A very large Latin American pension fund came to Rihan with a real problem. Latin American markets run out of room fast. They run out of Mexican treasuries, Chilean treasuries, the Mexican equity ETF. When you have that much money there are only two pools deep enough to hold it: the S&P 500 and US treasuries.
So they asked him for an S&P 500 strategy. Three conditions, plus a fourth that mattered more than any of them:
It has to be long.
It has to have a buffer.
It has to have no bad extrinsic. His rule is “death before debit,” but as he clarified Thursday, “it’s actually death before extrinsic.”
It has to survive the pension fund’s investment committee, which meant every piece of it had to be defensible, in writing, to people who are paid to say no.
He presented it to the head of the Mexican SEC, because a pension fund there can’t use a strategy the regulator hasn’t blessed. They liked the trade. Then they asked him to sit on the board of one of Mexico’s public banks. He said no. The trade never got approved.
That fourth condition is why the whole session was structured as algebra rather than as a trade idea. He had to derive it.
The build, step by step
Start with the boring answer and break it.
A hundred shares of SPY. A hundred deltas. Long, no extrinsic, and Rihan is quick to say it’s not a bad trade at all. It just has no buffer, which is the one thing they asked for.
Buy the at-the-money call. Now you’re a hundred and fifty deltas. But you paid for it, and that premium is what he calls bad extrinsic. That’s his own phrase, and Battista made a point of crediting it to him. It just means long premium: negative theta, a cost of carry, the thing decaying against you every day you hold it.
Sell a call above it. Turn that long call into a vertical. You give back some of the delta, you get back some of the money, and now you’re around a hundred and twenty-five deltas with half the bleed.
Now the algebra. Above the line you have shares. Below the line you have derivatives. So convert the shares: sell an at-the-money put, buy an at-the-money call, and you own long synthetic stock. Nothing about the position changed. It’s still a hundred and twenty-five deltas. It’s just written in a different alphabet.
And once it’s written that way, something falls out of it. You’re now long two at-the-money calls. Which means you can sell a second call above without ever being naked. That’s the extrinsic gone, on the upside, with no uncovered short call anywhere in the structure. Rule one at Grow Your Pile is that we don’t sell naked calls, and it isn’t negotiable.
Where’s the bean in the rice?
Rihan's phrase, and he apologized for it being a Mexican saying. You get a plate of rice and there's one black dot in it. Where's the problem? The upside is clean. The problem child is the downside: that short put.
So you buy a put at the money, on the same strike as the one the synthetic left you short. That's the only place it can sit if it's going to do what comes next. Protection costs money, though, and that's bad extrinsic straight back into the trade. So you sell a put below it to pay for that. It doesn't quite cover it, so you sell a second one below. You're long a put, so neither of those leaves you naked anywhere.
Now line the whole position up left to right and read it off the way he did on screen. Two short out-of-the-money puts. Then a short at-the-money put and a long at-the-money put, sitting on the same strike. Then two long at-the-money calls. Then two short out-of-the-money calls.
That pair in the middle cancels.
Take them out and count what's left. Two short out-of-the-money puts, two long at-the-money calls, two short out-of-the-money calls. Two of everything, carrying about a hundred deltas between them. Divide by two.
**One long at-the-money call. One short out-of-the-money call. One short out-of-the-money put.** A 1-1-1, and about fifty deltas. Rihan read forty-nine off the screen. A defined-risk call structure, a buffer under the market, and, done right, a credit on the way in.
That's the Smart SPX. Battista calls it a beautiful trade. Rihan just calls it the smart.
If you want the fast version without the derivation: buy the at-the-money call, sell a higher call worth about half of it, then sell a put low enough to finance whatever extrinsic is left. Rihan goes one strike further than “financed” so he collects something, because he’s greedy that way. Roughly a dollar in SPY, ten dollars in SPX. The part Battista lit up about
When Rihan finished cancelling the legs, Battista recognized it immediately, because it’s what he did for a living.
“When I was a market maker on the floor of the exchange, what you just did with your position we would do every day at the end of the day.”
No computers to do it for them. He’d cancel long call spreads against long put spreads, pull the boxes out, then butterfly off whatever was left. Two hundred contracts became a hundred, a hundred became forty. Boxes don’t move. Butterflies barely move. What’s left is your real risk, and that’s the only thing you have to manage. He’d trade three or four thousand contracts a day and carry five thousand on the sheets, and this is how he found out what he actually owned.
Same exercise Rihan just did on eight legs. That’s the point of the algebra.
Where the risk really is
A member asked whether the short put makes the drawdown worse. Fair question, and the answer is no.
Yes, those puts grow faster on the way down, because they have premium in them. But delta is king. You took the position from a hundred deltas to about fifty. All the way from the current level down to your short put strike, you lose less than the index does. Past the short put, you’re one-for-one with the S&P again.
You can’t have everything. Upside participation, no cost, and no downside risk is not a menu you get to order from. What you did was move the risk down, and pay for it by capping the top.
The cleanest way he frames the bargain: the structure takes out the losing months in the four-to-five-percent-down range, and in exchange it caps your winning months at around two percent. That’s the whole trade in one sentence. If that swap doesn’t appeal to you, this isn’t your strategy, and he’d say so himself.
The natural follow-up: if your short put sits at roughly a fifteen delta, one standard deviation out, why not just sell that put by itself? Because the naked put pays you a fixed, fairly small number. This structure gets you the same buffer and a multiple of that. That’s the trade.
And it needs saying plainly: if the market goes nowhere, this makes you almost nothing. It’s a bullish trade. You have to be right about direction, eventually.
Doing it in your size
Rihan builds these in SPX because that’s how he thinks. Battista pulled him back to SPY for anyone trading smaller, and the SPY version is identical — buy the at-the-money call around fourteen dollars, find the call worth about seven and a half, sell the put underneath. Same shape, same fifty-ish delta, same buffer. There’s a small dividend wrinkle in SPY that SPX doesn’t have, and SPX markets are wider.
SPX is ten times the size of SPY. You can do three or four SPY versions and still be half an SPX. If you aren’t comfortable trading ten contracts of SPY, QQQ or IWM, you have no business doing this in SPX.
Neither of them likes mini SPX, and not for the size. It just isn’t liquid enough. Both would rather do SPY or /ES and /MES. And in futures you can run it as a campaign: one on every week or every month, over and over.
Then Battista asked the only question that matters and answered it:
“What’s the only thing that takes us out of this game? Size. Retail investors are not successful, not because they’re not smart enough, or the game is rigged against them, or they don’t understand direction. They understand direction better than anybody else. Retail investors fail because they trade too big. They can’t stay in the position to give themselves time to be right.”
Managing it
When it works. Rihan’s backtest let it run to expiration. In practice, ninety percent of max is plenty, and take it off. Or, in his words, if you’re a chicken like him, you take it off at a scratch.
The move worth stealing. This one is Battista’s and it’s the best piece of position management in the hour. The heavy risk is the put side. So when the market rallies and the put you sold for thirty dollars is worth fifteen, take some of that money and buy a put below it for two or three dollars. Now you own a put spread instead of a naked put, your downside is capped, and you can leave the upside on into perpetuity. It costs you part of the profit. It buys you the ability to stop watching it.
Rihan does a version of the same thing with the credit he collects on the way in. That dollar in SPY, or ten in SPX, sits in his head as money to spend on a long put later. Spend it, and the risk is out of the trade.
When it goes against you. You roll the short put down and out. Then you roll it again. Volatility expands on the way down, so you get paid more to do it. And even if price never comes all the way back, when volatility contracts you get a lot of that premium back anyway. Rihan’s line: the lower price may last, but the anxiety doesn’t.
He backtested this fifteen to twenty years before the pension fund would look at it, and the crisis period is the part they cared about. Coming out of 2008, his numbers put the strategy back at breakeven around July 2009, against January 2010 for a long-only position. Six months earlier. Not a different universe, but six months is a long time to be underwater.
IMAGE: Monthly Returns of the $SPX / S&P Return vs Smart SPX
Don’t read that chart on its own. He was equally blunt with the pension fund about the other half: through the worst of the volatility this thing takes a beating of its own, because the short positions get repriced against you while it’s happening. You still feel the crash. You just get whole sooner.
And the data stops in 2016. That’s the deck as he presented it at the time, and nobody has extended it since. So take it for what it is: his backtest, not a promise, and we haven’t rerun it.
When to put it on. Both of them said the same thing without prompting: on a down day, with volatility expanding. Rihan will sometimes put the call spread on first and wait a day or two for a better level on the put, and he’ll tell you straight that that’s market timing and not textbook. Sometimes he’ll put two units on and only sell one of the puts.
“It’s trading, Tony.”
Herb’s question: this, or the one-by-two?
Herb asked whether the Smart is better than the one-by-two for a market going up. Rihan trades both, and the distinction he drew was clean:
The one-by-two is a trade he puts on when he wants the market to come down to him. He’s trying to capture the space between his long put and his short put.
The Smart is what he puts on when he thinks the market is done going down and he wants to be double bullish: bullish on the short put, bullish on the long call spread.
You can hold both. The one-by-two actually gives the naked put a little cover.
Herb also got a second thank-you, because Herb is the reason we started trading short-dated IWM puts at all. He pushed us into it, we did his trade this week, and it worked. That is not a direction we would have gone on our own.
Members — the replay
VIDEO: replay link:
What our books actually did this week
You saw all four of these in alerts. Here they are in one place, because together they’re the whole session in miniature.
The 1-1-1 is the one to look at. It went on August 18 for a $2.57 credit — $257 in our pocket to be long the S&P twice — and it came off this morning for another $1.85 credit, $185. Credit in, credit out. We never paid premium at any point in that trade’s life. Total: $257 + $185 = +$442.00 on one unit.
That is the trade we spent the hour building, and it’s why he keeps saying death before extrinsic. The structure was designed so that the cost of being long was zero, and it finished that way.
And then there’s the four dollars. Same trader, same week, and he’ll tell you about both without being asked. That is the other half of the lesson, and it’s the half most people never get to see.
What’s coming
Liz Dierking is next week’s guest. We’ll confirm the day in the invite. Come with questions, this one’s worth showing up for.
Faster trades. This isn’t finalized, so treat it as a teaser. We know the gap between when we place a trade and when the note reaches you is a real problem. Five, ten, twenty minutes, and the market has moved. Sometimes it works for you, sometimes against you, sometimes you miss it entirely. We think we have a workaround that gets the trade to you instantly if you want it that way. We expect to close the deal in the next week or two and have it running around the middle of the month.
One of you paid us a compliment about the alerts on the call, and the answer is worth repeating. It’s easy to post a trade. We write out the reasoning because the trade isn’t the product. Knowing why we did it is. Teach you to fish, not hand you a fish.
Thanks to Herb, Bart and David for the questions. Three of them changed where the hour went.
And it ended the way it always ends: you’ve got to risk it to get the biscuit.
Grow Your Pile Office Hours is educational and is not investment advice or a recommendation to buy or sell any security. Options involve risk and are not suitable for all investors. Strategies discussed carry different risk profiles; long-premium strategies can lose the entire premium paid, and short-premium strategies can produce losses that far exceed the credit received. A short put can require you to buy at the strike and the loss can be substantial in a falling market. Read the Characteristics and Risks of Standardized Options before trading.
