HIPOS Weekly Update: New Trade on the Call Side Entered

by | Sep 28, 2017 | Alternative Income, HiPOS (High Probability Options Strategy), Option Trading, Volatility

With volatility depressed as markets continue to dabble around all-time highs, today for the second time this year a bearish short call spread appeared on ZEGA’s radar that qualified for entry. Now we realize that long-time HIPOS strategy alums normally see short put spreads entered below the current market. Instead a short call spread involves selling a lower strike call option paired with a long call strike higher above the current market. While those following at home typically are rooting for the markets to stay as far above the short-put strike, for this one you’ll need to switch jerseys and root for the price of the underlying Russell 2000 Index to remain as far BELOW the short strike as possible.

As always, above is the graph which displays the chart for the underlying index. The vertical blue dotted line represents expiration day of November 3rd. We now see the short call strike of 1575 ABOVE the market as well as our normal purple defensive curve indicator. A few things to note on the trade. ZEGA’s research has shown that since 1990 when the index passes the old high by 2%, there is a low historical probability that price will continue up another 5% in the next 25 days. Research shows that only 4% of those instances see a move greater than 5%.

It is important to note that this was not necessarily a market direction call. Instead the trade followed ZEGA’s strict rules for entry. Because calls typically have not shown enough premium, especially with interest rates so low, they normally are not considered for a trade. As mentioned, the only other time this year we have seen this play out was in the March position where we sold a call spread that resulted in an Iron Condor position once puts were added a few weeks later.

On that front, a few things on this position. Your clients may have a question as far as the balances and left over buying power in accounts. We only used half the available funds on this one. The reason being is that we were able to bring in 2.21% target profit on the trade. Even when using half the account it still would result in a target profit of roughly 1.10%. Using half, the buying power does two things. It reduces the risk for the position and also allows us to put on a second tranche should price continue higher while still avoiding our entry criteria.

If the market were to sell off enough that would let the put side qualify for entry, we could also institute a short-put spread trade on simultaneously as we did back in March. Off course if we make any additional adjustments we will be back on the blog with updates.

Some final thoughts. Today the Russell 2000 Index went up over 2%. Based on the implied volatility on the index, a 1 standard deviation expected range for today would have been +/- 0.81%. The big move today wound up resulting in a 2.59 standard deviation move which would have been in roughly the 1.99% probability of happening range. Compared with much smaller moves in the other indices this proved to be the outlier today.

If a HIPOS trade on the call side is a little tough to get your arms around that’s ok. We know that they have been rather infrequent. Part of the issue is the low interest rates. Higher rates would increase call values. Frankly, I almost titled the article the George Costanza trade. You remember from Seinfeld where he did the opposite. “Right is wrong, up is down”. Look at this trade the opposite way you normally would. As always hit up one of the ZEGA team with any questions.

Now for the particulars:

Index: Russell 2000 Index

  • Position type: Vertical spread
  • Short strike: 1575
  • Long strike: 1600
  • Risk (prob. ITM): 2% at time of entry
  • Targeted return: 2.21% ($.52 on a $50 requirement)
  • Targeted portfolio return: 1.11% (half the accounts utilized on trade)
  • Distance OTM: ~6% at time of entry
  • Expiration: November 3rd: 37 calendar days to expiration at time of entry





Check the background of these investment professionals on FINRA's BrokerCheck »