Question

For this question, assume that you expect the market to drop over the next month.  You have four possible strategies:

1. Short the SPY ETF
2. Short S&P500 futures contracts with May delivery
3. Sell Call Options on SPY, with May expiration
4. Buy Put Options on SPY, with May expiration

Critically evaluate both the return and risk of each of these strategies.  Be sure to justify all answers.

Answer 1

Shorting the SPY ETF is similar to a short postion in the cash market. There is no leverage, and hence the risk is also unleveraged. This means that for each 1% change in the index, the value of your position changes by 1%.

Shorting S&P500 futures contracts leverages the returns and risk because the entire value of the contract does not need do be put up in upfront cash. Only a portion of the contract value needs to be deposited as margin. Due to this, each 1% change in the index will result in a leveraged (more than 1%) change in the value of your position.

Selling Call Options on SPY exposes you to limited gains and potentially unlimited losses. The return is limited to the premium received on the call options. If the SPY rises over the next month, the potential losses are huge since it is a short call option.

Buying a put option on the SPY limits the maximum loss, hence it is a relatively low risk strategy. The potential gains are large if the SPY drops as expected. This strategy is also a leveraged strategy as the each option contract has a multiplier. Therefore, the risk and returns are leveraged.