Stock returns aren’t normally distributed. Very small daily returns occur more frequently than a normal distribution would suggest, and very large daily returns also occur more frequently than a normal distribution would suggest. The “average” move, perhaps unintuitively, occurs less frequently than a normal distribution would imply. If this doesn’t make sense, imagine a room with five basketball players and five jockeys. The average height of the jockeys might be 5′ to 5’6″ tall averaging 5’3″, and the NBA players might be 6’3″ to 6’9″ averaging 6’6″ tall. The average for the room would be 5’10½”, yet there’s a huge gap between the tallest jockey, who is 5′ 6″ and the shortest basketball player, who is 6’3″. The average height in the room is 5′ 10½”; close to the average height of the American male, yet none of the room’s occupants are very “average.” When events at the extremes occur more frequently than a normal distribution would suggest, the distribution is said to be “fat-tailed.” Interestingly, stock returns also exhibit some asymmetry. In a perfectly symmetric distribution (like a standard normal distribution), the left and right sides mirror each other. If a distribution exhibits skew or skewness, that means the left and right sides of the distribution aren’t symmetrical. If returns periodically have very large or sharp downside moves, for example, that can cause the distribution to skew left (negative). Options prices for the S & P 500 and its proxies typically have higher implied volatilities for downside puts and lower implied volatilities for upside calls, reflecting negative skew. Part of that may indeed be driven by the actual return characteristics stocks exhibit, but some of that is also simply a function of supply and demand. Investors often prefer to buy insurance, increasing demand for downside puts relative to upside calls. What to do To illustrate this, observe the closing prices for SPY January 630 puts on Wednesday, which were priced around $6.70, versus the price of January 725 calls, which were priced around $2.85. Both options were approximately 6.9% away from the roughly $678 closing price of SPY, but their prices differed significantly. (Note: interest rates and dividends also have a role to play in the relationship of put and call prices, but we’re ignoring that for simplicity in this conversation.) Therefore, if one wanted to use protective collars without incurring a net premium, the sale of a January 725 call would finance the purchase of a 580 strike put. That’s not particularly appealing because the upside gains are capped at 6.9%, but the downside protection doesn’t kick in until the S & P declines by more than 14%. That asymmetry is not in our favor. But what if we use vertical spreads instead? Selling an upside call spread to purchase a downside put spread? As I write this, the January 640/600 put spread costs about $4.95, and the 710/740 call spread costs the same. So one can buy a $40 wide put spread that is approximately the same distance from the current stock price as one can sell a $30 wide call spread. In this case, “skew” is now working to create asymmetry in our favor. The verdict? Experiment with vertical spreads to put the odds in your favor. Rather than simply collaring your stocks by selling upside calls and buying downside puts, consider selling upside call spreads and buying downside put spreads — or both. DISCLOSURES: None. All opinions expressed by the CNBC Pro contributors are solely their opinions and do not reflect the opinions of CNBC, NBC UNIVERSAL, their parent company or affiliates, and may have been previously disseminated by them on television, radio, internet or another medium. THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.
