Didn't see the downgrade coming!
In case you missed it, Fitch downgraded the sovereign rating of the United States, from an AAA rating down to AA+. The last time this happened was 2011 when S&P also downgraded it to AA+. If you want to see the ratings and dates here’s a link.
Who is this Fitch anyway? Fitch is one of the top four international credit rating agencies. The others are Moody’s, Standard & Poor’s, and DBRS Morningstar. Why did they do it? They cited risks like governance (e.g., the debt ceiling standoffs), as well as rising interest payments and deficits. They do have a point; here’s the forecast of the US Govt debt:
The downgrade seemed to catch everyone by surprise, mainly because there was no new information, and in July last year, Fitch had affirmed the AAA credit rating, saying it was stable. But it happened, so we need to know the effect it will have on the market.
How did it affect the market?
First of all there was a nasty drop, then a little more, then another nasty drop. Have a look at the chart:
What was interesting was that 3 days before, DBRS Morningstar had reaffirmed the AAA status, and upgraded from negative watch to stable. Go figure! Here’s a list of the recent ratings:
What will happen now?
As usual, we will look at what happened before to get some clues. The last downgrade was in 2011, when S&P also downgraded to AA+. Here’s a list of the ratings 2011 – 2013:
And let’s look at the effect on the market. You can see that the market dropped on both the Moody’s and the S&P downgrade, but the effect was not long-lived. The market traded sideways for a while, before rising again to new heights. So if the past is anything to go by we are in for a period of volatility and consolidation before the bull market resumes. However, I must point out that we are basing this theory on a sample of 1 which is not good statistics – but in this case it is the best indicator we have.
SPYG (Smaller Accounts)
SPYG is showing a similar pattern to SPY.
QQQ (Nasdaq ETF)
As always, keeping an eye on QQQ is a good idea, even though it is not part of the ITM strategy. Like SPY and SPYG it has suffereed some nasty drops. It is testing previous resistance at 372, and it will be interesting to see if this holds as support.
ITMeter
Still bullish, but confidence shaken a bit! However, we are still a long way from a death cross and it is normal to have pullbacks in a bull trend. No action required for now.
Which Option?
I am getting a lot of emails telling me that it is hard to find an option within the 1% rule. I agree; it is difficult, options are very expensive right now. In the past it was easy to get a 60% leverage with an effective price less than 1% above the current price. Now, it is hard even though the VIX is telling us that it shouldn’t be.
There are two ways to reduce the price of an option:
- Use a closer expiry date; or
- Get a lower strike.
Neither of these are ideal, but we have to be realists here. The market decides, not us. So lets look at practicalities.
The current price of SPY is $446.81, and 1% above that is $451.28. A strike at 50% of that is $223.40 and at 60% it is $268.09. Here is the option chain for March 2024:
If we take the $220 strike then the bid/ask is $231.28/233.15. Buying at the midway point would give us an effective price of $452.22 which is only slightly above (1.2%) the effective price we are looking for, so this is a possible contender. Of course this only gives us double leverage – if we want to go to a 60% strike ($268.09) we will have to pay more. The $265 strike gives us an effective price 1.67% above, and the $270 is 1.72% above.
This now comes down to personal choice; the 50% strike ($220) strike is ‘safer’ but you have less leverage; the 60% strike ($270) gives you more leverage but is less ‘safe’. By ‘safe’ I mean how much you lose if the trade goes against you – and not all trades can be winning trades.
Omens
I am really not superstitious, but for a while it seemed that I couldn’t get away from bears wherever I looked. The place I stayed in in the Camargue (France) was a nice change. I took it as an encouraging sign!
And back to reality . .
Well, my summer in Europe is over. This was my last day, in Chateauneuf-Grasse, getting ready to fly out of Nice, Cote d’Azur.
Finally the weather turned nice – just as I was leaving! The coldest, cloudiest and wettest summer I have ever had in France. Rethinking next year.
But it’s not all bad. This was the beach near my house this morning. Reality can be pretty good too!
As I am writing this (before market open) the futures are up significantly, so lets hope the last few days are just a temporary aberation.
Heather
10 Responses
Hi Heather, I hope you are well! I just got done reading your book ITM Bill Market Strategy. Got it yesterday on Amazon and finished it just now! Great read and a strategy that I’ve been thinking about implementing for a while, as I’ve always done better with LEAPS than any other shorter term options. I just never thought about the DITM part like you proposed. I’ve been trading options for nearly 6 years now, mostly on individual stocks with mixed success, so this book was a refreshing take! I’m excited to try it out when the market picks a direction. Made some money with Puts on NVDA in the meantime! Anyways, my question – I want to make sure I understand “effective price” correctly. I was just looking at the options chain on SPY for the Sept 2023 expiration. Just picking a random strike at $345 with a premium on the Ask of $124.21. That would make the effective price $467.21 (I get that part). What I don’t understand is you mention keeping the effective price at or below 1% of SPY’s market price. In this case, the effective price of this option would be 4.9% above SPY’s current price, correct? If so, I searched up and down the options chain and I can’t find a single strike that would put me within 1% of the index’s market price. Maybe that’s just the nature of the market currently? If you could help set me straight or point out anything I’m missing, that would be greatly appreciated! Despite my experience trading and studying currently for my securities licenses here in the US, this effective price concept is something I’ve never come across. Thank you in advance, Aaron from Texas
Hi Aaron
you probably wouldn’t have seen the ‘effective price’ anywhere as it is just a measure that I thought up! It is simply what you would be buying the ETF / Stock for if you exercised your option – so the coast of the option plus the strike. I think it is an easier and more intuitive measure than messing around with the Greeks.
Your question is one that everyone seems to be asking this week – if you look at the reply to James in the comment above I think it will answer your question – if not please get back to me.
h
Hi Heather, I have been reading you’re in the money book, and I am very interested in the strategy. I have been trading credit spreads for a little while, and had a great year so far. Lately, I seem to have lost my touch and the ups and downs are a little more than my stomach can bear. my portfolio is at $250,000. My question to you is would you invest most of that in just one deep in the money trade, would you spread it out maybe once a month at $25,000 each, therefore, potentially trading up to 8 to 10 months worth of trades. again, thank you so much for the book, and look forward to hearing from you.
Hi Mike
Glad you have been having a good year, and shame you have hit one of those patches where things don’t go right. They really are stomach-churning.
Re spreading your trades out over several months: that is a kind of dollar-cost averaging and I don’t think that as an investing strategy it is a good idea. I think that it started out as a way for brokers to get their clients to invest more (new) money every month, and the justification came from there. We don’t know where the market is going to be in the future, we can only deal with what it is showing us at present, and I am of the opinion that if the signals are right then get into the market. You may want to sequester some of your money in straight SPY shares rather than DITM options if you want to reduce your risk, maybe a 50/50 split would work.
Whether now is a good tijme to get into the market or not – currently SPY is having a pullback so it may – MAY – be a good time. If this is only a little bear trap then it is a good time. If it is a trend reversal then its not – we just don’t know. But the 10SMA is well above the 200SMA so the ITM strategy says we should be in a bull trade right now.
Hope this helps.
h
Good morning Heather, As you mentioned in your recent blog there are two ways for us to achieve finding options closer to the 1% mark. Those being using closer dates or choosing lower strikes. Would you consider rolling down to achieve this? I currently have options expiring in September with a 240. There are certainly ones that meet our criteria in the 150ish strike range, but I feel I am missing something here. All the best, Rob
Hi Rob,
With a September expiry you should certainly be rolling shortly. In the March 2024 options chain, With a strike of 240 that and bid/ask of 212.47 / 214.01 then if you are filled at the midpoint you have an effective price of $453.24, which is 1.4% above the current price. In the current environment when options are expensive then I would say that this is near enough. However, if you think it better to be more ‘safe’ (i.e. you are limiting a possible loss) then looking at the $220 or $225 strike would be appropriate.
If you see the question / answer above that may help, and if you have further questions please get back to me.
h
Hi Heather
Despite having read all your books and newsletters I still find it impossible to wrap my head around your option choice procedure. So I settled on a simple percentage of underlying price and chose the nearest strike price for my option.
But it irks me that I just don’t understand what you’re on about with this 1% rule.
Any chance of revisiting this and doing a one page, third grade reading level, simple steps walk through? 🙂
eg. In the current newsletter I read your option selection piece, made the following notes and am none the wiser. 🙁 And I don’t see the bottom line advantage of why I should be worrying. And that worries me! Why? Because you have pit so much effort into this idea and it works… Big thank you!
– Finding an option within the 1% rule is difficult due to high current prices.
– Two ways to lower option price: use a closer expiry date or get a lower strike.
– Current SPY price: $446.81, 1% above that: $451.28.
– Option chain for March 2024:
– Strike at 50% ($223.40): bid/ask is $231.28/$233.15 with effective price of $452.22 (slightly above target).
– Strike at 60% ($268.09): higher cost but more leverage, e.g., $265 strike has effective price of 1.67% above; and $270 is at 1.72%.
– Choice between ‘safer’ but less leverage (50%, $220) and more leverage but riskier (60%, $270). Safety refers to potential loss if trade goes against you.
Thank you have a great vacation/stay
James
Hey James
It’s good to be reminded to be clearer – I often thing I am explaining too much, and people will get bored, but as I am having quite a few questions about option choice let’s do a step by step.
1. Current SPY price is $446.81
2. We want to buy a DITM option that will give us leverage but not have too much time value. In the book I suggested that 99% Intrinsic value and 1% time value was a good thing to aim for.
3. The deeper in the money your strike the smaller your time value, and the bigger your intrinsic value. If you go OTM then your option is ALL time value, with no intrinsic value at all.
4. The option expiry date also affects the time value; if it expires in a few days then it is going to have less time value than if it expires in a year. You pay more for an option with a lot of time to expiry.
5. ITM suggested 1 year to expiry; it is OK to go for less than that (say 6 – 9 months) but just be aware that you will have to roll more frequently.
How do we know time value?
6. By looking at what I call the effective price, which is what you would be buying SPY for if you exercised your option. So, if you bought, say, a $200 strike option for $250 and you exercised you would be paying an effective price of $450 for SPY (How? $200 + $250).
7. Now the question is: how much of that is time value? We can buy SPY on market for $446.81 but we have bought it at $450.00 so the difference is $3.19. That is your time value.
8. If we express this as a percentage of the current SPY price, then time value is 0.68% (How? 3.19 / 446.81)
Why 1%?
9. The lower the time value, the more intrinsic value you have and so the less risk you are carrying.
10. I settled on 1% as a good rule of thumb so that we weren’t carrying a lot of risk.
11. At the time of writing, it was easy to find options with relatively high strikes that had time value of less than 1%.
12. Today it is harder; options are comparatively more expensive and not just because SPY has increased in value.
Leverage
13. If we choose a SPY DITM option with a strike half of the current SPY price then our results will be double that of SPY shares. For example it SPY goes up 10% we will go up 20% because of the leverage.
14. If we choose a SPY DITM option with a higher strike then our leverage will be higher (but, of course) the time value will be higher)
How do we choose an option at double leverage?
15. We need to look for an option at 50% of the current SPY price.
16. If SPY is at $446.81 then half of that is $223.40, so we will look at strikes of $220 or $225.
17. If we look at the $220 strike then the bid / ask is $231.28 / $233.15. Assuming we get filled at the midpoint we would be paying $232.22 for our option.
18. This gives us an effective price of $452.22 (How The cost of the option ($232.22) + the strike ($220))
19. This is $5.41 (1.2%) above the current price, so this is our time value. It is slightly more than we would have liked but is close enough in this expensive environment.
How do we choose an option with higher leverage?
20. We could look for an option at, say, 60% of the current SPY price.
21. If SPY is at $446.81 then 60% of that is $268.09, so we will look at strikes of $265 or $270.
22. If we look at the $265 strike then the bid / ask is $188.37 / $190.18. Assuming we get filled at the midpoint we would be paying $189.28 for our option.
23. This gives us an effective price of $454.28 (How The cost of the option ($189.28) + the strike ($265))
24. This is $7.47 (1.67%) above the current price, so this is our time value. It is slightly more than we would have liked but if you want to get higher leverage in the current environment these are the prices we have to pay.
I hope this answers your questions; I am so used to doing it in my head I keep forgetting that not everyone has been doing it as long as I have. But a good reminder. Next blog I will do section on option pricing and why they are more expensive.
Hi Heather,
Now that we are in a bull market, I’ve been learning the ins and outs of the DITM strategy in my account with decent success so far. I decided to re-read “In the Money: Bull Market Strategy” and “Timing the Market: Debunking the Myth…” since I last read them a over a year ago and I wasn’t ready to trade in a bear market. In the getting started section of “In the Money”, it mentioned using free cash to buy SPY shares until you have enough for a new DITM option. Based on the investment strategy in the “Time the Market..” book, I would buy shares of SPY when we exit a bear market and sell them when we enter a bear market. Do I have this correct?
Hi Jason,
The strategies outlined in Timing the Market and In The Money: Bull Market Strategy are different. The one described in Timing the market was using SPY shares (no leverage) and showing a simple method of getting in and out (i.e. ‘timing the market’) which increased your returns.
The ITM book describes a trading strategy using leverage – i.e. DITM options. I would suggest that you use the ITM signals to time your SPY share buys as well as options. If you are in a bull option trade then with any spare money you could buy SPY shares (or flutter a VERY little on a ATM / OTM option).
The Timing the Narket book was simply to debunk the myth of ‘time in the market’ being superior to ‘timing the market’ – not really as a strategy.
I hope this answers your question – if not please get back to me.
h