Executive summary

Veteran institutional trader Rich Excell reviews two E-mini S&P 500 option strategies for potential volatile markets around known catalysts.

  • Straddle using E-mini S&P 500 options
  • Calendar spread with weekly options

The world is becoming a very interesting place with many crosscurrents. In just six weeks, we have already seen:

  1. A double digit stock market correction despite earnings which remain quite healthy.
  2. A short-term interest rate market that has gone from under three rate hikes to seven rate hikes priced in for the next 12 months.
  3. Geopolitical concerns with major implications for the price of energy in Europe and the rest of the world.

That is a lot to get through, particularly when risky assets were quite fully valued as we ended 2021. Thankfully in our first three issues, we have discussed each of these topics.

This is typically when investors and traders alike are looking to add convexity (long options) into their portfolios. Remember from the first issue, options are insurance. The buyer of insurance is adding a risk management tool into their toolkit. Sometimes, however, insurance can get over-priced relative to history. This is when those with the right skillset can step in and sell this insurance and manage the risk in other ways.

With all these moving parts, it may not be time for most of us to think about selling insurance. Even though the catalyst of earnings are out of the picture, there are plenty of other events that still could occur, not the least of which would be any geopolitical stress. The next several weeks bring several important economic data points that could potentially impact the pace and magnitude of central bank rate hikes. Remember, implied volatility is the measure traders use to price an option. It is the expectation of the volatility over the life of the option. It should not be confused with historical or realized volatility, which is the volatility that the underlying asset actually moves on over a given period. The two are different but related. Traders will base their forecast on what has happened, but also on what the longer term mean value is for implied volatility. One can compare the two levels to see if there is a heightened sense of nervousness in the options market.

Figure 1: Implied vs. historical volatility

In Figure 1, I look at one-month implied volatility versus a rolling measure of 20-day historical volatility. The picture on the right is a graph of the spread between the two, showing that we are in the middle of the distribution over the last three years. We never know what the future will hold, but right now, options look fairly priced.

Long ES Straddle Example

When I speak to my derivatives class, the first three things I tell them to consider when designing a strategy are:

  1. What is your view on the direction of the underlying?
  2. What is your view on the volatility of the path to get there?
  3. How confident are you?

From there, we can start to think about the type of options structure to build and whether we want to be net long or net short options. I think if I asked most people these questions right now, I might get answers like:

  1. No idea what direction we will move 
  2. A choppy or volatile path
  3. I am not very confident

This is to be expected given the many crosscurrents mentioned earlier. If these would also be your answers, you might want to think about a long straddle position using E-mini S&P 500 (ES) options.

Here I have chosen one that will expire on March 18, after the release of major U.S. economic data and the next Federal Reserve meeting. In addition, any moves that happen because of the Russia/NATO stand-off may also benefit the position. A picture of the breakeven of this position is as follows:

Figure 2: Long ES straddle

Another way to think of the breakeven point of this strategy is to look at it on a graph of the underlying asset. In Figure 3, the red lines represent the levels where this long straddle would break even. These lines also roughly characterize, by change, the range of the market this year. If there is no incrementally new information, one might think this straddle looks expensive. However, will we really get no new information? Will we find out anything on Russia? Will there be a military conflict once the Olympics end, as many suggest? Will we get global economic data that could dictate the path of interest rates?

Figure 3: ES Underlying

Traders who may want to express a view on the near-term market volatility can also trade the changing delta of the structure as the underlying price moves. Traders will typically look to re-hedge throughout the trading day, as long straddle positions allow one to buy low and sell high. Even if the market stays within this range, but revisits both the highs and lows repeatedly in the next month, a trader may potentially re-coup the cost of the straddle. The risk and fear when one buys a straddle is that nothing happens, the market is very quiet and the option prices decay toward zero at expiration. With an FOMC meeting two days before expiration, it is reasonable to think that the usual path of time decay could be delayed in the case of this straddle.

Long a call calendar example

There are other ways to express a view in markets like these if a trader wanted to take a directional view. Let’s re-consider the questions to ask when considering an options strategy. Perhaps a trader may answer those questions as follows:

  1. I am bullish the S&P 500 Index
  2. I think that volatility might stay high in the very short-run
  3. My confidence is okay

A bullish view could suggest a long call or call spread strategy. The lack of confidence might mean that a trader wants to stay net long options premium as they are not confident enough in their directional view to sell puts. Finally, the short-term volatility expectation may help reduce the cost of the overall trade, giving a potentially better reward vs. risk position.

For this example, a trader is taking advantage of short-term volatility to sell an ES March 4 4500 strike call and buy an ES March 25 4500 call. Why do this? A trader, while bullish, may understand that the market likely will not have a sustained rally until the FOMC policy meeting is over on March 16. Implied volatility will likely be high in the week ending March 4, not only because of the Russian situation, but also because that week, we will get data such as the ISM and non-farm payrolls. In Figure 4, you can see that the March 4 implied volatility (19.2) is slightly below the March 25 implied volatility (20.4).

Figure 4: ES March calendar spread

There are many possible scenarios that could play out. For one, what if the Ukraine situation is resolved and economic data is soft, causing the rates market to reduce the odds of a 50 bp hike in March? If so, the stock market could rally even before the March 4 expiration. In this case, the trader is both long and short calls on the same strike. The resulting position would be neutral, as shown by the right side of the graph in Figure 5. The lower curves represent if a quick move happens, the higher curves if it takes longer. The longer it takes for the market to rally, the higher the expected return. If the market moves higher right away, the expected return would essentially be zero, with no net position in options. If the move doesn’t occur until after the short call expires, the trader potentially could have a greater profit.

There is another scenario, however. What if the news on Ukraine worsens? What if the economic data in the March 4 week is strong and the overall equity market takes a leg lower? In this case, both options could conceivably expire out of the money. Again, the left of the graph shows these moves. The sooner this type of move happens, the worse the trader might do. At expiration, however, they would only lose the premium invested, as shown by the purple line.

What would be the optimal situation? Perhaps the market does not move much or even goes lower between now and March 4. The 4500 calls on that day would expire worthless. What if the Federal Reserve then decides to hike only 25 bp in March, and the market has a sharp rally higher on March 16 before expiration? In this case, the trader is left with an individual long call option expiring on March 18. They can reduce the cost of this option by 60% by considering a calendar spread.

Figure 5: Expected return on the calendar spread

When trading and investing in markets with so much uncertainty, traders must be aware of the potential outcomes and their associated risk.  I would also suggest asking yourself:

  1. What do I think of the direction?
  2. What do I think of the path we will take to get there?
  3. How confident am I?

Answering these questions can help you determine how you want to implement your views.

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The opinions and statements contained in the commentary on this page do not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs. This content has been produced by [Data Resource Technology]. CME Group has not had any input into the content and neither CME Group nor its affiliates shall be responsible or liable for the same.


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