HIPOS Weekly Update: Expiration Week Arrives and Option Skew

by | Jul 18, 2017 | Alternative Income, HiPOS (High Probability Options Strategy), Technical Analysis, VIX, Volatility

As we enter the final week of our current primary HIPOS trade, the underlying index (Nasdaq 100) sits a good 14% above the short strike leg. While the NDX experienced the most historical volatility of late, the markets turned higher after Janet Yellen’s comments around a more measured (read slower) approach to future raising of interest rates.

During the final days until expiration, barring any dramatic change in the markets, your clients should not see much movement in the remaining value of the spreads in the accounts. Most of your clients, assuming the contracts expire worthless, will see in their activity a notation that positions removed due to expiration. This typically takes place on Saturday or Sunday after expiration.

With low volatility so much in the news, I’ve had a couple questions recently about how we are even able to get trades to enter? Don’t we sell volatility? It’s a natural question to ask since CNBC is doing daily stories about how historically low the VIX Index has been.

As regular readers know, typically ZEGA waits for a trade to meet all our stringent criteria for entry. A good portion of our entries happen after some short-term spike in volatility that allows a trade to qualify. Regular investors in our High Probability Options Strategy also recognize that selling call spread premium is rare (aside from our March HIPOS trade). But why aren’t calls more readily available to trade?

So, this week I’ll attempt to give a short answer to a rather complex options concept. Above we have a graph that depicts the out-of-the-money skew on the August 18th expiration S&P 500 Index options. They have roughly a month until expiration. The bottom of the chart shows the various strike prices ranging from 1000 to 3000. For reference the S&P 500 Index currently sits at 2460. The left hand vertical side of the graph displays the Implied Volatility percentage. Options are priced based upon interest rates, time to expiration, distance in or out of the money, and implied volatility.

Deeper out of the money puts carry more value than do deep out of the money calls. Part of this is people hedge net long equity positions against some sort of disaster. If you look at the chart, you can see not only do puts have more implied volatility premium than calls, they also see value in strike prices much farther away from the current underlying value of the index. The inherent risk premium contained in the various put strikes is one of the reasons why selling put spreads is more available than selling call spreads. The chart is referred to by traders as the volatility smile or skew. Kind of resembles a smile, right? Of course some of those deep out of the money options have only pennies of value.

Option pricing dynamics, skews, and implied volatilities can be a little heavy on a warm summer day. But don’t worry, ZEGA’s team handles all the calculations and management for your clients. If you take one thing away from today’s article, understand that put and call pricing does have a skew where puts contain more value due to hedging. We aim to take advantage in those pricing opportunities to deliver positive risk adjusted returns for your clients.

 

 

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