By Derek Moore
After yesterday’s Federal Reserve announcement of another ¼ point rate cut, the market settled back in as volatility was removed from the market. Now many long time HiPOS followers might logically think higher volatility on Fed announcement day would have been a better environment for the trade?
Most of the significant volatility premium was contained in the very short-term options and would not have worked as part of the HiPOS Conservative strategy. However, there was still enough implied volatility left in the October monthly expiration to find a put spread that met ZEGA strict entry criteria.
Now to the new trade. For this vintage we’ve put on a short put spread position with an October 18th expiration date on the underlying S&P 500 Index. Specifically, the 2650/2600 strikes are utilized with a target profit of 0.90% or .45 cents. This will have about 20 trading days until expiration. At the time of entry, the S&P 500 index was roughly 12% above the 2650 short put strike.
One of the interesting things about this position is the difference in how the options market risk model differs from our own. We run calculations to ensure that a position qualifies based upon ZEGA’s risk models. Often, we find inflated risk premiums in the market, hence an opportunity to profit with lower actual risk. However, in this case, our model was more rigid in that it portrays risk as higher than what the market numbers say.
Put another way more plainly, we were more conservative with our position selection, than where the market has evaluated risk. This means that our spread was farther away than what traditional models would dictate hence yielding a little lower profit target than usual.
Finally, while we are not entering positions based on timing or directional view of markets, this expiration does occur prior to earnings season and future fed announcements. Naturally, there is always “Tweet risk” these days, but the scheduled news cycle should be less plentiful.
Now for the Particulars
- Index: S&P 500 Index
- Position type: Short Vertical Put Spread
- Short strike: 2650
- Long strike: 2600
- Risk (prob. ITM): <1% at time of entry
- Targeted return: 0.90%
- Distance OTM: ~12% at time of entry
- Expiration: October 18th or 20 trading days