High yield debt is potentially attractive here as the yields have increased due the recent price declines (for example JNK has a yield of 7.8% 1 ). We would like to replicate the yield of junk bond debt with short ETF options instead of long ETF.
However we should consider the downside risks in case this current sell off continues (we need to protect capital in this situation as yield will not save us). We have been patient waiting for this sell option trade to come in over the summer and there is in the potential to tiptoe into the water as the market has sold off some.
Trade Risk / Reward
The following compares a long etf trade versus a short put option trade:
Standard Long ETF trade
Long 100 JNK = 38.25 * 100 = $3825. Expected dividend payment between now and year end would Sept, Oct, Nov, Dec = 0.25 * 4 = 1.00. This gives an implied breakeven price of 37.25 (assumming the dividends hold up).
Downside protection = 1.0 dividend stream divided by stock price 38.25 = 2.6%
Short ETF option trade
Sell 1 put contract – JNK Put Dec 2011 strike 36 for 1.00.
Downside protection = 1.0 put price minus the strike price of 36 is 35. The difference between 38.25 stock price and the 35 breakeven point is 3.25, so 3.25 divided by 38.25 gives 8.4% to breakeven.
Scenarios by 17th Dec 2011 (option expiration)
Stock Price ETF Option
40 1.75 + 1.00 = 2.75 1.00
39 0.75 + 1.00 = 1.75 1.00
38 -0.25 + 1.00 = 0.75 1.00
37 -1.25 + 1.00 = 0.25 1.00
36 -2.25 + 1.00 = -1.25 1.00
35 -3.25 + 1.00 = -2.25 0
30 -8.25 + 100 = -7.25 -5.00
Please note the trade idea is to replicate the yield of the ETF with lower risk. If the ETF zooms higher you will lose out on the capital appreciation – if this will annoy you, then long etf is the better trade.
In our opinion, these are 3 reasons that make selling JNK ETF options attractive:
Implied volatility “high” and trending lower (vega)
The implied volatility in the last month spiked higher(approx range 27% to 17%), but is now trending down. The bet is that the implied volatility will continue lower even if the etf price trends lower as well, therefore potentially making money by the volatility collapse. This makes this option trade more attractive now as opposed to over the summer when the implied volatility was at “normal” 10% levels. Volatility when the sold put option is placed is very important – selling an option in very low volatility environment can reduce the chance of trade success.
Selling the future dividend stream now
One additional advantage with selling puts on income producing ETF’s is that part of the implied future dividend payments (between now and December) are included in the put premium. All things being equal when each dividend payment is paid the value of an out of the money put option should decrease by proportion of the dividend payment. Note: this is proportional to how far out of the money the put option is – for example “at the money” put option price may decrease in price closer to the actual dividend amount (e.g. if dividend payment was 0.25, put option may lose 0.20). This effect is less pronounced if the put option is further out of the money (e.g. may only lose 0.10), but is a factor. The numbers used here are illustrative not mathematically based.
Time decay (theta)
This is less relevant in the first 3 months of this trade, but will accelerate from November into December. In our opinion you are better served by selling JNK options above 1.00 price so that the premium can erode with time. Our logic is that way “out of the money” JNK put options tend to have very wide bid/ask spreads and still may require an ask of 0.2 to buy back to exit (even if its effectively a “junk” option). If you want to buy the option back to close the trade its easier to make a profit if sold above 1.0. Completely subjectively the decay from 1.00 to 0.5 seems to happen faster than from 0.5 to 0.2. We also feel that waiting around for a couple of months for a trade to go from 0.5 to 0.2 exposes you to downside market risk relative to the final benefit (picking up pennies in front of a steam roller). This a totally subjective trading rule that works for us.
Trade execution suggestion
JNK is a liquid ETF and has some liquidity in the options – some days “at the money” options for the next few months have less than 10 contracts trade, but for example today (2nd Sept 2011) someone put through a few thousand contracts on Dec 2011 puts at strike 36 – so its hard to generalise. The options market here isnt “liquid” but it could be considered managable with limit orders. Would always recommend the use of limit options to achieve required prices (not market orders). Recommend to enter orders above the midpoint then reduce if not filled (e.g. quoted bid/ask 0.9/1.10 enter at 1.05 (or maybe even 1.1 if you’re feeling lucky)). These are “typically” slow moving ETFs on a intra day trading basis so the trade isnt likely to zoom away from you during the trading day – as such if you hang an optimistic sell put limit order out there for the trading day you may get a good fill during a dip. Our perception is that “typically” ETF movement gaps on the open based on overnight sentiment.
1 JNK has a yield of 7.8% – this was calculated manually as last dividend payment 0.25 multiplied by 12 months divided by stock of 38.25 as of 09/02/2011 at 11.30am. Typically yields will be calculated manually (not just copied from finance websites which sometimes include one off dividends or are just inaccurate).