- Major US indices ended last week near record levels
- But it's been a bumpy and turbulent ride
- S&P 500 flirts with last July's all-time high
- Oddly, both equities and defensive assets are gaining
By Georgio Stoev
Major indices in the US ended last week near record levels. We should not forget that the ride was bumpy and had a fair amount of turbulence. Following a poor start to the year and then the February scare, equities have rallied and are now above their December highs. Furthermore, the S&P 500 is flirting with all-time high of 2,131 made last July.
It is not so much that we find the US equity benchmark setting a record for the books, as it is the environment around it that we find somewhat "unnatural". While equities are gaining, defensive assets such as bonds are also gaining. This is not supposed to happen. The price of bonds is negatively correlated to the price of stocks. So when the yield on the 30-year US T-bond touched an historical 2.1% last Friday, stocks were supposed to move down as well. The purpose here is not to explain the microeconomic reasons but to merely indicate the state of funk the markets are in.
While the fear disappeared, the volatility index (VIX) dropped 18% and closed inside the range of $13-$16 or the pre-Brexit levels. As volatility abated, traders re-examined their positions with the E-mini S&P 500. The strike prices of 2200 for calls and 1900 in puts are suggesting range-bound trading over the next 30-50 days. The outlier among the top traded was the 1700 deep out-of-the-money puts.
Although bond rates can go lower, the capital flowing into "defensive" assets such as gold and bonds competes directly with equities. It is therefore hard to see this rally beyond a short-term speculative bump. If any real catalyst is to move equities forward this should Q2 corporate profits, already in motion.
Options with options
For speculative investors, earnings could provide for a sharp move up or down. This one-time event will swell options premium on both sides (calls and puts). If volatility expands to relatively high levels, traders will look to sell options going into earnings. There are option strategies such as short strangles and straddles that benefit from the volatility "crush." The last could be executed in variety of ways but generally an investor will sell OTM options, both calls and puts, and expect after an earnings announcement the stock to trade in a range.
If an investor believes that shares of Netflix will not move more than $11.69 he could benefit by selling OTM options (109 calls and 86 puts) and collect on some $11 premium. If, on the other side, he believed that the stock will definitely trade more directional following the earnings report, he could buy the strategy. There are variations of the long and short strangle but the principles are the same – do you expect a big move? if yes, you could buy it, if not – you could sell it.
For others, looking to balance their equity position into earnings, you could look into the collar strategy. The strategy is a combination strategy consisted of short OTM call and long OTM and of course the underlying. While the upside is limited with the sale of the short call, the downside is also limited to the strike price of the long put.
Long 100 shares Facebook ($118.30)
Short 1 AUG 120 Call at $ $3.80
Long 1 AUG 115 Put at $3.10
With the Facebook collar, the investor would capture the appreciation of the shares up to $120. At the same time he could exit the shares at any time before expiration for guaranteed $115, and collecting $0.70 per contract.
Have a great week ahead!
– Edited by Clare MacCarthy
Georgio Stoev is futures and options product manager at Saxo Bank