June 30th, 2008

Comparing ETFs vs. Puts on S&P 500 Decline to 1150

In the last post, I presented graphs comparing the price of various indexes and their corresponding PowerShares UltraShort ETFs. But another option for capitalizing on the market decline I believe we’re facing over the balance of the year is purchasing put options instead. The question you should be asking, therefore, is “If I have $10,000 to invest, why not puts rather than UltraShort ETFs?” Well, here’s the comparison:

Put Options

S&P 500

1278

1250

1225

1200

1175

1150

SPY

127.5

125

122.5

120

117.5

115

5 Mos

4,951

6,317

7,942

9,833

11,997

14,423

4 Mos

4,413

5,799

7,471

9,443

11,716

14,271

3 Mos

3,767

5,168

6,901

8,981

11,396

14,120

2 Mos

2,954

4,362

6,181

8,416

11,042

14,000

1 Mos

1,833

3,219

5,181

7,710

10,703

14,016

0 Mos

0

0

3,623

7,246

10,870

14,493

The above table assumes: the funds are invested in put options on the S&P 500 ETF, or SPY, with an expiration of December 31 and a strike price of 125, or slightly under Friday’s closing price of the SPY, or 127.5 (corresponding to the S&P 500 close of 1278). On Friday, approximately 1450 put options could be bought at the closing price of $6.90/option for a total investment of $10,000.

Using an option pricing website like Hoadley or Numa, the options projected value could be estimated at different points in future and for different projected levels of the SPY/S&P 500 Index. If the S&P does decline to 1150 by the end of September (3 months remaining till the options expiration), the total value of the put options would be $14,120. You’d have a loss on the Put options if the S&P 500 Index ends the year at anything more than about 1180 which represents the premium paid and needing to be recouped first.

And how does that compare with purchasing the UltraShorts ETF on the S&P 500 (SDS)?

UltrShort ETFs

1278

1250

1225

1200

1175

1150

127.5

125

122.5

120

117.5

115

5 Mos

9,993

10,579

11,026

11,324

11,771

12,740

4 Mos

9,993

10,579

11,026

11,324

11,771

12,740

3 Mos

9,993

10,579

11,026

11,324

11,771

12,740

2 Mos

9,993

10,579

11,026

11,324

11,771

12,740

1 Mos

9,993

10,579

11,026

11,324

11,771

12,740

0 Mos

9,993

10,579

11,026

11,324

11,771

12,740

If the Index does decline to 1150, regardless of when, the investment would be worth $12,740. As contrasted with the Put which generate a loss if the Index doesn’t decline to 1180, so long as the Index doesn’t increase while you own it, the ETF should produce a profit.

In sum, while the Put might generate a larger profit, there’s a much higher risk of a loss. Betting on the market to decline is risky strategy in and of itself since it’s declined 20% already from the October highs but investing with no chance of a profit unless it declines by another 5.5% (the premium of the Put contract) is more risk than I’m willing to bet.

Remember, this is a strategy aimed at generating some profits if the market declines. The safe route is to sit on cash just waiting this market turmoil to pass.

Subscribe below or click here to learn more about help for navigating turbulent markets.