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New HiPOS Trade: How Debt Ceiling Volatility Creates Short Volatility

By Derek Moore

New HiPOS Conservative Trade

More debates and indecision around the debt ceiling?

ZEGA’s trading team decisively took advantage of the jump in implied volatility by entering a new short put spread position. When implied volatility jumps, it lets us sell volatility via short spreads further away from the current price of the S&P 500 Index. All the while collecting the required premium compared to the risk.

We are always watching the volatility surface.

Last Thursday very near-term implied volatility (how pricey (or not) option premiums are), was conspicuously very low given all the news in markets.

That has quickly recovered as some fear has crept into option markets to coincide with the debt ceiling headlines. The combination of a pop in volatility with a retracement of the market (S&P 500 Index) means we get a better entry on the heels of the prior trade that just expired at full profit. We’ll get to the particulars in a bit, but I’ll note the distance between the short 3350 put leg and the market is around 18.5%.

Again, the ability be further away while still getting enough premium is directly related to higher volatility levels and creates a better opportunity for you and your clients.

HiPOS Position Graph

Above we see our normal graph tracking the price of our underlying (S&P 500 Index), expiration date (June 23rd), and short put strike level of 3350.

At the time of entry, the S&P sat roughly 18.5% above that 3350 level. This is the amount the short put leg of the spread was out of the money. Then we have the curved purple line. We like to include this as it provides a visual of where, should price close below this line, ZEGA’s traders may take a more defensive posture to further manage risk.

The more time that passes towards expiration day, the more time decay erodes the value (premium) of the spread.

As sellers of volatility, we take in premium and eventually want that value to go to zero at expiration to realize a full profit.

The sloping nature of our purple defensive posture line reflects that positive erosion of time decay and reduced probabilities that a market will reach that 3350 area. The more a trade moves toward expiration day, the more room to breathe it has.

Off course we have rules for all of this, but we like to give a little insight and what you want to root for.

What Are You Rooting For?

Since this is a short put spread, you want the markets to hang out where they are or move higher ideally.

It’s also fine if markets move lower so long as they don’t move too far too fast down towards that 3350 level. As we mentioned above, as a trade seasons and time decay starts to erode, flexibility in where the S&P 500 Index can go expands.

It’s worth noting you also don’t want volatility to experience a large spike higher as that will negatively impact the unrealized gain or loss of an open position.

As the trade moves along we’ll be back with more updates and insights.

 Now for the Particulars: 

  • Index: S&P 500 Index
  • Position type: Short Put Spread
  • Short put strike: 3350
  • Long put strike: 3300
  • Put Spread Risk (prob. ITM): < 1% at time of entry
  • Targeted total return: ~1%
  • Distance Put Strike OTM: ~18.5% at time of entry
  • Expiration: June 23rd , or 20 trading days until expiration