The Simon Trade

"I'm here for one reason and one reason only. I'm here to guess what the music might do in a week, a month, a year from now. That's it. Nothing more. And standing here tonight, I'm afraid that I don't...here...a think. Just...silence."
--John Tuld (Margin Call)

Nose bleed stock prices and uber low vols found me revisiting the Minyanville classic about Simon. John Succo tells the tale of a trading desk friend who bought cheap out-of-the-money S&P index puts in the summer of 1987 and rode them down the subsequent October crash.

What makes the story so interesting is not just that Simon got the timing right on trading a market meltdown, but that he was able to express his trade in a vehicle that was extraordinarily priced.

Option selling had been in vogue for years. Market makers had been making a killing selling puts in a rising market, collecting the premium, then watching the puts go to zero. The popularity of 'portfolio insurance' added to The Street's 'short vol' position.

Somewhat like today's situation where investors are overreaching for yield in an era of interest rate repression, put sellers in 1987 were willing to sell puts at very low prices because they figured that the premium, however low, was like free money. Not only was this creating a dangerous macro environment due to the increased leveraged wrought from massive put selling, but it was suppressing put premiums to extraordinary lows.

John notes that Simon was able to buy six month 10% out-of-the-money puts for less than 0.05% of the index. This enabled Simon to control more than 20 times the underlying stock compared to today, where similar puts typically cost ~1% of the index price.

Stated differently, Simon was able to secure far more leverage per trading dollar than a trader could purchase in today's environment.

As markets weakened and his puts grabbed delta, Simon's P/L exploded higher. When Simon closed his project on the day of the crash, the result was...early retirement. By my calcs, Simon's $12,500 investment (2000 puts @ $.0625) grew to $11.8 million (2000 puts @ $59).

So, with current volatility indexes tickling record lows, does this mean that a bearish market participant can leg into a trade similar to Simon's?

Nope.

Although low implied vols mean that many at-the-money options are cheaper than usual, there is still demand for out-of-the-money puts. Currently, a 10% out-of-the-money put on the SPY costs about 1.1%, and there is chunky open interest at strikes down option chain. The condition where volatilities implied by prices paid for out-of-the-money options are high compared to implied volatilities for at-the-money options is sometimes referred to as 'skew.'

In short, despite the decline in implied volatility in general, prices of out-of-the-money puts have not come down much. Skew is high.

This does not mean that buying index puts to express a bearish view is necessarily a bad idea. A six month 10% out-of-the-money SPY put currently costs about $2. If the SPX drops 20% between now and December expiry then that option will be worth $20+.

A ten bagger would surely be a great trade. However, it requires a large decline in the SPX over the next six months. The probabilities of such an event, coupled with relatively high prices for the speculative instrument, do not match the risk:reward profile of The Simon Trade.

position in SPX