6. Comparative Strategies

I have seen some incredible moves to the upside in the S&P 500 market. I received an interesting email message from a reader:

"I have been told by an advisor that buying S&P 500 Dec put options could be very profitable because of Y2K fears escalating. However, that contract expires in 6 weeks and I'm wondering if in that time the S&P 500 could really drop quite a bit. Plus I am confused as to what strike price to purchase. He recommends the 950 put but that's only $150 and very far away. Would it be wise to buy a more expensive put with a closer strike price since the Dec. contract expires fairly soon? Any help would be great."

My answer:

"Buying a Dec 950 put makes sense only for a trader who's extraordinarily bearish in the short term.

Here's what I mean:

The OptionVue5 software shows that if the Dec S&P 500 futures contract declines 300.00 points (from 1375.00 to 1075.00) in a month, the put will earn a profit of $1,750. And that's assuming implied volatility rises 10 percentage points (from 20% to 30%).

Of course, it's a very low cost speculation because it costs only $150 (60 points). So if the market crashes to 975.00 in a month and the crash is accompanied by a 15 percentage point increase in implied volatility, the Dec 950 put will earn a profit of $7,500. Not bad for a $150 "lottery ticket."

By contrast, consider buying the Dec 1100 put. It costs $600. If the Dec S&P 500 futures contract declines the same 300.00 points (from 1375.00 to 1075.00) in a month, and if implied volatility rises 10 percentage points, this put will earn a profit of $11,300. That's more than six times the $1,750 earned by the Dec 950 put.

And if the market crashes to 975.00 in a month and it's accompanied by a 15 percentage point increase in implied volatility, the Dec 1100 put will earn a profit of $30,600 (as compared to $11,300 for the Dec 950 put).

Does this mean it's better to purchase the Dec 1100 put? The point can be made that spending an equal dollar amount on the 950 puts (buying 4 of them) will earn more profits than buying 1-1100 put provided the market does indeed crash. Otherwise the single 1100 put will perform better.

The answer ultimately comes down to just how bearish you are and how much money you want to risk."

"Knowledge is power and all traders can benefit by continually bolstering their knowledge base. I hope to contribute in that regard."  Paul Forchione