Acorn Update: SPY Straddle
Our hedge against a breakdown in the crowded dispersion trade
As mentioned in the Monday Morning Notes, we are re-setting the SPY straddle, referencing the close today.
Strike: $512 (put and call)
Expiry: March 15th (we will probably roll this to April 19th this coming Friday - some readers may prefer to go straight there)
Total premium: $8.825 ($882.50 per contract pair)
Link to OptionStrat worksheet via clicking the image below.
Original thesis from yesterday’s ‘Section 2’
This week in ‘S2’ we are going to dive into the world of volatility trading. The trigger for this was the publication by my good friend
of an excellent and detailed analysis of the volatility dispersion trade.He, as well as other ‘vol’ luminaries such as Cem Karsan, have been highlighting this trade as a potential source of fragility for US equity markets. There is a link below to the note. It is paywalled, but he has kindly said that if you email him at kevin@themacrotourist.com he would be happy to share.
The TLDR of Kevin’s analysis (which in no way does appropriate justice to his 3 notes on the topic!) is as follows:
Trading dispersion involves sophisticated hedge funds and dealers holding short positions in index options against long positions in options of the underlying index constituents.
The dispersion trade has been extremely profitable in the (falling vol, narrow breadth) environment of the past 2 years. As such, it has grown massively in popularity (scale), with multiple large ‘pods’ (teams) now trading the strategy at the big multi-strategy hedge funds like Millennium and Citadel. The space is getting crowded.
The strategy is implicitly short correlation and CBOE index of 3-month implied correlation is currently sitting at 17-year lows!
These ‘multi-strat’ funds run very disciplined risk management policies and will terminate positions ‘with extreme prejudice’ as soon as things stop working (i.e., if implied correlations suddenly start mean reverting to more normalized levels).
The ‘very bad day in the office’ scenario involves single stock options going ‘no bid’ while the pods all scramble to cover their short volatility positions at the index level. The VIX potentially ‘does a Gamestop’ and goes to the moon!
Kevin is choosing to position for a potential ‘event’ via a long position in VIX futures. This makes perfect sense, but the 🐿️ has a bit of an allergy to trading VIX futures. My principal issue is that it is a reasonably expensive position to ‘carry’. VIX futures are in contango up until the US election. The cost of rolling a long VIX futures position each month starts to add up very quickly.
Given that there is no way of forecasting when a sharp change in correlation trend will occur, we do not have a sense for how long we need to insure against the risk. Remember that the dispersion trade can also unravel in a scenario in which a blow-off top sees all stocks rising in unison!
I happen to feel that equity markets are currently still hunting for excuses to rise rather than to fall. A gently appreciating market should continue to keep implied volatility pinned down. As such, we need a structure that can offset some of that cost of carry.
For this reason, I think it makes sense to explore an alternative methodology using option straddles on the SPY -0.09%↓ S&P 500 ETF.
Unfortunately, this is not a ‘fire and forget’ strategy. The position will require reasonably regular strike and maturity readjustments. Given the deep liquidity of SPY -0.09%↓ close-to-the-money options, I am not concerned about the friction costs of trading regularly.
Let’s start by looking at the volatility surface for SPY -0.09%↓ options. We will start the position with the March 15th (regular) expiry (the yellow line below), where at-the-money implied volatility is currently trading at around 11% (versus December in the mid-to-high teens IV).
To open the straddle, we purchase 1 x $508 call for $5.12 and 1 x $508 put for $4.46 for a total debit of $9.575 (or $957.50 per contract pair). Link to OptionStrat worksheet. Time for a quick 🐿️ video explainer:
I know that some of you don’t watch the videos (you all have your reasons!). I did however want to pull out a ‘GIF demo’ of the Vega profile of the trade as it will be our ‘guide rope’ for the ongoing management of our trade.
As we role our strikes and maturities we will be seeking to stay (as far as possible) within the light green zone (of maximum Vega aka maximum exposure to changes in implied volatility). The implication here is that we will be looking to roll from the March 15th expiry to the April 19th expiry within a few days. We will also need move our strikes (up or down) in the same direction as the market.
The strategy will lose money in the event that the market gets pinned at current levels (not my base case in a week that brings both Biden’s State of the Union address as well as a congressional testimony session for Jerome Powell). The position will also lose value in the event of further drops in index implied volatility. If that happens, it would be unusual for the index to be higher from here (with the call leg in the money - hopefully neutralizing the loss on volatility).
Quick note: I wrote / recorded this section on Friday Australia time, so pricing is based off last Thursday’s closing prices. I will update the worksheets and track the strategy (for acorn purposes) off the SPY -0.09%↓ close on Monday 4th March. Any questions, please reach out by email, in the comments below, or in The Drey!
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