The world is becoming a very interesting place with many crosscurrents. In just six weeks, we have already seen:

  1. A double digit stock market correction despite earnings which remain quite healthy.
  2. A short-term interest rate market that has gone from under three rate hikes to seven rate hikes priced in for the next 12 months.
  3. Geopolitical concerns with major implications for the price of energy in Europe and the rest of the world.

That is a lot to get through, particularly when risky assets were quite fully valued as we ended 2021. Thankfully in our first three issues, we have discussed each of these topics.

This is typically when investors and traders alike are looking to add convexity (long options) into their portfolios. Remember from the first issue, options are insurance. The buyer of insurance is adding a risk management tool into their toolkit. Sometimes, however, insurance can get over-priced relative to history. This is when those with the right skillset can step in and sell this insurance and manage the risk in other ways.

With all these moving parts, it may not be time for most of us to think about selling insurance. Even though the catalyst of earnings are out of the picture, there are plenty of other events that still could occur, not the least of which would be any geopolitical stress. The next several weeks bring several important economic data points that could potentially impact the pace and magnitude of central bank rate hikes. Remember, implied volatility is the measure traders use to price an option. It is the expectation of the volatility over the life of the option. It should not be confused with historical or realized volatility, which is the volatility that the underlying asset actually moves on over a given period. The two are different but related. Traders will base their forecast on what has happened, but also on what the longer term mean value is for implied volatility. One can compare the two levels to see if there is a heightened sense of nervousness in the options market.

Figure 1: Implied vs. historical volatility

Figure 1: Implied vs. historical volatility
Source: Bloomberg

In Figure 1, I look at one-month implied volatility versus a rolling measure of 20-day historical volatility. The picture on the right is a graph of the spread between the two, showing that we are in the middle of the distribution over the last three years. We never know what the future will hold, but right now, options look fairly priced.

Long ES Straddle Example

When I speak to my derivatives class, the first three things I tell them to consider when designing a strategy are:

  1. What is your view on the direction of the underlying?
  2. What is your view on the volatility of the path to get there?
  3. How confident are you?

From there, we can start to think about the type of options structure to build and whether we want to be net long or net short options. I think if I asked most people these questions right now, I might get answers like:

  1. No idea what direction we will move 
  2. A choppy or volatile path
  3. I am not very confident

This is to be expected given the many crosscurrents mentioned earlier. If these would also be your answers, you might want to think about a long straddle position using E-mini S&P 500 (ES) options.

Here I have chosen one that will expire on March 18, after the release of major U.S. economic data and the next Federal Reserve meeting. In addition, any moves that happen because of the Russia/NATO stand-off may also benefit the position. A picture of the breakeven of this position is as follows:

Figure 2: Long ES straddle

Figure 2: Long ES straddle
Source: QuikStrike

Another way to think of the breakeven point of this strategy is to look at it on a graph of the underlying asset. In Figure 3, the red lines represent the levels where this long straddle would break even. These lines also roughly characterize, by change, the range of the market this year. If there is no incrementally new information, one might think this straddle looks expensive. However, will we really get no new information? Will we find out anything on Russia? Will there be a military conflict once the Olympics end, as many suggest? Will we get global economic data that could dictate the path of interest rates?

Figure 3: ES Underlying

Figure 3: ES Underlying
Source: Bloomberg

Long a call calendar example

Figure 4: ES March calendar spread

Figure 5: Expected return on the calendar spread