Can You Out Smart Wall Street?

At the start of each New Year forecasters often make big and bold predictions for various asset classes. A year ago according to the average Wall Street prediction forecasters called for a conservative 7.4% advance for the S&P 500 index during 2013 saying it would rise from 1426 at the end of 2012 to 1531. In the event stocks put in a sizable 29.6% rise. The rationale of a recovering economy may lead analysts to expect further stock price gains this year despite protests that at least some of last year’s gains were perhaps borrowed from 2014.

The median projection across Wall Street analysts within the latest Bloomberg survey predicts that the S&P 500 index will end the year at 1946 – or 5.3% higher than where it closed in December.  Such forecasts are a combination of prospects for earnings growth, predictions about the economy and finally just a bold guess on where stocks could end the year. Many Wall Street analysts crunch company and sector balance sheets to come up with earnings forecasts. Wall Street analysts anticipate earnings per share across the index constituents to rise from $107 to $118 (+10%). How strong dividends will climb is equally a factor for the path of the stock market since it competes with risk-free yields on treasury securities. Other analysts also factor in the prospects for the broader economy into their calculations. Growth for the world’s major economy of say 2.7% for 2014 and with receding fiscal headwinds may support the expectation of a vigorous rally for stocks.

Currently the equity options market is in minor disagreement with those views of macro economists looking to gauge the balance of power between buyers and sellers this year. The following chart shows the Probability Distribution of the popular S&P 500 SPDR ETF (Ticker: SPY) using the December 2014 options expiration. Using premiums across all of the available strike prices you can see that investors currently expect the underlying index to close the year somewhat higher than the current trading price of around 1830. The cost of options at each strike price implies a specific probability that the index will land within the boundaries to nearby strike prices. Adding up all of the probabilities along the bell-curve covers 100% of expected outcomes.

Chart-S&P SPDR Exchange Traded Fund

Currently the options market is telling us that the highest implied probability is for the SPY exchange traded fund to settle at the December expiration date between 189-190, which is 2.7% below the consensus estimate amongst forecasters.

Chart-What if forecasters are wrong again?

Let’s update the same chart to reflect a rosier view for stocks. After all, Wall Street forecasters got it badly wrong last year by underestimating the major rally that ensued. Let’s assume a rally of say two-times the power that the herd is looking for and we shall pencil in a 15% rise for the SPY to 212.5. By assigning a higher probability than that implied by current options pricing to a rise of that magnitude through December, we can display a more bullish profile instead and one that can be used to model optimistic options strategies to take advantage of such a view.

As was noted earlier since all probable outcomes must sum to 100%, by pushing the custom probability line higher around strike prices covering 212.5 for the SPY, by definition the likelihood of lower settlements has diminished forcing the red custom probability line down across most other outcomes.

Now, we will not pretend we know better than Wall Street forecasters. The market could decline throughout 2014 or as we demonstrate above, could rally harder than expected. But what is clear is that by utilizing the IB Probability Lab, users can adjust their forecast across any stock and tailor their options strategies accordingly.

For example, by assigning a stronger probability to another strong rally for 2014, the IB Probability Lab will generate multiple legged options strategies based on those assumptions. From the strategies generated, the investor can examine the Performance Detail to display expected profits across the Probability Distribution and view the trajectory of available Greek values in order to better understand the risks of working with the trade as the market moves.

Under the expectation of a bigger year-end gain for stocks, the Strategy Selector offered a variety of combinations. We simply limited the number of legs under our scenario to two, which generated three available choices for the bullish outlook. The Strategy Selector showed the sale of the December 189/183 put spread (sell higher strike puts and buy an equal number of lower strike puts to limit losses) as the most efficient two-legged scenario in this case. Adding legs results in more flexibility. The visual below illustrates the outcomes against the probability distribution we defined earlier. The bullish play results in a net premium, which remains a constant above a specific strike price for as far as the rally lasts. Losses erode if the custom probability fails to play out as expected but are limited in the event that stocks fail to rise as anticipated.

The final visual allows the investors to see the profit and loss profile relative to Delta, one of the available Greek risk metrics. The ‘kink’ in the reading of Delta in the lower panel reflects the time when the investor is net long the market, which is the moment losses start to diminish as the market pulls away from the lower strike to the moment when gains are maximized. Thereafter the reading of Delta falls to zero.

Chart-Characteristics of a bullish put spread

Conclusion – 2013 turned out to be a lousy year for Wall Street forecasters who vastly underestimated the extent of the rally. Investors may be better off relying on their own gut instincts when trying to project the future. For bulls and bears alike, by focusing on the Probability Distribution over time and examining associated possibilities and risks of relevant options strategies, 2014 might provide investors with the ability to better analyze the probabilistic nature of the process. The more information and insight we have, the more likely we are to get it right.

About Andrew Wilkinson 1023 Articles

Affiliation: Interactive Brokers

Andrew Wilkinson is the senior market analyst at Interactive Brokers Group, where he provides daily commentary and analysis on U.S. equity options trading throughout the trading day. Andrew provides webinars designed to explain option-related trading scenarios covering futures, fixed income, forex and equities.

Interactive Brokers: Interactive Brokers offers direct market access to around 80 electronic global markets from a single account. Successful traders and investors understand that superior technology and lower trading costs can result in greater returns. For 32 years we have been building direct access trading technology that delivers real advantages to professionals worldwide. With consolidated equity capital of US $4.4 billion, IB and its affiliates exceed 1,000,000 trades per day. In addition, our prudent and conservative risk policies make Interactive Brokers a safe haven for your money. Discover some of the reasons why IB, the largest independent US broker/dealer, is the professional traders' and investors' choice.

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