This could be the best way to bet on stocks now

Upside options get cheaper
Upside options get cheaper   

Bulls, rejoice!

The price of bullish call options on the S&P 500 has fallen to historical lows. That means that from a historical standpoint, it is remarkably inexpensive to make a bullish bet on stocks by buying on the options market.

Specifically, what Susquehanna head of derivative strategy Stacey Gilbert found (using a theoretical options pricing model) is that the price of 5 percent out-of-the-money options expiring three months in the future has fallen to the seventh percentile of what's been exhibited over the past 25 years.


Using hypothetical numbers, that translates into a current cost of 0.39 percent of the value of the S&P 500, compared with an average cost over the past five years of 1.10 percent of the index value.

"In terms of how much money it costs you to have exposure in the S&P 500 [rising in the future by] 5 percent, we're looking at historic lows," Gilbert said.

Dennis Davitt of Harvest Volatility Advisors agrees that call options have "never been more economical." On the other hand, he said, "The puts [options to sell] are all-time expensive relative to the calls."

In fact, while selling a 10 percent out-of-the-money call once yielded enough money to buy a 20 percent out-of-the money put (before the financial crisis, that is), selling a 10 percent out-of-the-money call now yields only enough to buy a 38 percent out-of-the-money put, Davitt notes. (The 38 percent is less valuable than the 20 percent because that out-of-the-money put is further from the current market level and thus it will take a bigger move to yield a return.)

He pins this on the prevalence of investors selling out-of-the-money calls against long holdings to increase yield. As more investors sell, prices naturally fall.

Additionally, the higher current prices of deep out-of-the-money puts (due to a shortage of willing sellers) drives call prices lower, due to an interesting connection between probability theory and the options market that may best be explained in an advanced statistical finance class.

The bottom line, however, is simple. Given current pricing dynamics, if one wants to increase one's exposure to the market, buying slightly out-of-the-money upside calls is not a bad way to do it.