Executive Summary

The implied volatility curve around the September 21 FOMC is steepening.  Rich discusses a Tues-Wed E-mini S&P 500 (ES) delta neutral horizontal strategy to express a long volatility view.

Investors and traders are back from the summer holidays meaning that the markets are back in full swing. Not only is participation back to capacity, but volatility has returned to the market in a big way. This past Tuesday, traders saw the August CPI reading come in at 8.3%, 0.2% higher than expected. Immediately, rate hikes were priced into the Fed Funds futures market and equity traders reacted. By the end of the day, ES1 was down over 4% in a three standard deviation move. A move we should expect to see only once every three years, and which we do not typically see on the back of an economic data point instead of a bigger headline event.

The rationale made sense. As you can see in the Figure 1 chart, in the forward EV/EBITDA, the expectation of rate hikes in the future that I back out of the Eurodollar futures curve are inversely proportional to the multiple equity investors are willing to pay for stocks. The last time the number of rate hikes were expected to be this high was in June, a time when the forward multiple was at 11x instead of the current 12.3x. Some positive investor sentiment needed to come out of the market.

Figure 1: One year rate hikes from Eurodollars vs. Forward EV/EBITDA multiple of S&P 500 Index

This brought the futures down to the trend line that has been forming from the series of the higher lows we have seen over the course of the summer. The longer-term downtrend line was not tested on this recent move higher. Technical analysts are accustomed to say that triangle patterns tend to break in the direction of the shortest line. If that is the case, there could be more downside ahead for the Equity market.

Figure 2: ES futures Ichimoku chart with trendlines

One factor working against that is the bearishness that pervades the market currently. Based on several surveys and measures of positioning, equity investors are already quite bearish. A great example of this comes from the latest Commitment of Traders report that shows levered investors have a sizable short position built up. While not as extreme as June, it still may show that traders are currently leaning in one direction.

Figure 3: Commitment of Traders report - leveraged funds E-mini positions

Also, add onto the potential catalysts of this upcoming earnings season. If one looks at the latest readings of ISM, which came in better than expected at 52.8%, we still see that we are in a downtrend having peaked over one year ago. In addition, the ratio of new orders to inventories anticipates the direction of the ISM going forward, which makes some intuitive sense. If new orders are falling and inventories are building, the pace of economic activity should be slowing. The level and direction of ISM also correlates with the percentage of positive earnings surprises in the S&P 500 Index. This is expected to fall as well. Falling multiples and falling earnings is a dangerous combination, perhaps indicating why bearish positioning is so large.

Figure 4: ISM, ISM new orders to inventories and percentage of positive earnings surprises in S&P 500 Index

This puts a lot of focus on the next major catalyst for the markets, which happens at the FOMC meeting on September 21, 2022. As I mentioned before, the number of rate hikes moved higher after the CPI report. Instead of wondering if we would get 50 or 75 basis points, the question has now turned into whether we get 75 or 100 basis points.

Figure 5: Target Rate probabilities - September 21 FOMC meeting

Expectations at future meetings have changed as well. If we look to the November FOMC meeting, we can see that the modal probability has moved to 75 bps, which was 50 bps only a few days ago. The market sees the Fed as potentially becoming much more hawkish.

Figure 6: FOMC meetings target rate probabilities

Looking at what is priced into the SOFR futures market, we can see that a 4% terminal funds rate and a policy path that looks much more like the Fed dot plots is now the expectation. Remember, it was only a month or so ago that the market was much more dovish than the Fed, something Fed speakers took great pains to try and reverse in commentary post the July 27 FOMC meeting and the August Jackson Hole speeches.

Figure 7: SOFR futures vs. Fed dot plots

This all suggests to me that while there may be some consensus forming around the direction and even the magnitude of rate hikes on September 21, the commentary from Jay Powell in the press conference after may be the most important event of the week. What will the forward guidance look like? For me, it suggests that I might want to own volatility for that particular event, but how do I know if I am paying the right price? In the book “Dynamic Hedging,” Nassim Taleb gives us the formula for computing the forward implied volatility for the period between two expirations:


Looking at the various E-mini S&P 500 (ES) options in the market now, we have daily options along with weeklies, regular, and end-of-month expirations. In early October, Tuesday and Thursday options will be added to the current listings on the Nasdaq-100 (NQ).* This allows a trader to pinpoint the exact events they want to position for. In addition, the level of implied volatility across these shorter dates can vary considerably based on whether there are catalysts or not.

* Pending regulatory review

Figure 7: SOFR futures vs. Fed dot plots

Zeroing in on the dates around the FOMC meeting, we can see that the implied volatility curve is quite steep around the next FOMC.

Figure 9: E-mini S&P 500 (ES) option term structure – four day view

Using the formula above, we can back out that the implied volatility for the FOMC event is a shade over 37%. We get this by bootstrapping between the 22% implied volatility for September 20 and the 24.7% volatility for September 21. A 37% implied volatility approximates a daily move of 2.34% if we use 252 trading days and the square root of time. I compare this expected move to the actual high to low moves we have seen on the other FOMC days this year. It would be the lowest expected move for the year, at what may be one of the most pivotal meetings of the year.

Figure 10: Expected move for September FOMC and actual moves from 2022 FOMC meetings

Short-Dated ES strategy example

For me, the trade then is to get long this forward implied volatility. I might suggest in one of the most pivotal meetings, in which forward guidance will play a large part and where the market sits at a technically critical level and positioning is extreme, the expectation for forward volatility should not be near the lowest of the year for an FOMC meeting. For this example, one could sell the September 20 ES 3975 calls and buy the September 21 ES 3975 calls. This trade sells a 22% implied volatility and buys a 24.7% implied volatility as the calculation above showed. There is no Greek risk until after the September 20 expiration. At that time, one could delta hedge the 3975 calls to make them delta neutral. This would result in a long one day straddle, priced for a 2.34% expected move on that day, and delta hedge accordingly based on the news.

Figure 11: Short ES 9/20/22 3975 calls/Long ES 9/21/22 3975 calls

With the flexibility offered by virtue of daily options, traders can fine-tune their trading strategy for a particular event. As previously mentioned, in early October, Tuesday and Thursday options will be listed on the Nasdaq-100 (NQ), giving traders even more flexibility to express their views. By learning how to bootstrap what is priced into the implied volatility term structure and comparing that to the empirical results of previous moves around similar catalysts, a trader can determine what may seem relatively inexpensive or expensive. The opportunity to fine-tune a trading strategy has never been better in ES or NQ options.

Good luck trading.

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