HIPOS Weekly Update: Nasdaq Declares Independence

by | Jul 5, 2017 | Alternative Income, HiPOS (High Probability Options Strategy), Option Trading, Volatility

The Nasdaq 100 (NDX) continues to see higher volatility than the other two main indexes we use: the Russell 2000 and the S&P 500. As of the open Wednesday, its’ own volatility index VXN remains elevated. Normally the hierarchy when it comes to volatility sees the Russell 2000 (RVX) occupy the highest levels. So, this represents a short-term re-arrangement reflective of the recent weakness in the information technology sector. Of late, we’ve also seen the NDX be up on down days in other markets, or down when other indices are higher.

With regards to our spread position, it currently sits roughly 10.5% above our short strike of 5000. With 16 calendar days to go until expiration, time decay can be a positive for the position. In the graph above, you’ll also notice that with the passage of days since entry, we now have more breathing room above our purple curve which illustrates when our traders may need to take defensive action. The more time that passes the more room the trade has to get to expiration safely.

Some advisors may have noticed the duration to expiration on this trade was shorter than usual compared to other positions in 2017. Initially, we had 21 days to expiration. Some recent trades were more along the 29-day variety. As a result, we are already in the final two-week period. The very reason it was possible to find something of shorter duration was the lift in volatility. The days to expiration is only one of many inputs ZEGA uses when calculating our desired entry.

This week I wanted to address how the spread positions are priced. More specifically, you might have received questions from clients as to why new trades might immediately show a loss when logging into their brokerage firm’s client portal.

The reason deals with what a firm uses to value the combined spread trade. A short spread involves selling one option and buying another. In our current position, we sold the NDX 5000 put strike and purchase the NDX 4900 put strike to generate a credit. Options have a bid and an ask price much like stocks. But spreads are generally put on with the intention of trading at the mark or middle price. Simply the difference between the bid and ask.

Consider the following hypothetical example. Let’s say we just put on a short-spread trade with the following legs.

1400 Put Bid 5.80 Ask 6.30

1380 Put Bid 2.70 Ask 3.20

Many brokerage firms price in positions assuming one would have to buy at the bid and sell at the asking price. Spread traders though typically look to execute trades at the mid points or both. Sort of a meet in the middle idea.

When your broker uses the price of the short leg with the Ask price and the long leg at the Bid price, it provides the worst-case valuation. Instead, most options trading platforms use the mid-point to assign a value to positions. We prefer the mid-point and brokers like TD Ameritrade use a mid-point mark at month end on the client statements.

The issue that may cause some confusion for your clients is when they log into their accounts and spreads are instead priced using bid-ask instead of the middle point. If in the above hypothetical example, we just sold the position at $3.10, and that remains the current mid-point price, we are even. We have neither an un-realized profit or loss.

But when a firm assumes you would need to buy back the short option at the ask and sell the long option at the bid instead of using the mid-point on both, the position looks to be priced at $3.60. Since a short spread involves selling for a credit that you want to go to zero, a price of $3.60 would imply a loss of .50 cents even though the mid-point pricing would have it at even.

Therefore, sometimes your clients may wonder why a brand-new trade shows such a loss immediately. Of course, prices can change should the underlying markets move in one direction versus another. Hopefully this helps to answer questions, especially from newer clients using HIPOS.

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