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Oct 22

Strategies for the crashing market

category: FN3142 Quantitative Finance, Quantitative Finance no comments

Strategies for the crashing market

This year is a wonderful time to short the market. During the pandemic the Fed has been pumping money into the market, and it was clear that the huge rally from March 2020 to December 2021 was nothing but a bubble. It was also obvious that the rally would be reversed by the turn from Quantitative Easing to Quantitative Tightening. Since just about all assets are falling, shorting the market is a very low risk play. The question of timing the trades will not be discussed here (January, March, May and August have been the best entry points). We look into how options can be used for shorting.

Put debit spread

When the market crashes, shorting indices (S&P 500, NASDAQ, Dow 30 and Russell 2000) or their proxies (exchange traded funds SPY, QQQ, DIA and IWM) is less risky than shorting individual stocks. That's what I learned (among many other things) from John Carter. Using put options instead of shorting stocks requires less capital. A further reduction in the capital requirement is achieved by using put debit spreads (their effect on buying power is zero).

Denote p(K) the price of a put with a strike K. We know that p\left(K\right) increases with K (you have to pay more for the right to sell at a higher price). A put debit spread strategy has been discussed earlier. It consists of two put options (sorry for the notation change): buy a put p(K_{1}) with a higher strike K_{1} and sell a put p\left( K_{2}\right) with a lower strike K_{2}. The initial outlay is debit=p\left( K_{1}\right) -p\left( K_{2}\right) >0. Let S\left( T\right) be the stock price at expiration T. The max profit is K_{1}-K_{2}-debit and it is positive if K_{1}-debit>K_{2}. The max loss is -debit<0.

The payoff is illustrated in Figure 1.

Comparison of option strategies

Figure 1. Put debit spread on the left, call credit spread on the right

Call credit spread

A call credit spread is a strategy consisting of two call options: buy a call c(K_{1}) with a higher strike K_{1} and sell a call c\left(K_{2}\right) with a lower strike K_{2}. Since you have to pay more for the right to buy at a lower price, we have c\left( K_{2}\right) >c(K_{1}) and you are credited credit=c\left( K_{2}\right) -c\left( K_{1}\right) >0. For the payoff we have 3 cases.

1) Case S\left( T\right) \leq K_{2}. Both calls are out of the money and the max profit is credit.

2) Case K_{2}<S\left( T\right) \leq K_{1}. The c(K_{2}) call, being in the money, is exercised by the buyer and you lose K_{2}-S\left( T\right)<0. The c\left( K_{1}\right) is out of the money and expires worthless. Thus the payoff is credit+K_{2}-S\left( T\right) and the break-even stock price is S\left( T\right) =credit+K_{2}.

3) Case S\left( T\right) >K_{1}. Both calls, being in the money, are exercised. The profit from the long call c\left( K_{1}\right) is S\left( T\right) -K_{1} and the loss from the short call c(K_{2}) is K_{2}-S\left( T\right) , so the payoff is their sum plus the credit K_{2}-K_{1}+credit. Normally, it is a loss.

Comparison of the two strategies

The above discussion is summarized in Figure 1. Both strategies can be used if the outlook is bearish. Here we indicate two situations when one is preferred over the other.

Situation 1. Following unexpected bad news, the market falls a lot in one day and it is clear from macroeconomics that it will continue to go down for some time. If prior to the fall there was a healthy rally, it didn't make sense to buy a put. Right after the fall volatility increases, so puts  become expensive. Buying a put debit spread is appropriate because volatilities from the long and short legs of the spread offset each other and one can increase the potential gain by selecting the strikes K_{1},K_{2} further apart.

Situation 2. A different approach is appropriate if a strong one-day fall is expected and any further developments are hard to predict. In this case selling a call credit spread with close expiration is recommended. This allows the investor to take advantage of the time decay. The strikes are selected above the current price S: S<K_{2}<K_{1}. The time value decay for the short call c\left( K_{2}\right) will be greater than for the long call c\left(K_{1}\right) (because the latter has a higher probability of staying out of the money). Therefore the open profit will quickly approach the max profit credit and the spread can be closed out earlier. This allows the investor to capture most of the premium received from placing the trade.

Mathematical approach to evaluating strategies

This will be explained using call credit spreads

Step 1. The payoff from a long call, neglecting the price c\left( K\right) paid, is \max \left\{ S\left( T\right) -K,0\right\} (if S\left( T\right) \leq K, you throw away the call and get 0; if S\left( T\right) >K, you exercise the right to buy the stock and get S\left( T\right) -K).

Step 2. What the long party gains, the short party looses, so the payoff from the short position (this time neglecting the credit received) is -\max \left\{ S\left( T\right) -K,0\right\} =\min \left\{ 0,K-S\left( T\right)\right\} .

Step 3. Let K_{2}<K_{1}. The payoff from the call credit spread is the sum of the payoffs from the first two steps:

\max \left\{ S\left( T\right) -K_{1},0\right\} -\max \left\{ S\left( T\right) -K_2,0\right\}.

Evaluating this expression for different price intervals gives the next table:

0 if S\left( T\right) \leq K_{2}<K_{1}
K_{2}-S\left( T\right) if K_{2}<S\left( T\right) \leq K_{1}
K_{2}-K_{1} if K_{2}<K_{1}<S\left( T\right)

Step 4. Adding the premium received credit=c\left( K_{2}\right) -c\left(K_{1}\right) we get the total payoff

credit if S\left( T\right) \leq K_{2}<K_{1}
K_{2}-S\left( T\right) +credit if K_{2}<S\left( T\right) \leq K_{1}
K_{2}-K_{1}+credit if K_{2}<K_{1}<S\left( T\right)

Exercise. For a long put the payoff is \max \{K-S\left( T\right) ,0\}, for a short one -\max \{K-S\left( T\right) ,0\}, for the strategy with K_{2}<K_{1} it is \max \{K_{1}-S\left( T\right) ,0\} -\max \{K_{2}-S\left(T\right) ,0\}-debit, where debit is as above.

The pictures have been produced in Mathematica with K_{1}=390; K_{2}=380. I put them side by side for you to better see the difference. The risk-reward ratio is better for the put debit spread (the left chart) than for the call credit spread (the right chart). The latter should be closed earlier and it takes longer for the open profit/loss of the former to approach the max profit. Such strategies could have been used a couple of times on SPY since September 12, 2022.

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