As February winds down, there are many negative headlines weighing on the markets. However, stepping back and looking at a daily chart of the Nasdaq-100 futures, the market still appears to be in a strong uptrend. Importantly, when prices breached the Ichimoku cloud last summer in August and September (white candles), we observed the lagging span (red line) never broke through the cloud. This indicated that the trend remained intact and those were buying opportunities. One thing that may worry traders here is that the Ichimoku cloud itself is starting to flatten, indicating that the market may be moving into a period of consolidation. Does that make the futures more vulnerable to negative news?

Underpinning the trend of the market has been the earnings of the leading stocks in the index, primarily in the tech sector. With the earnings season 80% completed, we can see that once again the earnings are coming in better than expected. The earnings analysis on Bloomberg shows us that while sales haven’t been much of a surprise at all (0.45% surprise), there is still a 6.44% positive surprise for the index. Consumer discretionary, energy and real estate have been leading the charge in terms of earnings surprises. While there is much discussion about the impact of AI on the market, we can see that the tech sector has only had a 2% positive surprise this quarter. The lower right corner of that top chart shows that when sectors have positive earnings, there are positive sector moves and vice versa. Earnings are certainly important.

The bottom chart shows the earnings expectation priced into the market currently. On this metric, we can see that there is a very high bar right now, as over 17% growth in earnings is expected this year and 15% in the next. It is because of these high earnings expectations that the market valuation looks less onerous as we look out further. However, if earnings do not materialize, the valuation of the market can become a bigger concern.

Looking at a chart of the Nasdaq Index the last few years, we can see that the forward P/E of the market has been moving coincidentally with the market. P/E multiples are a measure of investor sentiment, and what we observe is positive sentiment drives the market higher (top) and eventually, the earnings growth catches up to the price action in the market. The bottom chart is interesting, however. This shows the estimate for current earnings for this year. You can see that each year around March there is a ratchet higher in earnings that the market uses to price stocks. This is when traders and investors stop looking at 2024 numbers and prices in 2025 numbers, you know the ones where there is a 17% growth priced in. However, as we saw in 2022, when these earnings are trending lower before the ratchet, the bump higher is not as large as when earnings are trending higher into the March period. Thus, the bar is set quite high but perhaps after an earnings season that was fine but not really great, particularly when it comes to the tech sector, we won’t see as large of a bump higher in the forward earnings the market uses to price. Is there scope for tech earnings to not carry the market as much going forward as investors paying a premium P/E may be thinking?

Perhaps that is what leveraged money is thinking right now. As we can see from the recent Commitment of Traders report, leveraged money is the shortest it has been in Nasdaq futures for the last three years. Do traders know that the bar is set high, and they are looking for disappointment here? If markets break down technically, is there scope for these positions to move even higher? It is quite interesting to see such a short position when we did not witness the same magnitude of a short, even in the de-risking events of August and September last summer. 

Turning to the options markets, it is time to dig into where and how we may want to express our idea. The top chart shows the term structure of implied volatility for options on Nasdaq-100 futures. There are options that expire every day of the week in the Nasdaq-100, which gives traders the ultimate flexibility. The setting I used on QuikStrike shows all expirations that are less than 30 days, so I am able to see the implied volatility of each expiration and decide which one may best fit my needs. I am looking at a couple of different catalysts. The first is the March FOMC on March 19. This is when we will get the new DOT plots from the FOMC. Will investors get nervous if the FOMC doesn’t see the same number of rate cuts as the market does currently? The second catalyst also occurs mid-month and this is when analysts start updating year ahead earnings and the market changes focus. For this reason, while there are daily options to use, I wanted to use the March expiration (March 21) options so that I will be sure to capture both of these catalysts. I can also see based on the term structure that this is one of the lowest levels of implied volatility for options expiring in the next 30 days.

Turning to the pricing of implied volatility by strike within that expiration, I can see that put options carry a large premium to the at-the-money options while call options trade at a discount. I want to make sure that the options I choose for my trade idea take into account the skew within the expiration so that I know I am getting good relative value for my idea.

I see that the technical support for the Nasdaq futures comes in around 21,000. Thus, I want my structure to have the top strike around that level because that could be the point where a move lower stalls out, with the bulls battling the bears, or where there is an acceleration of the move. I like to use asymmetric strikes on these butterflies because it is a low premium way to express a direction view. If there is a consolidation and bulls and bears battle, or if the FOMC is not a catalyst, potentially we see something akin to last summer, as the futures price dips below the cloud but the lagging span does not. If this is the case, there is a possibility that at March expiration, we hit my maximum P&L of 900 around 20,000.  However, if prices break down, I still make money because the difference of the strikes would make me 500 ticks, but I am spending less than 100 ticks on this entire structure. Thus, on a large move lower, I would still make 400 tick profit. The risk to the idea is the premium I am spending of 97 ticks, so it is a fixed risk idea. I don’t mind buying some options at these levels because there are catalysts coming up and we saw on the term structure of implied volatility that we are buying at a low point in the curve. However, I have also used the skew to my benefit by selling 2 of the 20,000 puts that carry a higher implied volatility than the 21,000 puts (4 vols different). Yes, I have to pay even more for the 19,000 options but because they are further out of the money, the absolute premium is lower.

This butterfly gives me a good reward to risk way to play a potentially bearish outcome. If the move stalls, I can make 900 vs. the 97 ticks that I spent. If there is a big move lower, I still make 400 vs. the 97 ticks spent. Either outcome has attractive reward to risk. The worst case for me is finishing at or above the 21,000 strike and I lose all premiums.

With daily expirations giving the ability to customize, and several tools at their disposal to analyze the different expirations, options on Nasdaq-100 futures provide a very interesting way for traders to find asymmetric reward to risk ways to express their views. Flexibility and functionality are great tools for the toolkit.

Good luck trading!

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