The Striking Price

The Case for Shorter Expirations

Creating listed expirations of less than a week would help investors more closely calibrate thoughts with market events.

By Steven M. Sears

Saturday, August 1, 2015

For as long as most investors can recall, hedging stocks has been a good way to hand money to derivatives dealers.

The Standard & Poor’s 500 index has advanced like the Marines since March 2009, overcoming obstacles and investor fears. Buying calls and selling puts was the better trade. Meanwhile, stocks haven’t really stopped advancing.

Now, China is inviting comparisons with the U.S. in 1929. Europe is bickering over economics. And it’s fashionable to note that a smattering of stocks is driving the S&P 500’s advance. A reader even asked for advice hedging a $1 million stock portfolio.

The question was posed to Belmont Capital’s Stephen Solaka, a former options dealer now managing money. With the SPDR S&P 500 Trust (ticker: SPY) around 211, he recommended buying 48 SPY August 207 puts and selling 48 SPY August 202 puts. To eliminate the cost, investors could also sell the SPY August 214 call. This put-spread collar protects stocks against a decline, and still leaves room for a rally. If stocks surge, hedgers must cover the short call or sell stocks.

The construct highlights a fundamental issue always facing investors—defining and managing risk. This creates an opportunity for exchanges and dealers to update the options toolbox with a new product.

LAST WEEK, CBOE Holdings (CBOE) introduced Volatility Index futures with weekly expirations. CBOE says the new contract offers investors a more precise, responsive method for trading VIX. It’s an important point, and one that should be broadly available to investors. Creating listed expirations of less than a week would accomplish that goal.

The shortest expiration now available is a week. By further bending expirations, and thus implied volatility, investors could more closely calibrate thoughts with market events. This would lower trade costs and amplify profits or losses.

Sub-weekly expiration might even mitigate industry challenges. The growth of options-trading volumes is sclerotic. Exchanges need to show investors they aren’t stodgy utilities. Sub-weekly expirations would probably trade actively. These days, weekly expirations are about all anyone trades.

Dealers could use the new expiration cycle to urge exchanges to address a major issue: quote traffic. Dealers quote thousands of options. Ultrafast-computer trading firms routinely target dealers. Massive options-quote matrices are tough to update, and predators pick off dealers updating quotes. Exchanges could ease this by changing dealer quote obligations for deep in-the-money options that rarely trade. Those options could exist in special quote facilities so dealers could focus on trading active contracts. In return, exchanges get a shot at products that might boost volumes.

Individual investors are almost always an afterthought. But they deserve some of the same customization that exists in the over-the-counter market that banks operate for top customers. Those investors also get special treatment in the listed market from “show desks” that dealers operate for banks and interdealer brokers.

In time, a trade mechanism or order type should exist, so Paul from Peoria can trade Facebook ’s (FB) calls two strikes above market that expire in two days.

To keep the market from devolving into a gambler’s gallery, sub-weekly expiration cycles could be limited to the 50 most-active options classes. This would cover major exchange-traded funds and top stocks that dominate trading volume. Dealers could easily hedge the risk, and investors would have more choices. The quote-traffic problem might even get mitigated.

The issues here are nuanced and complex, but everyone knows they are looming over the industry. It’s time to address them. 

Reprinted by permission of Barron's Online, © 2015 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

The views expressed in the above papers and articles are solely those of the author of the article, and do not necessarily reflect the views of OIC; the information presented is not intended to constitute investment advice or recommendations to purchase or sell securities of any company; and the information presented is based upon particular events that may or may not recur in the future.

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