CNBC: Friday Close
Tracking the Trade*(please read disclosures):
Our market volatility bulletins tend to come in two major parts: one where we cover general activity in the equities markets and the VIX, and another part where we identify and then track a trade over the course of several days.
On Friday, we wrapped up our sim trade that we initiated on Monday, January 30. This piece will review how we closed the trade, and in a sister piece we shall comment on how it went, strengths/weaknesses, etc. To be clear, there is no great reason as to why the trade "should" be closed; we just set a two-week time horizon on the position, and so we're sticking to that.
As a reminder, the focus in writing these pieces is educational. We repeat during our Market Bulletins that these trades are not actual recommendations; we are not "telling" you what to do, but rather we are walking you through what a reasonable way to execute a strategy would be in the event that you the reader similar a similar thesis to that stated just below.
The bulk of this piece informs readers as to what our original thesis was, and then discusses the mechanics of how to most effectively close this trade down.
Our opinion is that investors and traders give way more attention to developing a strong thesis than they do to understanding tactics or mechanics. This is a mistake. Please carefully read how we conduct a "hard close" on this trade that we've gradually instated over the last two weeks.
Buy-the-Dip is clearly still alive for now (as we observed last week and every week for SPDR S&P 500 (NYSEARCA:SPY)), but the market has over-reached. The CNBC article that we referenced in Thursday's bulletin speaks to a market that has entered an almost dream-like phase. VIX tried to pick up the week before last, but it failed early and failed hard.
Even at peak nervousness, the index never made it to a thirteen-handle over the past two weeks.
Front-end VIX contango is simply a marvel at these levels. From our perspective the catalysts for increased volatility keep coming, but are summarily disregarded.
We hypothesized that any meaningful pullback would be instinctively bought up, at least initially. Our downside action was therefore limited due to market knee-jerk reactions built in over the past four years to buy any SPX weakness. Therefore, while we preferred a trade with an inverse exposure to SPY, it was not our primary objective as we illustrate the dynamics of this particular trade.
The week before last, we "legged into" a long-volatility play whose sensitivity to time is positive rather than negative. In other words, rather than enduring a nasty contango with a long-VIX product, we could get positive exposure to both volatility and time. In keeping with wanting a VIX-like product, we will also set a negative exposure to S&P price movements.
For those who do not know, "legging into a trade" refers to the popular practice of gradually building into the overall position rather than trading all the desired options legs at once.
First: the visualization of our two trade legs put on for the week of Jan 30-Feb 3:
We normally cover tactics (the how-to) before mechanics; seeing as we're closing out this trade, discussing how we do so first may be valuable.
Over the past several sessions, we placed the following trades:
Our objective was to take a trade that "acted like VIX" over a certain defined range of times and S&P values. As such, we gradually built a position that had a positive exposure to VIX, a negative exposure to the S&P itself. Finally, we wanted a position that paid us with the passage of time via positive "theta", rather than costing us the roll yield of contango. While it is not strictly possible to fully eliminate that contango (you pay it in other ways), the theta acts as a strong offset.
We'll dissect the trade in our follow-up piece tomorrow, but for now we shall discuss a "hard unwind". By a hard unwind we are referring to removing in absolute terms all our exposures; this is likely not the way that we would actually unwind this particular group of options.
That said, a hard unwind is the most straight-forward from an expositional standpoint, and it's the most "honest" close. So this is what we shall explore below.
Unwind the Mar 2150 2175 put spread
Feb 7's trade modification effectively gave us a 25-point put spread ("ps") for March expiry. We'll take this off at a credit of $.90 (very liquid and easy to do).
Unwind the Feb, end-of-Feb ("EOM") 2300 call spread
On Jan 30, we sold a Feb 2300 call; on Jan 31, we bought an EOM 2300 call. It is quite simple to unwind this as a pair.
Unwound for a credit of $5.25.
Repurchase the EOM 2275 P
At a price of $5.25, this would be a prime candidate for a soft close. We could for instance buy it down 30 strikes and pay half the price, but then have to sit on it until end-of-month. There are any number of ways to calm this option down other than simply buying it back, and frankly we'd likely avail ourselves of one of those possibilities. Still, we're conveying a hard close here.
Sell the Mar Apr 2150 calendar spreads 4x
This is where most the pain on this trade lives. We purchased these for a combined total of $39.50; they are now worth $31, for a combined loss of $8.50 on the second leg. It is highly likely that we would do a soft close on this as well, which would carry the strong potential to reduce those losses to perhaps $4. We however will sell these out as-is.
Most nuanced close: The Feb 2285, EOM 2320 Call Spread ("cs")
The call spread is the trickiest here, due to the fact that next Friday's call is in the money and fairly near expiration. It is under these circumstances that options can get quite illiquid. This was the bid-ask on Friday:
Before we go on, once again perhaps a soft close is in order on this position. One could allow this trade to play out more if so inclined.
Now, at $1.25 wide, this trade is not horrifically illiquid; it is quite possible that we could get filled somewhere at or near the mid. Still, notice "2" on the bid and "2" on the ask: not great. In this particular instance, what we are about to demonstrate for you would not be too important (though still useful); other times, it is indispensable.
"Calls are puts and puts are calls"
All options, call or put, are basically a big basket of sensitivity to various factors. For example:
- "How does the call price change if the underlying goes down a point?"
- "How does the put price change if all else is held constant and another day passes?"
- "How does the call price change if implied volatility picks up?"
And so on and so forth. Sure it takes some learning: we believe that not only is this subject matter fascinating, but can also be quite profitable and can afford investors a rich new view of the world.
We'll detail this in future pieces, but if we take aside differences in market liquidity, we can use put-call parity to buy our call more efficiently than going into the options market and buying back that illiquid, wide bid-ask call.
Source: The Options Guide
We understand that for many people this is starting to look more complicated than they'd like. And at first, it is complicated. But with a little effort you get the hang of it and it can be quite worthwhile.
Put-call parity (formula shown above) says that we can create a synthetic call simply by trading the put with the same strike and expiration, and then buying the underlying (in this case buying an ES). So rather than buying the call, I can buy the super-liquid put and just buy ES.
Note in the trade order just above that we buy the put and also buy the futures, rather than just buying the call; for many platforms, you can just add this straight to your order. There is an extra bit of commission because you are now also purchasing a futures contract.
Notice, however, that the bid-ask spread has been cut in half from the $1.25 on the raw call spread, which more than makes up for the extra couple bucks on the futures purchase. Relatedly, notice that the bid quantity of 133 and the ask quantity of 40 is much higher than on the original spread.
In this particular instance, closing the raw Feb 2285 call is not too problematic. But in other cases, these deep-in-the-money options can really have erratic and wide bid-asks. You want to trade the synthetic here.
The following visual shows that trading the spread with the real call vs. with the synthetic is identical:
The payoff diagrams are the same because the options exposures are the same.
"But in the first instance, you're paying $19, and in the second you're paying $2304!"
We're paying $19 either way. In the first instance, we simply remove all our exposure, at a cost of $19.
In the second instance, with the synthetic call, we have left our Feb 2285 call in place, but also bought a Feb 2285 put and purchases a futures.
The combination of selling a Feb 2285 call and also buying a Feb 2285 put guarantees that we will sell the futures on Feb 17 for 2285; but we're simultaneously buying the futures at a net price of 2204: this guarantees a $19 net cost when all is said and done, just like the $19 on the first alternative!
This can be a lot to take in, and so we shall break the tactical discussion and what-worked, what-didn't conversation in tomorrow's piece. For now, we can rest assured that we have completed hard closes on each and every option and we are now flat in terms of our position.
Before we leave you though, a look at the hard close proceeds:
Using hard closes, not proceeds are $13, against a combined entry cost of $16. This would amount to a loss of $3 for the full position.
The SPX moved higher, and the VIX closed a little lower, than when we began. So this trade has moved against us. For the record, the trade was working quite nicely until the big up move on Thursday. We had warned on Wednesday that the Feb 2285 calls that we'd sold were definitely what had us most on edge, but that we wanted to allow the market to play out.
"How could this trade still go wrong?"
A really big up move in SPX over the next couple days wouldn't be so hot, and the same could be said of a large down move on the underlying. The at-the-money short Feb call is really what is driving our profitability right now. When you short an option, the best scenario is to just hang out and go nowhere. Small moves up or down from here, while perhaps not helpful for our VIX exposure, are great from the standpoint of letting that call (and the March puts we sold for that matter) melt off.
"Any way to change that?"
You could. We proposed a trade mod yesterday that was designed to remove the negative impact of a large and sustained move lower. You can always modify a current position. We just don't believe in overtrading a position. Looking at the straddle prices at the beginning of this section, the market just doesn't see a lot of catalysts for a big move in either direction. Of course this does not mean that the market is "correct"; it just does not see much cause for concern.
Thank you for reading, and we hope you enjoy the format of these discussions. Please comment below, as we are very interested in your thoughts!
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Disclosure: I am/we are short SPY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: We actively trade the FX and futures markets, potentially taking multiple positions on any given day, both long and short. It is our belief that the S&P 500 is meaningfully overvalued. As such, we typically carry a net short position using ES options and futures. We want to emphasise that these "trades" are for educational purposes, to demonstrate how to reasonably analyze, enter, adjust or modify a position. These are NOT actual trade recommendations.