Incoming for 2016

Stock markets across the globe are bombing on the opening day of 2016. But there is still a good way to generate income. A flat stock market in 2015 and with stocks falling out of bed on the opening day of 2016 investors will once again be looking for a place to generate yield.

Barron’s even placed it on the cover the hunt for income on the cover of their 2016 preview issue. But rather than the hodge podge of junk bonds, MLPs or REITs I suggest looking at some basic options strategies that can deliver some of the best risk adjusted returns. Since the Zero Rate Interest Policy (ZIRP) began in 2010 the hunt for yield has been a driving force of investor decision making. It has forced many to accept lower returns or take on increased risk; and in some cases assume a bad combination of the two.

The S&P 500 eked out a modest 1.8% gain when dividends are included. In bonds you would earned next to nothing holding anything with less than a 5-year duration. If you went out in time to the 10 year you earned a whopping 2.25% in yield and nothing in capital appreciation. If you took on the risk of high yield the measly 5.5% average yield was most likely than wiped out by a 7.2% decline in principal.

Options for Income

One area that produced outsized returns especially relative to risk was selling option premium on equities. The Chicago Board of Options Exchange (CBOE) has host on indices that employ a variety of strategies for writing options based on the S&P 500 Index all of which outperformed the underlying benchmark.

What was unusual, though makes perfect sense given the flat market, was that the iron condor strategy was far and away the best performer delivering a 9.2% return for 2015.

CBOE Income index performance 12.30.15

Remember, an iron condor is a neutral strategy that consists of selling both an out-of-the money put spread and out of the money call spread both for credits. The position profits if the underlying remains within a range and both spreads to expire worthless allowing the writer to collect the premium.

This strategy worked to perfection as the S&P remained in an historically narrow range through nearly the first 8 months of the year. The box in the chart below shows it held within a 3.35% range from mid-January until August.

SPY chart 1.03.16

The strategy avoided large or prolonged drawdowns as the double dips in late August and October were both were very brief and quickly bounced back and resumed, albeit a bit wider and lower, range for the remainder of the year.

The other item helping option selling strategies is the somewhat elevated level of implied volatility which created relatively rich premiums. Even during that long stretch of a very narrow range the VIX traded with a persistent premium as investors continually braced for a rate hike, a sell-off, some impeding geo-political event or just fear of the unknown.

When we look at the current term structure of the VIX futures we see it is still a steep cantango, that is the later dated futures have a big premium not only over the cash index but to the front month. Currently February futures trade some 3.29% above January, which itself is 2.8% above the 18.1% level which itself is above the 14.2% average for 2015.

VIX Term Structure 1.04.16

What that string of numbers means is that investors are bracing for the new year and what first quarter earnings reports and have already priced in some big market swings. But what the green line in the chart above also shows is how quickly the VIX will revert to the mean; once the concerns of the 12/18 gap lower dissipated the premiums quickly came out of curve.

Flying Condor

My expectations are that the market will hold within a range during the first two weeks of the year as investors await first quarter earnings and the FOMC meeting scheduled for January 26. Given the above I think options are fully priced and offer a good way to generate some short term income.

Using options, the regular monthly options that expire January 15 we can set up a short term iron condor with very attractive risk profile. The position is comprised of selling both a put and call spread for a credit. Specifically:

-Buy January $193 Put

-Sell January $196 Put

And

-Sell January $205 Call

-Buy January $208 Call

For a total $120 Net Credit for the Iron Condor

The position would deliver a $120 profit if shares of SPY are between $196 and $205, a 4.4% range, at the 1/15 expiration. That translates into a 66% return on risk (the margin requirement and maximum loss is $180 per contract) over just the two-week period.

That is incredible attractive for a market neutral strategy with a relatively wide profit zone. The full risk graph and probabilities are shown below.

SPY Iron Condor 1.04.2016

This is a good way to start the year by generating solid income during the first two weeks while everyone else hunts around for where to place their bet on their bold predictions for 2016. We can wait and get paid for doing so.

— Steve Smith

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About the Author: Steve Smith