By Derek Moore and Jay Pestrichelli
For many years we’ve given updates on our HiPOS Conservative and referred to it as our “Main HiPOS Trade”. However, with the recent surge in adoption of the HiPOS Aggressive strategy we felt it was time to add it to our HiPOS updates. For clients new to HiPOS Aggressive, we’ll provide a bit of a deep dive into the strategy in the second half of this article.
On Thursday 9-17, we entered into a pair of spreads that were bullish the NDX via a short credit put spread paired up with a bearish SPX long debit put spread for the September 25th expiration. The continued tech sell-off and pop in volatility post the Fed meeting allowed the entry to meet all the strategy’s rules of entry.
Each of the spreads are both considered to have a high probability of expiring worthless as intended and that will deliver the targeted returns. However, the bullish NDX bias and bearish SPX bias has the advantage of divergence/convergence on our side as well.
As illustrated in the chart above, at the time of entry the SPX had a +3% 20-day outperformance over the NDX. This happens to be at the top of the historical divergence range. If history repeats itself, we expect a convergence or a retracement to the 0% line and even over divergence to the bottom of the range. This implies that regardless of the direction the market moves, we expect the NDX to outperform the SPX. For example, if the SPX is down say 5% over the next week, we expect the NDX to be down 5% or less. That would be considered outperformance, even in a down market. Conversely. if the SPX is up 3% over the next week, we expect the NDX to be up by more than 3%.
Pairs trades are relative performance to each other, and in this case if the market has a dramatic sell off, we expect the SPX long debit spread to go in the money first (that’s good for long spreads) for either divergence reasons or just that it isn’t as far away as the NDX spread.
One of the key rules to keep in mind with HiPOS Aggressive, we always aim for the protective long portion to be at or inside the short spread. This case is no exception as the SPX long put spread was 8.6% OTM and the NDX short put spread 9.6% OTM.
Now for the Particulars:
- Index: NADAQ Index vs. S&P 500 Index
- NDX Short put strike: 9900
- NDX Short strike 9.6% OTM
- NDX Premium of 4.4%
- SPX long put strike: 3050
- SPX Short strike 8.6% OTM
- SPX Cost of 2.1%
- Total Targeted return: ~ 2.3%
- Expiration: September 25th or 7 trading days to expiration
What is HiPOS Aggressive?
As the name implies, the strategy is more aggressive than our conservative version of HiPOS, but still uses the core philosophy of selling options for premium generation with positions that have a high probability of success. In our case, that means a high probability of expiring worthless.
So what’s different about Aggressive? First, the spreads we sell are closer to the money and that means riskier. With Conservative, we typically put on positions that have a 99% probability of success. In comparison, the options utilized with Aggressive are closer to a 95% probability of expiring worthless. As one would expect, the additional risk from 1% probability of loss to a 5% chance of loss comes with additional return. It’s worth noting that although we add this risk and return, we still ensure that the return received exceeds the risk. For example, if we sold an option that had a 96% probability of success, implying a 4% risk, we’d want to make sure that we had the potential to earn more than 4%.
The second difference is the addition of protection to the position. With the extra premium, we have a budget to spend on a hedge. In other words, there is money to add in a protective debit (aka long) position paired up with the usual short spread just discussed. This pairing is done on a different index and aims to provide an offset to the potential losses if the market moved against the primary credit spread. The theory here is that if the market makes a dramatic move against one of our high probability spreads, all the indexes will move in kind. The long debit spread aims to provide profits reducing the net loss in the short spread.
Some of you might have heard us refer to this trade tactic as our Paris trade and has been the modus operandi of the HiPOS Aggressive strategy since October 2018. The pairing of long and short spread comes with a little additional analysis. As anyone who has done a stock pair trade knows, this tactic benefits from successfully predicting a separation or divergence in performance of two different positions regardless of general market conditions
As such, we watch the usual indexes for opportunities to use the pairs tactic to get an advantage with our positions that anticipates a divergence or convergence. History has shown us that the indexes will naturally have some outperformance or underperformance relative to each other, but regularly revert once out of balance enough. See the chart below. It shows the difference in the 20-day change of the S&P 500 and the NASDAQ 100 going back to June 2017.
The green line on the chart represents the SPX 20-day change MINUS the NDX 20-day change. When the green line is above 0% it tells us the SPX has outperformed the NDX over the past 20 days. When the green line is below the 0% level, it means the NDX has outperformed the SPX over the last 20 days.
As you can see, the chart oscillates regularly between the two indexes outperforming one another and appears to have range-bound limits. This informs when to expect a reversion or convergence in index performance. For example, the most recent data shows that the SPX has outperformed the NDX by 3% over the last 20 days. Or said another way considering the current market sell off, the NDX has out-declined the SPX by 3% over the last 20 days. But even if the markets were going up and the NDX was lagging vs. the SPX, we expect the green line to oscillate back to 0% and even go negative. This is what helps us choose a bias that benefits if the NDX performs better than the SPX.
This divergence methodology is an important factor when choosing both the indexes and the bull/bear bias of the positions. In this current example, we want to be bearish SPX vs. an NDX bullish because the NDX has underperformed more than the SPX.
Its important to note that convergence of the indexes is not guaranteed to happen before expiration. In the past we’ve seen plenty of examples where the divergence continued well past its historic range leaving our protective position ineffective. In those situations we’ll have take defensive actions when necessary through trade management and usually comes with a degree account volatility.
There’s more to come about this strategy and we understand it is complicated. Combining the philosophy of premium selling with pairs trading isn’t very common. So, feel free to reach out to us with questions and what you’d like to see in these posts. As with all option trades, the most interesting parts come when we have to manage through a position. So be on the lookout for updates when the markets decide to act in improbable ways.