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Bullish Stock Buyers Bet on Big Windfall if Stocks Rise 11%

Bullish Stock Buyers Bet on Big Windfall if Stocks Rise 11%
(Dave Bredeson/Dreamstime)

Tuesday, 16 July 2019 02:33 PM

U.S. stock investors are homing in on a strategy that promises a gigantic windfall if stocks can extend their bull run through the second half of the year.

After Maxwell Grinacoff, a derivatives and quantitative strategist at Macro Risk Advisors, observed a $1.6-million wager in the options market last week that pays off if the S&P 500 Index climbs another 8% to 10% by year-end, he recommend an even more bullish position in a recent note.

It goes like this: buy calls on State Street’s S&P 500 tracker -- the SPY ETF -- that expire in December with a strike price of 330. Sell calls at the same expiry with the strike price of 335, capping upside but also cheapening the trade.

If the fund climbs a bit more than 11% to end the year at or above 335, the $0.37 premium spent would turn into $5 -- a return of 13.5 times, excluding transaction costs or commissions.

That means SPY would need to advance at least 34% in 2019 for the max payout to be achieved, a level that hasn’t been seen in more than two decades. But it so happens that the last time it occurred, 1995, was a year in which the Federal Reserve cut rates with stocks at all-time highs, a phenomenon rates traders are expecting to occur again later this month.

“We have observed bullish year-end structures trade in large size recently, perhaps as investors look to ‘hedge’ a continued market rally into year-end,” Grinacoff wrote.

This trade holds appeal to investors who want to lock in gains but still capture significant upside, or those with a fear of missing out even more after having been on the sidelines, Grinacoff reasons. And the flatness of call wing skew -- that is, similar implied volatilities for relatively far out-of-the-money options at different strike prices -- makes financing such a position cheaper than it often is.

“There is the potential for a catch-up trade which could be a tailwind for equities through year-end,” he writes.

Over the last 50 years, the S&P 500 has been up 10% over any given six-month timeframe more than a quarter of the time. In the almost 30 years since 1990, it’s been roughly a coin flip as to whether the S&P 500 gains 10% in the second half of the year. And yet the pricing of the call spread suggests that there’s only a 10% chance that SPY ends the year above 330.

If there’s cause for worry among investors, it’s a replay of a scenario in which everyone wants to own options on stocks, but few want to own actual equities.

The attractiveness of such call-spread trades -- and a penchant for stock-replacement strategies across Wall Street due to low implied index-level and single-stock volatility heading into earnings season -- is a similar set-up to when U.S. stocks peaked in September 2018.

Investors elected to gain exposure through calls in anticipation of a sharp rally (and because it was relatively inexpensive to do so), but then the underlying went no bid until after Christmas.

© Copyright 2019 Bloomberg News. All rights reserved.

   
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U.S. stock investors are homing in on a strategy that promises a gigantic windfall if stocks can extend their bull run through the second half of the year.
bullish, stock, buyers, windfall
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2019-33-16
Tuesday, 16 July 2019 02:33 PM
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