Predicting the S&P 500 – January 2012 Edition

Don’t Quit Your Day Job is a site which varies between many types of articles – Personal Finance, Politics, Investing, Economics, Random…  One of those categories, Investing, has been given short shrift in order to make way for more articles in the other categories.  Today we plant a stake; ‘Investing’ will now have a featured article monthly, where we’ll use options to try to determine the outlook for the S&P 500 in the near future.  Since this is the first such article, let’s discuss the method we will use to predict movement.

Options?  Intriguing.  How Does Your Method Work?

When you invest in a stock, you have to be right on one aspect: direction.  Sure, you want your stock to move in the direction you choose – either increasing in value if you went ‘long’ and bought shares, or decreasing in value if you went ‘short’ and sold shares.  You have some idea that you want the movement in the near future, and you’d prefer a big move in the proper direction (although you’d certainly be happy for any move).

Options investing brings two new aspects into the game.  Options investing, like stock investing, allows you to predict direction.  Options contracts also have a defined expiration – so they require you to pick a time-frame.  Finally, options contracts have a strike price – the value at which they are declared either in the money or out of the money on the day they expire.  In total, with options, you have to predict direction, magnitude, and time-frame.

To the Charts We Go!

I have selected numbers which imply roughly a 75% chance that the price on a certain date will be in my range.  That means that one quarter of the time we should see the S&P 500 outside of the predicted range on the expiration date, and three quarters of the time it should fall in the range we predict.  This method is based at actual trading values at a point in time (see ‘implied volatility‘, below).  That means I’ll get two curves – one for the implied prices of ‘calls’ (roughly the equivalent of going long) and one for the price of puts (roughly the equivalent of going short).  Let’s take a look (numbers retrieved over weekend – this method uses publicly traded options contracts so the curve continually moves) at numbers for options expiration in Febrary, April, and December.  One last note: this information is based on options for the ticker ‘SPY‘, an ETF that tracks the S&P 500, not the index itself.

Implied Volatility

Implied volatility in options prices is the volatility which is priced into an options contract based on an options model.  The method I am using is a live model, and uses the closing prices of the options contracts after Friday (options expiration Friday).  Basically, implied volatility is a forward looking measurement of how much an instrument will change in value over a period of time.

To the Charts!

First, the charts.  Remember, the model implies a 25% chance SPY (our S&P 500 proxy, multiply by 10 for a S&P 500 guide) will close outside the range listed.  This first chart is calculated using puts.

The second chart is calculated using calls, and gives predicted closing prices on the same dates.

Want to See the Numbers?

You can see that as you go further out, the ‘spread’ for 75% of the price range widens.  This makes sense because it should be harder to predict a price for dates further out than immediate.  As for our model itself?  We’ll have to start logging results before we know if it’s worthy!  Here are the numbers:

02/17/12 04/20/12 12/21/12
Put High 132.5 167.76 145
Put Med 131 131.77 131
Put Low 124.74 117.91 105
02/17/12 04/20/12 12/21/12
Call High 134 137.21 144
Call Med 131 132.11 130
Call Low 127.5 128.82 119.39

 

What do you think of the pricing model? Do you expect the S&P 500 to track the same path – likely rising the next few months, but staying flat through December? How are you managing your own investments?

Comments

  1. says

    Haha, I know how badly you’ve wanted to publish this one!

    I agree more so with the call implied pricing.  Discounting for the TVM, I think the S&P has seen the best it’ll see so far.  Political rhetoric will keep the market calm through the summer before divided government (Obama win?!) brings a rally in the fall.  

    • says

      Public shame if it fails and public triumph if it doesn’t? I’m pretty pumped to test the model.

      And yes, you caught me. I was holding my breath for Friday so options would expire!

  2. says

    It also doesn’t surprise me that the upside on the call chart appears to be slightly higher long term than the downside line. To me, this says that the best case scenario buyers are willing to bet on is an average year (slightly higher) The main thing this seems to show me is a reluctance to bet more than a guess on direction, but of course I’d need to see some volume numbers to verify that….there’s your next article idea, free of charge!

    • says

      Sorry about getting caught in spam, now to see if Disqus honors the whitelist in the future!

      I didn’t know how to play the volume – I talked to JT about it for a bit, and we figured to make it significant the tool should only care when volume is above some % of the total put/call daily volume. For the calculation I did yesterday, I used 0.2% of daily volume and 0.015% of daily open interest to determine if there was interest. Of course, I also lost the numbers I used – I’ll try to fix it for the February edition (sorry!).

      It does seem that if you used my model you could make money by arbitraging and assuming put-call parity, but I think that transaction prices (and dividends and interest rates) might be the cause for the fluctuations. I’d actually like to believe that I figured out something that legions of Math PhDs could not – then I’d get to name this effect!

      • says

        I think you’d make more money going long T-Bills.  (Wink-wink, the market for options on SPY is pretty darn efficient.)

  3. says

    I think you need to do a Podcast on this PK!  You know, with lots of sound effects and charts of course.  As far as the S&P, I think it has run it’s course and will be flat the rest of the year.  The EU debt crisis could effect that negatively though.

    • says

      You think people want to listen to my boring baritone? I kid; I’m more expressive than, say, a Ben Stein. But this face deserves better than ‘Radio!’.

      I think the market agrees with you, for what it’s worth. If the chart is to believe, it’s all about capturing the dividends this year…

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