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HiPOS Aggressive Trade Update: Divergence Emerges

Today ZEGA’s traders put on a new position in the Aggressive version of the HiPOS strategy. For this iteration we paired a short call spread on the Russell 2000 Index (RUT) with a long call spread on the S&P 500 Index (SPX). As a reminder one of the tactics this strategy employs involves using diversion analysis to strategically sell volatility in the index that has moved disproportionately to the other index where we are long volatility.

The Divergence at the time of the execution was -5%, meaning the RUT has outperformed the SPX by 5% the last 20 trading days. If you look at the graph above, you can see the relative performance over the last 20 days between the two going back to mid-2019. Selling volatility premium above or below a market on an index is nothing new for many of you. However, the long SPX call spread is meant to help offset a situation where we see a systemic move higher in both.

Here you would lose on one but gain on the other if you find that kind of a move materializes. At entry, the RUT short call leg was about 6.5% above the current market level. The SPX at entry finds the long call leg about 5.35% above its respective index level.

Pairing these two option spreads intends to capitalize on the convergence of the indexes. As you can see from the line chart above, this divergence oscillates between the RUT outperforming versus the SPX to the SPX outperforming the RUT over time. The idea here is that an eventual convergence of the indexes (line moving to 0% difference) will take place.   The current divergence tells us our long SPX call spread has the chance to appreciate even if the RUT keeps moving higher.   

This pair expires in two weeks on November 27th. Keep in mind that this one includes both a holiday and a half day of trading on the 27th. This winds up being 7 ½ trading days after the close today. The profit target is +1.68%.

Finally, we see above the familiar graph which shows the expiration date, short call spread, and purple curved line on the Russell 2000 Index short call spread. As usual, we want the market to stay below both lines as they move toward the expiration date and expire worthless for a full profit realization. There are instances where we can harvest some of the remaining long call spread premium. If that develops, we will update further.

While this is a chart of the RUT, you will notice the addition of the dotted black line showing theoretically where the long SPX call spread would sit. The key point here is that we have a long spread inside of the distance between the current market and the short RUT call spread.

This goes back to the central idea of pairing off a long spread with our short spread position to aim to protect a situation where the whole market moves against the positions. Of course if indexes further diverge against us, the protection would not be as helpful.

HiPOS Conservative Update

We will be writing a more detailed update later in the week as we march toward expiration this Friday morning. As of early afternoon Monday, the market remains about 7.5% below the short 3810 call strike. Given this is expiration week, ideally you and your clients will not see too much variation in the remaining embedded premium remaining in the spread.

While the market has risen and moved towards the short call spread, the fact that time value is eroding has kept the positions with an unrealized profit at this point in the trade. Stay tuned for an update later this week.