By Derek Moore
Not sure how many of you fellow Netflix subscribers noticed that they have not one, but three different burning fireplace videos. Its unclear if we should call it a movie or a show, but if you search fireplace or yule log it will come up. The one is in high definition 4K and complete with crackling wood for your holiday enjoyment.
So why the yule log of option strategies? As I am writing this, I’ve got the video rolling and watching a fireplace video takes quite a long time for some of the pieces of wood to finally burn. With our HiPOS trades, often you are watching the market urging time to move by quicker to that time decay kicks in.
With the Christmas holiday and some shortened trading sessions coming, we are down to about 3 1/2 trading days left in the year once markets close Christmas Eve. Coincidentally, December 31st is also the expiration date for our current HiPOS Conservative trade.
The graph above really illustrates the march higher in the underlying Russell 2000 Index where we are short the 2100 call strike as part of our spread position. Monday seemed like the day the RUT would finally break only to rally hard off the lows to close up for the day.
The trend higher though, has remained rather orderly running just south of the purple curved line. As a reminder, this line represents areas where a close of the index above the line might result in ZEGA taking a more defensive posture in the management of open positions. Each day in the trade that passes allows for more freedom for the RUT to move higher.
Despite the index moving against the call spread, the trade has held up relatively well. This position is a good example of how each leg of the spread (long call and short call) can start to see some divergence in the remaining time value. Simply, the short leg is lower than where we sold it for (that’s good!). Yet, there is still more to go on the way to hopefully plunging in value close to or at zero.
The long call leg, has in fact lost almost all its value. The reason to bring this up is that the position is showing less of an unrealized gain given these characteristics and where we are in the cycle to expiration day. Without getting too technical, the remaining probability of the index closing above the short leg still has some embedded risk premium while the long side probability is miniscule thus reflected in its value.
So, for this trade what you want is the index to take a break from it’s uptrend and time to tick away. As we mentioned in previous posts, at ZEGA we run quite a bit of numbers around our trades. Going back 30 years to 1990 the Russell 2000 Index had never, after making a fresh all-time high, move greater than another +13% higher over a 25-day period. Currently the RUT is close to +15% higher over 25 days’ time.
There is a first time for everything and why probabilities of an outcome are not absolute certainties. There is quite a bit of care in choosing which expiration and strikes to sell volatility premium on and the rules have provided a foundation to the strategy over the years.
Finally, on Conservative HiPOS, do not be surprised if the ZEGA trading team closes out the position early prior to the end of trading on New Years Eve. Of course, we will update you all here on the blog as usual.
As we had previously guided on the blog, last week we decided to close out the short RUT call spread on the last day to trade. You might remember that those contracts were A.M. settlement rather than end of day. At times if the market gets too close to the strike, to reduce risk we close it down. The good news is that we still wound up with a profit on that tranche as well as the S&P 500 Index legs. We explained the morning vs evening settlement a little more in a recent piece, but generally with an A.M. morning settlement, the available time to trade was right before the closing bell the day before the A.M. expiration.
The final index settlement value is determined sometime in the afternoon after each one of the stocks in the Russell 2000 Index opens. Since we cannot trade during that process, depending on how far away our spread is, the prudent thing is to take our profit and not hold the overnight risk.
With only a short number of trading days left in 2020, you and your clients should anticipate remaining in cash for 4 or 5 days between market holidays. If that changes, we will post an update.
So with that turn on Netflix Yule Log video and we hope everyone has a great holiday!