For some time, we have tracked, for each month's portfolio, the same duration and out-of-the-money S&P calls and puts, as well as either actual or theoretically-managed put and call portfolios.
Typically, in a healthy equity market, either the puts are positive and the calls are negative, or vice versa. This has been the case for most of the period during which we have invested in options, rather than the underlying equities.
Because of this sign difference, and the tendency of the positive side, in volatile market conditions, to outperform the negative one, a straddled option portfolio produces returns which a simple equity portfolio strategy cannot. The latter has to be net long or short to have any potential to earn a non-zero return.
However, to our surprise and disappointment, there seems to be a market condition in which both calls and puts sink in value. And the accompanying chart of our November 2008 portfolios demonstrates this.
Both the S&P calls and puts, and our option portfolios of calls and puts, are negative.
What, we asked ourselves, could cause this condition? It seems theoretically impossible that investors would value both calls and puts negatively at the same time for the same equities.
The calls are negative, we reason, because macroeconomic and business conditions are so dismal- now, and looking forward for the duration of the options.
Why, then, are the puts also negative?
Here we believe we see the cost of heavy-handed, unpredictable government intervention.
Back in late March, we saw rising puts suddenly fall after the Bear Stearns rescue. It became clear to investors that the Fed and Treasury would not let money be made by betting on a falling market. The resulting two month period of April and May were good for calls. Then sentiment overwhelmed government intervention, and puts took off once more, as volatility increased to unhealthy levels.
The current mix of badly-designed, pork-laden government programs, including TARP-2, renamed, the spending in the "stimulus" bill, TALF, the looming auto sector bailout, and suspected industry-changing provisions of the stimulus bill, all seem to be leaving investors unsure of where falling business fortunes might be unexpectedly propped up, irrationally, by some government program or cash injection.
With uncertainty regarding governmental actions so high, we reason investors are wary of what would otherwise be reasonable bets on the imminent fall in value of many equities.
Thus, we see a rare event- both puts and calls of the same equities posting a temporary negative return. Since this is an inherently unstable position, we expect that puts will rise in value in the next few months. It seems unlikely that government's unpredictable meddling can last for very long before bringing bad consequences, e.g., inflation, rising interest rates, continuing poor economic results from delayed, not eliminated recessionary forces.
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