HiPOS Weekly Update: Tested but Hanging Tough

By Derek Moore

HiPOS Conservative Update

The S&P 500 Index (SPX) closed Tuesday afternoon down for the day after trying to rally into positive territory.

Despite the downturn, the SPX remains almost 11% out-of-the-money (OTM) above the short put leg in the current open credit spread. With 13 trading days remaining until expiration, the trade is showing an unrealized loss. Time decay is helping as we are past the initial period right after entry. The distance OTM is still a healthy amount while the implied volatility in the market is hurting the value of the spread.

Remember, as sellers of volatility, we take in a credit and then want the trade to eventually expire worthless to realize a full profit. 

We’ll get to what we want to happen in a bit, but while the trade is being tested, it is holding up relatively well.

Reviewing The Graph

Above we have our normal illustration showing the chart of the S&P 500 Index, the horizonal dotted papaya line showing the short 5150 put level, the blue dotted vertical line representing the March 21st expiration day, and the pink ZEGA Risk Curve.

The distance on that graph from the current SPX price to the short spread leg of 5150 represents the OTM amount. The risk curve represents areas between now and expiration where if the SPX should fall below it, we may take a more defensive posture to further manage risk. We normally point out that the reason that line curves down and to the right is due to the positive time decay inherent in short volatility trades.

The probability of a current market getting to the 5150 level is determined by the current implied volatility, time to expiration, and the distance OTM.

You might notice that Tuesday’s candlestick bar drifted down towards that risk curve. It didn’t move below it and every day that passes, that line drops down further and further until we get to expiration day. The reason you see that shift is that as time passes, the probability changes as to the likelihood of the SPX closing below the short 5150 strike.

The less time and the more distance the current market is from the short strike leg, the lower the probability.

Now as Implied volatility has risen, that also changes the calculus in how likely a market is to reach a level.

We sometimes reference this in our podcast “Broken Pie Chart” around earnings around what the options market is pricing in for a one standard deviation move. Leaving aside the math, just understand the higher volatility, the greater potential move is being priced in.

Back to the curve, while we don’t disclose publicly our internal rules for trade management to protect our clients using the strategy, I’ll share that when the SPX (or other underlying) moves below that line, it means there is more sensitivity to corresponding changes in the underlying.

I promised no math so for now let’s move on to what you want.

What Are You Rooting For?

Obviously, you want the market to move higher.

Of course, it can hang around here and go sideways or even move lower, but given where it is currently, more breathing room would be welcomed.

The other aspect you want is a drop in volatility which has risen as you can see below in the graph.

Source: Bloomberg

While this most recent close on the VIX Index of 23.51 isn’t nearly as high as December’s or August's, it is elevated which means the value of the spread is higher due to the volatility component inherent in option pricing.

You want that to drop.

Then you want time to move forward.

I mentioned that there are only 13 trading days left after Tuesday until the March 21st expiration. Time decay is an asset when selling premium and the less the better is the general rule with OTM options.

If anything changes, we’ll post an update but if not we’ll plan on our regular weekly update next week.

You can check out our website https://zegainvestments.com/products/hipos to learn more about HiPOS, its risks, and benefits for yourself.