Current Equity Derivative Market Conditions: Moving Away From Puts

As part of our derivatives portfolio investment risk management, my partner and I keep a close watch on current conditions. We check our proprietary equity-related volatility measure on a daily basis, as well as frequently observe a market return-related measure, to assess whether we should be in calls or puts.

In this post on July 1st, I noted that our equity allocation signal had gone to a 'short' position. Just a few days prior to that, I wrote here that,

"Back in April, I thought we had a good 4-5 months of call options portfolios before we had to worry about weakening markets. Instead, in only six weeks, we're somewhere between neutral and short in our evolving outlook for equity allocations in the next month."

We bought puts in July and August. Marking the absolute point of inflection somewhere in mid- to late-June, when we sold our April, May and June calls, the period for puts has lasted roughly 10 weeks.

Based upon recently falling values in our proprietary volatility measure, and a slowly, stubbornly-rising S&P return for August, we now anticipate liquidating our put positions within the next week.

It would appear that investor sentiment has changed markedly from the mid-summer skittishness. As my partner and I reviewed the recent developments in financial and commodity markets, as well as the economy, it would appear that several sources of investor aggravation this summer have abated. Commodity prices- including energy- have fallen, Freddie and Fannie are presumed to be the object of a takeover by Treasury, and economic performance continues to be lackluster, but not a severe recession.

Thus, the volatility typical of downward-moving equity prices and capitulation has seemingly ended.

Thus, we expect our September's options portfolio to be either a straddle of puts and calls, or just calls.

As we have observed the performance of our put portfolios for July and August, as well as a synthetic June put portfolio, we have noted that puts seem to lack the concentrated energy and consistent advances of call portfolios. Additionally, the time periods over which puts remain the preferred side for investment are, on average, far shorter than those for calls.

Mirroring the infrequency of periods of short equity portfolio allocations, put portfolios don't occur as frequently as call portfolios, either.

Together, these characteristics make the periods during which we invest in puts more risky in general. We condition our expectations to be for shorter timeframes in the puts, and, after observing the performance of the June and July put portfolios, much lower returns, as well.

We still believe that put portfolios can provide positive returns during periods of serious equity market downturns. However, we are learning more about how much shorter are the effective durations of those portfolios, and how much less, on average, their positive returns can be.