The basis for the Excell with Options this week will be looking at the largest option hedger in the market. Those who have been trading options the last several years may be aware of the market-driving collar hedge done by the portfolio managers of a large bank. The notional size of their hedge is as much as $26 billion notional. They always used a put spread collar, selling an upside option to fund the purchase of a downside put spread. This put spread was the disaster or massive drawdown protection, while using a call to fund it helped protect against the drag on returns that options premium can be. Since the size is so large, the open interest left a large footprint in the market so all traders knew where the strikes were and could attempt to position for the strikes and for the roll each quarter. This quarter, the bank’s traders used the S&P 500 Month-End futures and options (SME) plus basis trading on those futures (SMET). This product creates a more bespoke hedge for the traders because of the size (double E-mini), settlement (afternoon on close) and style (American vs. European) meaning less operational complexity, tighter execution and potentially less market impact. 

In my QuikStrike Spreadbuilder, I created the bank’s put spread collar from their perspective to show the graph of how it hedges their long equity exposure. In addition, one can see the Greeks from the bank’s perspective, knowing that the Street has the opposite position on. At the time of trade, the Street is getting long options as one can see the bank is short gamma and vega. This is because it sells two options and buys one option. In addition, one can see the net cost is close to zero, the goal of the option collar, but the structure provides one-to-one downside protection between the option strikes. Below the lower strike, the bank become long again; however, long fund portfolio managers are not afraid to get long again when the market has gone down 20% in the course of a quarter. In fact, the bigger risk to the bank is that markets move above the call strike, up 6.5% from the time of trade, which would see the deltas of the fund “called away” meaning there is substantial tracking error. However, there is no such thing as a free lunch, and this is the cost for the hedgers that they presumably are willing to bear because the explicit cost of option premium does present a drag on portfolio returns. It is always a question of trade-offs and this is that tradeoff.

Above is the same spread but at current futures prices. One can see that in the two weeks since the trade was put on, futures have moved almost to the upper strike, meaning dealers have gotten much longer gamma. This will mean there is dealer delta hedging that could serve to slow the pace of the market move higher. Bear in mind that this option position still has almost three months until expiry, which means if futures are anywhere near this level over the next month or two, the gamma position will only continue to get larger for dealers since gamma grows as markets approach expiration. This gives one a sense of the market impact from this position.

Looking now at a graph of implied and historical volatility, one can see that the volatility risk premium, or difference between the implied and historical volatility, has collapsed. In fact, it is negative. This is due to a couple of forces. The first is that historical volatility by its very nature is lagging. It is tracking how much the market has moved over the last 20 days, not how much it will move over the next 20 days. The implied volatility is a traders’ best guess at the next 20 days, based on elements of serial correlation and mean reversion. Serial correlation means that if markets have been volatile, one would expect it to remain so for some period and vice versa. Mean reversion meaning over a period of time traders will expect volatility to revert back to its long-term levels. There is another driver of implied volatility though – supply and demand. End user activity will also have an impact on implied volatility levels and as shown in the previous chart, dealers have already moved into a large long gamma position. It was large at the start of the trade and only got bigger. This means market markets are long gamma and vega, so when asked to price new options ideas, their price will be biased lower because they don’t want to get longer knowing how large the theta bill is already. What dealers see as additional risk can potentially be an opportunity for option traders, though.

Looking at CME Group S&P 500 Month-End options, I turn to the implied volatility surface to see where there might be opportunity. From this surface, I can see that the upside options have a deep discount vs. the at-the-money options as they tend to. I also see downside options with higher implied volatility, but this really starts at 25 delta and below. Options that are closer to “at the money” do not have much volatility premium. As I look at this, I feel like there is an opportunity to get long volatility, so I am naturally drawn to a strangle. The implied for the calls will be lower, and if the put strike is closer to the at-the-money, the overall volatility will not be that high. In addition, by spreading out my strikes, I can avoid being long what the dealers are long because I fear their prices for what they are already long will bias prices downward. Finally, I can see that the June S&P 500 Month-End prices are biased lower vs. the dates around it. For me, the May expiration looks attractive because it is the next lowest implied volatility among the Month-End options. Strangles in the May month-end period may be the best place for traders to look.

Putting this all together, I opt to buy a May Month-End 6600-7000 strangle. I know that traders are essentially at the dealers’ long option collar strike right now. However, this is still about three months away, so things are not at the maximum option Greeks. Yes, they have already biased prices lower, as one can see in the implied vs. historical volatility graph. This is a risk but is also an opportunity. I see opportunity because there are still a considerable number of catalysts that could see both sides of the strangle achieved. For starters, the world is still in the middle of the Iran war. When there is news of a ceasefire, futures move up sharply. When there is news of more bombs or struggles in peace talks, futures sell off. This alone may be catalyst to a long gamma position. I have effectively paid a 17.5 implied vol for this strangle, and knowing options move with the square root of time, I know that means I need 1.10% move per day to breakeven on my theta bill. Given moves the last 20 days, that seems achievable. Will that last? That gets me to my other catalyst. The market is starting earnings season. By all accounts, earnings are still expected to be quite good because of tax code changes and the tailwind from previous rate cuts. However, the market will be focused on the commentary about uncertainty over the rest of this year because of affordability issues that may be the result of higher oil and gas prices. This earnings season alone could create a good deal of volatility that traders can take advantage of by owning strangles and scalping their positions. 

Implied volatility may be too low given the potential catalysts in the market over the coming month. This has created a big gamma and vega position for dealers leading them to offer implied volatility below the lagging historical volatility so that they do not add to an already large, long position. This creates opportunity for traders who are content to take some of that gamma off their hands and scalp deltas against it. 

Using the tools CME Group provides to monitor options market activity can help traders create opportunities to have convex positions to navigate uncertain times in the market.  Good luck trading!

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