On Oct. 24, 2016 the exchanged-traded fund based on the S&P 500 Index (SPY) closed at 214.89. Less than two weeks later, Nov. 4, 2016, SPY closed at 208.55. What happened? Federal Bureau of Investigation Director James Comey announced the FBI was looking further into Democratic nominee and former Secretary of State Hillary Clinton’s e-mail situation. The markets were clearly spooked by the possibility of a Donald Trump presidency.
On the night of Nov. 9, the S&P 500 E-mini futures were halted after dropping 5% on the news that Trump had won the election. Gold was up 4.3% and the Nikkei was down 5.3%. Markets are more comfortable with the status quo and Hillary Clinton representative it in this election. Trump was clearly the candidate of change.
The panic subsided and SPY actually closed up 0.54 from the previous day’s close. From that time to May 31, 2017, the market actually gained 11.63%. This is what is known as the Trump bump. Why the bump? Trump’s tax plan proposed lowering the corporate tax rate from 35% to 15% as well as a pledge to reduce regulations. If that tax pledge went into effect the profitability of publicly traded companies would increase dramatically. Does this mean that if the tax reform passed both houses of Congress that the market would explode or was tax reform already baked into the market? That’s hard to tell. It would seem logical, however, that failure to pass legislation regarding tax reform would send the market reeling.
There are a number of positions that would protect a trader or investor from a market downturn: they could liquidate their holdings into cash, short shares of SPY or use an options overlay strategy to hedge their position. We are going to look at two different options strategies.
Both of these strategies exploit the negative correlation between the implied volatility of options and market direction. Implied volatility is the level of time value embedded in option premium. The greater degree of uncertainty or fear in the market the greater the time value. This means that a downward move in the market produces an upward move in the CBOE Volatility Index (VIX) and vice versa. VIX derives its value from the amount of time value embedded in the SPX options. On April 21, SPY closed at 234.39 when VIX closed at 14.63. The next trading day, SPY closed at 237.17 while VIX closed at 10.84. On May 16, SPY closed at 240.08 while VIX closed at 10.65. On May 17, SPY closed at 235.82 while VIX closed at 15.59. You get the idea. When the market is ascending, there is no reason to worry. When the market is dropping, it’s time to look to buy any put in sight.
On June 2, the VIX closed at 10.22. The June VIX futures closed at 11.65 while the August futures closed at 13.65 and the November futures closed at 15.80. Because time value is currently at rock bottom it makes sense that the further you go out on the calendar the higher the VIX futures would be trading as a reversion to the norm. VIX options are an equity product regulated by the Security and Exchange Commission while VIX futures are regulated by the Commodity Futures Trading Commission, so there is no cross margining, but VIX options are based on the price of VIX futures.
Let’s take a look at the November VIX call options. We could buy the Nov. 13-20 VIX call spread for 2.10. If we do it 10 times we have risked $2,100. The maximum value of the spread is 7.00 so the maximum possible profit would be $4,900. Recent spikes in the VIX have been very short lived and haven’t resulted in similar moves in the futures. If, for instance, the VIX popped to 30.00 in the next month the VIX futures wouldn’t be near 20. It would still be a profitable trade (see “Spreading VIX,” above).
Another approach is to establish an out-of-the-money put ratio spread in SPY. This would also work with SPX options and options on S&P futures.
We can buy 15 December 223 puts and sell 10 December 233 puts for a $37.50 credit. If the market keeps heading higher then it’s no harm, no foul as the trades expires and you keep the premium. If it heads down, the pop in implied volatility will make the spread profitable. As you can see, the real risk is near expiration in the 223 area (see “SPY ratio spread,” below). An adjustment or liquidation of this trade will be necessary six weeks before the December expiration if it is close to the 223 strike.