By Derek Moore
It would seem like a tale of two markets of late. One day listening to CNBC the prognosticators profess doom and gloom, the next day full steam ahead. While the market has been volatile of late thus far the underlying S&P 500 Index is sitting a bit above where it was when we first placed our primary HiPOS trade. So, are the market winds changing back to bullish?
The good thing about selling deep out of the money volatility is that the strategy doesn’t need the market to go up to hopefully realize a profit. Instead it of course can go up since we are short a put spread. But sideways and down is also just fine. Provided the market doesn’t surge down too far too fast.
When the trade was placed, it was done during a short-term spike in implied volatility meaning we could sell a spread position that was roughly 19% out of the money. We noted last week that this was a further distance than we’ve been getting recently. It is also why as markets retraced on prior days it did not affect the position quite as much.
Looking at the graph above, that increased distance out of the money shows itself in the increased breathing room between the current market and the defensive posture purple curved line. This being the area that ZEGA’s traders may take measures to help reduce risk.
After the close today we now have 17 trading days until the September 6th expiration. The index priced at the close roughly 21% above the short put strike price of 2300. Since the spike in volatility already happened prior to placing the trade, this trade also can lead to see a positive unrealized gain if it should shrink back down.
This brings us to a question I had been saving to answer in one of our articles and the volatility aspect fits well. So how does volatility moving up or down affect our HiPOS trades? Well, when we sell a short put spread, we are short volatility. This means that if volatility should increase, all else being equal, we would see the value of the spreads increase which would not be a positive. The inverse would happen should volatility fall as that component of how options are priced would cause a drop in the value.
Now, I did say all else equal. But rarely are other factors that price an option not changing themselves. But think of it this way, the less implied volatility baked into the price of the options, the less the premium derived from that one component is.
For now, we’ll end it here but of course keep the questions coming. In the coming weeks you will be rooting for markets to get less volatile and either stay where they are, move higher, or move lower but not by too much.