity.

And like our Patient Investor portfolio, I will be rebalancing every month around expiration. This simply means that we could have a position for just one expiration or, at least in theory, in perpetuity.

Next Live Analyst Briefing with Q&A

Our next Live Analyst Briefing with Q&A is scheduled for tomorrow, August 16, 2022, at 12 p.m. ET, where we will be discussing the options market, giving a detailed look at open positions, strategies used, and will have a follow-up with live questions and answers. Register here.

The next Cabot Options Institute – Fundamentals issue will be published on September 12, 2022.

About the Analyst

Andy Crowder

Andy Crowder is a professional options trader, researcher and Chief Analyst of Crowder Options. Formerly with Oppenheimer & Co. in New York, Andy has leveraged his investment experience to develop his statistically based options trading strategy which applies probability theory to option valuations in order to execute risk-controlled trades. This proprietary strategy has been refined through two decades of research and real-world experience and has been featured in the Wall Street Journal, Seeking Alpha, and numerous other financial publications. Andy has helped thousands of option traders learn and implement his meticulous rules-driven options trading strategies through highly attended conferences, one-on-one coaching, webinars, and his work as a financial columnist. He currently resides in Bolton Valley, Vermont and when he’s not trading, teaching and writing about options, he enjoys spending time with his wife and two daughters, backcountry skiing, biking, running and enjoying all things outdoors.