HIPOS Weekly Update: Calls Introduce Themselves
On Wednesday, we entered a new HIPOS primary trade. If you looked at our normal graph above, you probably wondered if we posted it upside down. Well actually this trade uses a tactic many may not have seen in the strategy – or at least advisors who have employed our HIPOS strategy after April of 2013. That was the last time we used a call spread instead of a put spread to generate premium.
As a specialist in premium selling we look at both the bullish (Puts) and bearish (Calls) spreads every time we enter positions. We use our internal proprietary calculations to assess the best position for your clients – provided it meets our strict criteria. While normally your clients are rooting for the market to stay above our purple exit curve, this time they should be looking for the Russell 2000 Index (RUT) to stay below the purple ROLL curve. The reason is we are short a vertical call spread above the current price of the index. I’ll explain more on the roll part later.
With a short vertical put spread, we are short volatility. A spike higher in volatility once the position is on would hurt the value of the position. A move lower towards our short strike price would negatively affect the value. While we would have positive time decay, meaning each day that passes value would come out of the position which is positive. So, thinking about the put side, 2 out of 3 main drivers of position value hurt us.
With calls, only 1 of 3 negatively affect us. Why? Because if the market moves higher one would expect volatility to either remain roughly the same or contract further. We still enjoy time decay each day. Price moving higher towards our short call spread is the main thing that could be negative.
With a short call spread it requires a little more active management by our traders. I alluded to the purple ROLL line earlier which is a departure from what we normally reference as our exit line. The reason is that unlike short put spreads which see their cost to buy back to exit increase as volatility increase, short calls spreads don’t suffer that same volatility effect. Thus, often our traders can either close or roll the position to another expiration or strike. This is consistent in playing defense where appropriate for your clients.
We often discuss with advisors the risks on a short put spread premium selling strategy. The main one is a black swan event where markets significantly gap down at open from the previous day. A short call spread has no black swan risk. Instead the risk is more of a melt up. Given the choice often we would rather use calls. However as many of you know, call spreads most of the time don’t meet our rules for entry.
Finally, we know some of you might get questions as to what we would do if the put side qualified for a trade. We are still monitoring that and if one should arise we may establish that side as well. This would create a short iron condor position where accounts would hold a short call spread and a short-put spread at the same time. Don’t worry, if that happens we’ll be back on the blog to explain for you.
So now for the particulars:
Index Russell 2000
- Position type: Vertical spread
- Short strike: 1490
- Long strike: 1510
- Risk (prob. ITM): < 2% at time of entry
- Targeted return: 2.4% ($0.47 on a $20 requirement)
- Distance OTM: ~7% at time of entry
- Expiration: March 17: 29 days to expiration at time of entry on February 15, 2017