The Fed and the Mindset for a Downturn

I can hear it now from someone reading the title:  ‘A HA!  this guy is finally bearish after all this time — I knew he would come around‘.  That couldn’t be further from the truth, in fact the bearish label is completely inaccurate.  I don’t like labels, as when we describe ourselves bullish or bearish that puts us in a specific mindset unable to be flexible.  Hence, when we change our minds and decisions with changing markets our tactics are questioned.  In other words, don’t put me in a box.

Markets move in cycles and if we’re not able to identify shifts in these cycles, money flows and pricing structures then we will just be making the same mistakes in prior periods.  There are many valid arguments for bull market runs but also many good arguments for bear raids.  Liquidity and Fed accommodation are at the top of the list, and as long as those are strong you can bet that any pullback/correction will be short-lived.

Will there ever be a bear market?  Absolutely, and probably will cycle out the same as prior ones in terms of time and price (but unlike 2008/09 for specific reasons).  History tells us most miss a bear market, because they are far to late in identifying the conditions, preferring to continuously buy dips, fight a new trend that is swift, painful and over before you ever had a chance.  But if you’re unable to see what is truly happening and be flexible, you’ll get hit.  It’s like they said the five things to remember in the movie Dodgeball:  dodge, dip, duck, dive and dodge.

The Federal Reserve has been highly accommodative for more than six years and frankly has no plans to remove the easy monetary policy.  Oh, we are hearing about rate hike coming, likely to come on the back-end of 2015, but don’t be fooled – this rate hike cycle will be slower than molasses pouring out of a bottle, and may bore the market to tears.  A rate hike cycle is likely to change asset allocation models, and if there is any hint tighter money is going to retard economic growth then cash will soon be the big asset class (nobody will be buying stocks or bonds).  However, we are far away from that point, and even with low-interest rates we must acknowledge the Fed is still highly accommodative.


Options Strategy: The Iron Butterfly

The curiously-named “iron butterfly” is a complex strategy offering limited losses and limited profits. It is an expanded version of the basic butterfly (two separate spreads offsetting one another). The “iron” version is a combined straddle consisting of four options instead of the butterfly’s three.

An iron butterfly can be either long or short. The long version consists of a long call and long put at the same strike; and a lower-strike short put plus higher-strike short call. For example, General Mills (NYSE:GIS) was worth $49.40 per share on August 3. At that price a long iron butterfly could be created with the following contracts:

Long 50 call @ 1.00
Long 50 put @ 1.60
Short 47.50 put @ -1.54
Short 51.50 call @ -0.45
Net credit = -0.61

In a short iron butterfly, the positions are reversed; for example fpor GIS a short iron butterfly could have been constructed with the following:

Short 50 put @ -1.54
Short 50 call @ -0.96
Long 47.50 put @ 0.57
Long 51.50 call @ 0.49
Net credit -1.44


Choppy Waters – Weekly Market Outlook

The bulls managed to get a nice reversal rally going on Tuesday of last week. But, when push came to shove on Friday, the bulls couldn’t follow-through and carry the market meaningfully higher. Though the market finished the week above its key short-term moving averages, it also finished the week pointing in a bearish direction.

Maybe it was just a bad day. Maybe the market will rekindle last week’s jump-started rally early on this week and make a run for new highs. (There’s certainly room and some reason for it do so.) But, as has been the case all year long, there are a lot of maybes, ifs, and buts keeping the market stuck in the mud, creating a very choppy and only partially-predictable environment.  

We’ll explore the situation below, after a run-down of last week’s and this week’s economic numbers.

Economic Data

Last week was relatively busy on the economic data front, but none of it was as much-anticipated as Wednesday’s decision from the FOMC regarding interest rates. There was no change – the Fed Funds Rate remains at 0.25%. Moreover, though there was plenty of rhetorical, the language in the Fed’s said little more than the FOMC was likely to effect the first rate hike in years “soon”, as in (most likely) sometime before the end of the year. The bond market, slightly surprised at the lack of conviction, sent yields down slightly the rest of the week once they had time to digest the news.

Consumer confidence took a hit in July, according to not one but two different measures of sentiment. The Conference Board’s consumer confidence score fell from 99.8 to 90.9, while the Michigan Sentiment Index fell from 96.1 to 93.1. Both are a step in the wrong direction, but neither was a trend-breaker.  

Consumer Sentiment Trend Charts
Source: Thomas Reuters

We also heard the first estimate of Q2’s GDP growth rate last week. Economists think the economy grew 2.3% last quarter. Though the figure might be changed slightly with future revisions, any conceivable number for the second quarter is better than the first quarter’s 0.6% growth.

GDP Chart
Source: Thomas Reuters

Everything else is on the following grid:


SPX Version of SPY Hedge from Barron’s

Over the weekend, there was a discussion of hedging portfolios with options in my favorite column, The Striking Price, which appears every weekend in Barron’s. Steve Sears relayed a reader request to Stephen Solaka who manages money for Belmont Capital out in sunny but dry California. The question was basically, “How do I go about hedging a $1 million portfolio if I am concerned about the equity market over the near term?”

The response, formulated when the SPY ETF was trading around 211 involved buying an out of the money SPY Aug 207 Put and selling the SPY Aug 202 Put. The second part, where the option was sold helps pay for the premium paid out for the higher strike put but limits the benefit of the hedge a bit. As a final suggestion it was recommended that the SPY Aug 214 Call be sold as well.

There was no specific pricing mentioned in the article so I ran down to the trading floor this morning to get SPY and SPY option prices from the close on Friday. SPY finished the day at 210.50, close to the 211 price level mentioned above. The SPY Aug 202 Put could be sold at 0.40, SPY Aug 207 Put purchased at 1.07, and finally the SPY Aug 214 Call sold for 0.48. The net result here is a cost of 0.29 for the combined spread.

Anyone that reads our blogs knows that when I hear SPY I think S&P 500 Index (SPX) options. Taking the same idea I looked up SPX pricing from Friday. The S&P 500 finished the day at 2103.84, just a tad under 10 times the size of SPY. The SPXPM Aug 202 Put could be sold for 4.20, SPXPM Aug 207 Put purchased at 11.10, and the SPX 2140 Call sold for 3.90 for a net cost of 3.00 for the combined spread. Do note I used SPXPM option pricing since SPY contracts are PM settled.

Remember the original question was how to hedge a $1,000,000 portfolio and this is where we have to do a little math (and rounding). The recommendation in Barron’s was to use 48 SPY options at each strike. SPX is ten times the size of SPY so, rounding up a bit, the same basic hedge could be initiated using just 5 SPX options.

In addition to getting the same exposure with fewer options, SPX options are cash settled.  This feature of SPX options makes them ideal for hedging situations.  Therefore if the hedge pays off, which would mean SPX is below 2070 (the long put strike price), the holder of this position would receive cash.  Of course the amount of cash received capped on the downside through the short position in the 2020 Put.

The same trade using SPY options would give similar economic benefits, but if held through expiration, and SPY between 202.00 and 207.00, the result would be assignment on the short SPY 207 Puts and a purchase of SPY. The purpose of this trade is to hedge a portfolio, not to buy shares of SPY, so to avoid assignment the trade may need to be exited before expiration.  With SPX, the position may be held through expiration which results in cash, which we all know is just as good as money.

July: Tricky by Anyone’s Standards

Editors note – we would like to welcome Meredith Kelley Zidek as a new contributor to the CBOE Options Hub.  Meredith is a private investor whose interests include equities, options, and commodities.  She began trading equities in 2007, and since then has cultivated interests in corn, energy, and most recently, index and equity options. Almost all of her trading, which can be seen on, involves short options on volatility-related instruments.  She studies the movements of world indexes and analyzes options chains to determine advantageous timing for short-selling of contracts.  Meredith holds a B.A. from Loyola University, and resides in Hunt Valley, Maryland.

As if the first half of July didn’t provide enough adventure, I set out to bring in a few more dollars during the second half.  As usual, I survived some scrapes and scares and ended up with just that:  A few more dollars.

Set forth below is my ill-timed scheme to capitalize on what I believed would be persistent volatility aftershocks for the remainder of July.  I wrote calls on SVXY at the 94 strike for the July 31st expiration, and the very next day – well, you can see what happened.  Two days later, still hoping I’d hang in there long enough to get the glory, I reinforced the same strategical position (read: I made things potentially worse for myself) by writing UVXY puts at the 25 strike also for the July 31st expiration.

GrapeW 1

Now, take a look at the 14-day charts above to see where those securities ended up at month-end (the expiration date of my contracts.)  I would have been fine holding those through the end of the month, and would have made virtually all of the $946.50 I set out to make.  But in a fit of disgust on July 23rd, having already viewed a lot of red ink and pondered rolling schemes until my eyes were ready to fall out, I closed those positions, loathe though I am to book a loss – ever.  (And you will see by the end of this post that it was the only loss booked during the entire month.)  See below for the result:  Profit on one, loss on the other, for a net loss of a few hundred dollars.  As already mentioned, now I have the benefit of hindsight to see that I could have held onto them, but I consider my fundamental mistake – if I made one – to be writing those options too close to the stock price at the time and too far away (two weeks is a long time with anything trading that close to strike unless you want to characterize it as “level-calling,” or reckless speculating, which I am not casting judgment upon. I probably do it a lot.)

GrapeW 2


Options: Delta Neutral Trades

A delta neutral trade is one in which a long and short option contain offsetting delta so that the net delta is at or near zero. Delta is a measurement of the degree in an option’s price movement when the underlying moves.

The theme of delta neutrality can refer to many differently constructed strategies including spreads (covered and uncovered) and straddles. When an option position is covered with long stock (one short call offsetting 100 shares of stock), the delta neutrality creates an equivalent stock position. This position moves up or down and tracks the 100 shares synthetically, creating a form of leverage.

The delta neutral accompanying long stock in theory wipes out risk on both sides of the option trade (the long has no market risk because it is paid for by the short; and the short has no market risk because it is covered). However, as volatility changes, so will the relative risks of each option. If the risk does offset at the point of entry, traders have a great advantage in being able to react to movement in either direction (or both). The risk applies at the time of entry and subsequent movement can lead to rolling, closing, and expiration.

One variety of this concept involves two short options, one call and one put. The theory behind this is that offsetting exercise risk cancels out in the same way as a covered long and short position. But this is not accurate. Exercise risk exists separately for both sides in a trade of a short call and a short put. It is not neutral. Exercise of either can wipe out the initial credit received and exceed that credit by many points. Making matters worse, both shorts can be exercised when the stock moves first in one direction and then in the other. For example, a short call is ITM on ex-dividend date and is exercised; and then after ex-dividend, the stock price falls and by expiration, the short put is also exercised. The risk is especially severe when the two-short position is a straddle. One or the other of these options will always be ITM. In comparison, a spread may involve two sides, each OTM. Whenever using short uncovered options, the collateral requirements have to be kept in mind as well.


The Week in Russell 2000 Trading – 7/27 – 7/31

I was on the road for CBOE and on the other side of the world recently so I missed some of the market action of late. I knew the Russell 2000 (RUT) was lagging, but was honestly surprised to see that the small cap dominated RUT performance for 2015 is basically in line with large cap stocks which is represented by the Russell 1000 (RUI) below.  My impression was that China and Greece (storm that has passed – for the moment) were dominating the news.  However, the relative performance of RUT to RUI says the domestic business environment may be something to be concerned with over the balance of this year.


When I put these charts together each weekend I start with the RUT – RUI price chart and then move on to the volatility comparison chart that shows up below. After seeing the outperformance of RUI relative to RUT I am not surprised to see the premium of RVX relative to VIX at elevated levels. Everyone is a little on edge when we start to look beyond Labor Day each year, regardless of the market environment. This chart says the concern appears to be a little more about what may happen inside the U.S. versus the rest of the world.


Late Friday with the Russell 2000 hovering around 1237.50 a relatively large seller of an out of the money call spread showed up at the RUT post. They sold a few thousand of the RUT Aug 21st 1280 Calls at 1.21 and purchased RUT Aug 21st 1290 Calls for 0.71 for a net credit of 0.50. A move to 1280.00 from the late Friday price of 1237.50 involves a climb of 3.4%.   Often these out of the money spreads in RUT options have strike prices outside of the recent trading range which isn’t the case here. RUT has been as high as 1296 this year which would place the index at a price where the maximum potential loss of 9.50 would be realized at expiration.



The Week in VIX – 7/27 – 7/31

The S&P 500 was up over 1% and both spot VIX and VIX futures suffered the consequences.   Spot VIX lost almost 12% and the August future was down about 6% last week.

VIX Curve Table

VIX Weeklys futures were launched a couple of weeks ago and the first short dated contract expires this coming Wednesday on the open. I decided it was time for a quick look at how the nearest term contract has been tracking along with VIX. Day by day changes won’t tell us much so I sent my very competent summer intern down to the trading floor to gather intraday data for both VIX and the Aug 5th VIX Futures contract. The result is the chart below which shows VIX index prices every 15 minutes along with the midpoint of the bid – ask spread for the Aug 5th Future.

VIX 15 Min

The correlation between price changes for spot VIX and the short dated future came to just over 0.87 using the full seven day life of the futures and the close every 15 minutes during the day. Another thing to note is the VIX future closed at a little less than a one point premium to VIX yesterday. This is very similar to the recent price behavior of traditional VIX futures on the Friday before settlement week. As we get more observations for the new futures, I’m planning on seeing how similar the last few days into settlement are for those contracts compared to what has been normal for the old school monthly VIX futures.

On Monday VIX finished the day at 15.60 and the front month August VIX future finished at 15.78. As the close approached an interesting trade was executed in the VIX pit. There was a seller of 513 VIX Aug 15 Puts at 1.00 who also purchased 513 VIX Aug 15 Calls for 1.90. The quick readers will note this is the equivalent of being long 51.3 August VIX Futures based on the 10 to 1 relationship between the two. The trade did have another leg to it as 950 of the VIX Aug 16 Calls were sold for 1.59. The net result of all this buying and selling was a credit (sans commissions) of $104,880. The payoff diagram below is based on the dollar profit and loss if the trade is held to expiration.

VIX PO Corrected


The significant price levels for this trade are very close to 12.95 and 16.35. Near both of those levels this trade goes from being a profit to a trade to be concerned about. Remember this trade was executed on Monday and since then VIX has returned to the pre-teen levels finishing the week at 12.12. If this trade is to be successful a bump to the upside is going to be needed. I bet the trader behind this execution is hoping for less than bullish (for the equity market) employment report this coming Friday or some other negative (but not too negative) event in the next couple of weeks.

The Week in Volatility Indexes and ETPs – 7/27 – 7/31

I was reminded of my advancing age several times this past week. I’ll save those incidents for the other grumpy aging men on my block. One of the benefits (let me believe this) of being around for a while is having lived through a variety of market environments. This market got me thinking about John Gotti who was the boss of the Gambino family back in the day. One of his monikers was “The Teflon Don” as he was put on trial three times and acquitted three times. Teflon is a substance that nothing sticks to and I have decided to dub this market the Teflon Bull Market as regardless of what bad news gets thrown at it, this bull market keeps going. The only other time I can recall bad news never sticking to the market was the late 1990’s into early 2000. If you weren’t around back then to see what happened when that bull run came to an end take a look at a very long term chart of the Nasdaq-100 or YHOO stock. Trust me the big drop about 15 years ago is not a data error.

The VXST – VIX – VXV – VXMT curve saw a pretty big drop on the short dated end of things while the longer end worked lower as well. VXV and VXMT maintain a high level relative to the short end which has been the norm for 2015. However, the excuse for this price action was that the true concern for the market is when will rates start to move higher and now that the possibility is approaching it will be interesting to see if the worry shows up in VIX instead of VXV.


The S&P 500 worked higher by just over 1% and VIX returned to the tweens this past week. The long ETNs took it on the chin with VXX dropping about 5% and UVXY losing over 10% for the week. For those that like to think year to date, VXX is just pennies away from being down 50% for the year.

VXX Table


Looking through VXX trades last week I came across someone that appears to have a pretty specific idea about where VXX will be on September 18th. That is unless they have other plans to trade around this position. Late Monday there was a seller of 20,000 VXX Sep 18th 15 Puts at an average price of 0.475 who purchased 10,000 VXX Sep 18th 18 Puts for average price of 2.05. I say average price because these trades were done in two blocks. The net result, taking things down to a size that the rest of us can deal with, is a 2 x 1 Put ratio spread executed at an average price of 1.10. The payoff at September 18th expiration shows up below.


VXX was trading at 17.72 when this trade was executed. Since then VXX has continued to work lower and finished this week at 16.02 which is snugly tucked in the area of profitability for this trade. A quick check of prices late Friday showed the trade had an unrealized profit of 0.15. However, there are lots of trading days to go and anyone that has even heard of VXX knows it can keep moving to the downside or spike to the upside. When the trade went off the area to become very concerned began at 13.10 which was down 35.3%. As of Friday 13.10 is only down about 22%. Say what you want about VXX (and I’ve heard all the criticism and colorful language) but the price action is anything but dull.

The Weekly Options News Roundup – 7/31/2015

The Weekly News Roundup is your weekly recap of CBOE features, options industry news and VIX and volatility-related articles from print, broadcast and online and social media outlets.

VIX Weeklys Options Are Coming
Following the successful launch of VIX Weeklys futures, CBOE has announced plans to list VIX Weeklys options beginning October 8th, offering market participants more opportunities to trade VIX.  Weeklys offer investors short-term protection, as well as the ability to fine-tune the timing of their trades.

“CBOE Set to List VIX Options with Weekly Expirations” – Maria Nikolova, LeapRate

New Benchmarks Track Options-Based Strategy Performance
CBOE has announced plans to introduce 10 new options-based strategy performance benchmark indexes that highlight the long-term utility of options as risk management and yield enhancing investment tools.  Dissemination of index values will begin this Monday.  For more information, visit

“CBOE Releases Details on Raft of New Performance Indices” – Daniel O’Leary, EQ Derivatives

“New Appeal for BXM Index and Buy-Write Strategies in 2015” – Matt Moran, CBOE Options Hub

“Traders Score With Buy-Write Options Strategy Tuned to U.S. Calm” – Callie Bost, Bloomberg

Options Education Goes Abroad
CBOE Options Institute, the exchange’s world-renown educational arm, is joining forces with the Singapore Exchange (SGX) as demand for education in options and volatility products in Asia continues to increase.  Launching in the fourth quarter of 2015, “The CBOE Options Institute at SGX” will be dedicated to engaging Asian investors in the effective use of options and volatility strategies to manage risk.

“SGX, CBOE partner on options trading education” – Maria Nikolova, LeapRate

“CBOE, SGX Team Up For Options Institute” – Robert McGlinchey, EQ Derivatives

The VIX Index has remained close to record lows over the past couple of weeks, reflecting some complacency in the market.  Could this be the calm before the storm?

“Volatility Index Offers Share Investors False Sense of Calm” – Philip Baker, Financial Review

“Why Isn’t the VIX Higher?” – Adam Warner, Schaeffer’s Investment Research

“Watch Out, Volatility is Set to Spike: Trader” – Stephanie Yang, CNBC

“What To Make of the Cheapest ‘Overbought’ VIX In Years” – Adam Warner, Schaeffer’s Investment Research


Volatility of VXTY Futures in an Illiquid Treasury Market

A recurring topic of discussion among market participants is how illiquid the Treasury market has become and what impact this will have on volatility.   In particular, there is concern over a possible repeat of the “flash crash” of October 15, 2014, when a surge of volume in the CME’s 10-year Treasury futures pushed down Treasury yields and added two index points to the TYVIX Index in the course of 15 minutes.

Figure 1. TYVIX on October 15, 2014 731Fig1

From the point of view of traders affected by illiquidity, an even more interesting question is whether VXTY futures would be as sensitive to illiquid episodes as the spot index.  VXTY futures were listed in November 2014, just after the flash crash, but we have a clue to their response in the fair values of VXTY futures derived from Treasury options prices.

Figure 2.  Fair Values of VXTY Futures During the Week of October 15, 2014731Fig2


Weekly Stock Market Commentary 7.31.15

The chart of $SPX is the least bullish of the indicators. SPX remains in the 2040-2135 trading range that has bound it for most of this year. Basically this is a neutral chart.

Put-call ratios are much more encouraging. A strong buy signal has been generated by the standard put-call ratio (Figure 2). The weighted equity-only put-call ratio is also bullish (Figure 3).

Market breadth remains mixed, with the NYSE-based indicator now on a buy signal, but the “stocks only” is not.

Volatility continues to be the most bullish indicator. Recently, $VIX generated a “spike peak” buy signal as of the close of trading on Monday (July 27th). These are powerful signals.

In summary, there are positive signals emanating from put-call ratios, market breadth, and volatility indicators, as are all generating new buy signals. The only non-conformist is the chart of $SPX (and “stocks only” breadth). There have been many times in the past where $SPX turned out to be the dominant indicator, so I am not saying with certainty that the positive nature of the other indicators is guaranteed to make $SPX break out on the upside, but there is a reasonable chance that they will.


New Appeal for BXM Index and Buy-write Strategies in 2015

In a recent news article in Bloomberg, Callie Bost noted this year’s relatively strong performance for the CBOE S&P 500 BuyWrite Index (BXM), and she wrote —

Traders Score With Buy-Write Options Strategy Tuned to U.S. Calm.  Traders selling calls on stock holdings are beating the S&P 500 for the first time since 2011. The torpor in U.S. equities is proving a bonanza for traders employing an options tactic designed to capitalize on dead markets. …  ‘A churning market is the buy-write index’s best friend,’ said Mark Sebastian … ‘The fundamental drivers of buy-write’s underperformance – – Federal Reserve bond-buying and zero interest rate policies -– is coming to an end,’ Nicholas Colas, chief market strategist at Convergex Group LLC, wrote in a note Tuesday. … “

Ms. Bost also noted that the shares outstanding in an ETF designed to track the CBOE BXM Index rose to a record high in May.


Below are three charts showing the year-to-date % changes through July 29 for select total return benchmark indexes. (Total return indexes are pre-tax indexes that take into account reinvested dividends, which can have a significant impact over longer time periods.)

Note that all five of the buywrite indexes in Exhibit 1 had higher returns year-to-date than the four “traditional” indexes in Exhibit 2, and that two of the indexes in Exhibit 2 were down so far this year. Buywrite strategies harvest options premiums and often have the goal of generating returns that are smoother and more consistent than returns of equities and commodities.

Exhibit 1bvA - BuyWrite More

$EA Sports: It’s In The Game

Editor’s note:  We would like to welcome Park Research LLC @ParkResearch to the CBOE Options Hub family with their look at EA earnings in front of their report after the close today.

Electronic Arts will have their earnings released after Thursday’s closing. While we tend to think of an earnings release as a binary event – and more than not it is – we can also use the historical information to assess how investors and traders tend to react to the news.

Let’s take a look at some information. As of Wednesday (July 29), $EA closed at 72.18. Naturally, we looked at the 72 straddle. The options were marked at $4.90 or 7.11% move – this move is calculated from 72.18 to break-even to the downside of 67.05. As you can see below, that straddle move is described as the light blue filled area. Each candlestick is from each earnings move with 1 being the most recent to 20 being prior 20Q earnings move (i.e. 5 years ago).

EA 1


Out of the last 20 earnings, at least 11 of them had moved greater than the above straddle price some time during the day, but more importantly, 15 of them closed higher than the previous close and 17 of them were trading higher some time during the day. On average, its absolute max move for 20Q was 9.68%, its absolute gap open move was 5.06%, and its absolute closing move was 7.36%. On average, its max move is 10.99% and its close is 8.49% when the stock closed higher than the previous close. In this case, we want to take a look at a synthetic long, selling $68.00 puts and buying $77.00 calls with $0.06 credit. The breakeven area is $67.94 (ex. Commission); slightly above the lowest close area of $67.71 or -6.195%. However, on average, we expect the stock to be around $77.49 (using the average of absolute closing of 7.36%) well above $76.94 breakeven area or possibly to $80.11 (using the average of up closing of 10.99%).

EA 2


Will history repeat itself? We can’t be sure, but it seems the potential max risk is $0.23 while the potential reward is from $0.55 to $3.17. In the end, if you want to make money, you have to play the game…. And, as they say, “EA Sports, It’s In the Game”.