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HiPOS Weekly Update: Stuck in the Middle is Just Fine

By Derek Moore

To quote a famous 1972 song from Stealers Wheels, the market is “stuck in the middle with you”. This may come in handy should you find yourself in a random trivia game, or it could just be a nice analogy to where we’ve wound up in the underlying S&P 500 Index.

While the market has been more volatile of late, if you turned off all access to financial news, you’d probably say it’s a little higher than it was a few weeks ago and you’d be right. When we initially put on our most recent conservative HiPOS trade the short 2300 put strike was about 19% out of the money. Today it is sitting about 21% out of the money. This works out just fine for our position as we’ve experienced positive time decay in the position while seeing the market move further away.

With the September 6th expiration coming up we now only have 10 trading days left for the spread positions to reach our goal of expiring worthless. In addition to the passage of time, and thus positive time decay, we’ve also seen implied volatility come down. Meaning the volatility premium in the price, or premium of the spreads, has compressed which is also a positive. Remember, short spread trades are short volatility - so increases are a negative, while a drop-in volatility is positive.

A question I’ll address this week has to do with the remaining value of the spreads. First, why do they still appear to have as much value given that the underlying market is so far away. Secondly, if much of a target profit has been realized, why not close out early.

On the first question, while an option strike may be far out of the money, they still possess some value as market makers will not let investors purchase a lottery ticket for nothing. This is especially true on the put side where the black swan protection will always carry some cost. Many institutions still need to own out of the money protection relative to their long portfolios to reduce value at risk.

On the second question, related to the first one, option spreads still would cost more than a trivial amount to close out due to the embedded volatility and plain trading mechanics. If it costs us .10 cents to close out a spread, that might represent 15% to 20% of our initial target profit. This normally is too large a slice to forgo for investors in the strategy; especially given where the positions sit from a probability of expiring worthless (full profit) standpoint.

Where we might roll early is if we found an opportunistic new position to roll into that would be a benefit to you and your clients. We’ve got rules for that which our traders are always reviewing and calculating.

So, with that we’ll close out this week’s update. As always, if you have questions reach out to someone on the ZEGA team and who knows, one of your questions could be featured next in the blog.