By Derek Moore
Tuesday the Russell 2000 Index made another fresh all-time high rising another +2.40% to just under 1960. After underperforming against the other indices for some time, it seems like it has been on a rocket ship higher since.
If we refer to the graph above showing our normal array of HiPOS conservative attributes, we see that due to the passage of time, the index has not yet pierced above our purple defensive posture curve. This is due to the passage of time which provides more and more breathing room as we march towards expiration date.
While the market has yet to move above this area, it has moved against us enough that the current short call spread has shown an unrealized loss at times in accounts. The short strike of 2100 is still located a little over 7% out of the money (above) the Russell price level based on Tuesday’s close.
The trade still has 15 calendar days left until expiration and plenty of time to take a breather from the continued moves higher. Staying here and treading sideways or of course moving lower would be beneficial to the position. Remember, since we sell premium at the beginning of the trade, we eventually want the value to move to zero. Time moving forward also will help and we do have several weekend days and the Christmas market holiday in there.
We mention often how increases in volatility can hurt a position while reductions in volatility have the opposite effect potentially reducing option premiums. Unlike a material downturn where spreads widen and volatility jumps, we typically see the opposite during a melt up and volatility declines.
Volatility represented by the VIX Index has stayed above 20 since February so it remains elevated. But the point is that when you have markets moving against a short call spread position, melt ups are more orderly than meltdowns. If the market were to move in ZEGA’s estimation too close to the short strike, we may impart strategic tactics where we could roll the spread out to a future expiration date and further away from the trouble.
If that happens, we will update everyone. For now, you just want the RUT to have some sideways to down days to give some daylight in between the index price and short spread.
In the aggressive version of the strategy, it has been a tale of two indexes. With the S&P 500 Index we have a blend of a long SPX call spread and a short SPX call spread. If both expire worthless, we will realize a profit. Now you probably are saying, wait, didn’t the long SPX spread provide some protection against the short RUT call spread? Yes, that is the design of the position.
Due to the negative divergence where the RUT moved materially higher relative to the movement of the SPX, it did not offset the unrealized losses on the RUT position. This happens from time to time.
For the RUT short 2000/2040, what should you expect in this final week of expiration? ZEGA’s traders have several rules and tactics to deploy in cases where a market gets too close to the short strike. Also, given that the RUT spread is an A.M. expiration (last trades Thursday then final settlement price determined Friday morning), you most likely will see us look at rolling out further to a later expiration date to avoid the risk of an overnight gap higher in the index.
If the market should have a retracement and move lower this would make it possible to simply go through expiration as normal. We mentioned in the conservative portion of the update that markets moving higher to threaten a call trade are different than when we have short put spreads on. But we still have tactics we use in these situations.