The relative chart looks similar to the relative performance of the SPX Index vs. the NDX Index (or the RTY Index vs. the SPX Index). It seems to me the top seven market indices performance is the driver for this relative move.

Let’s visualize that this is being driven by a sector rotation, of which the top seven names are a large part. The Technology sector versus the Energy sector is part and parcel of the NDX vs. SPX trade. This is not an exact fit, however, I think the core driver of the relative index performance does largely come down to this sector decision.

Breaking down the sector performance for the last three months, I can see some lop-sided performance. Technology and communication services appears to be driving the bus, while energy has been left in the dust. Energy is the only sector that is negative over this period. Can this sector outperformance continue?

Looking at the SPX Technology sector performance versus the Energy sector performance over the last five years, I can see that we are more than two standard deviations from the mean. We are well below the levels from the end of 2021, after energy proceeded to go up by close to 100%, which appears to have reverted some of the relative performance, but not all of it.

What is the driver behind this sector performance? As my students in Applied Portfolio Management have been studying the last two weeks, I see inflation as the biggest driver of this relative sector performance. Inflation tends to benefit energy (and other commodity sectors that have high fixed costs) as the increased pricing allows these companies with higher operating leverage to get pricing to drop straight to the bottom line. However, the technology industry tends to be negatively impacted by inflation, particularly when it is high enough that it starts to impact wages. Technology has high variable costs – largely employee salaries. Therefore, higher inflation can lead to wage compression, which is a drag on sector earnings. I can see below that the move higher in CPI coincides with the relative outperformance of energy, while the falling CPI that has been the tailwind for the markets broadly has been the driver for the relative sector performance as well.

If the sector relative call comes down to inflation, and the index relative call comes down to the sector, I have to get the inflation call correct to be in a good place. My students also build economic models to forecast growth and inflation; the most common variables that show up in the dozens of models I see for inflation are commodity prices, money supply growth, PPI, financial conditions and inflation expectations. I have created a CIX to forecast CPI using these variables. I think it has been a good fit up until recently. Lately, it has started to pick back up at the same time I am seeing CPI trying to form a bottom. Is CPI about to turn higher and bring the Fed back into play? Inflation expectations and financial conditions suggest this is the case. The CPI, with a higher weight from commodities than my index, appears to say no. How might this break?

My next step is to try to understand how traders might be positioned. If there is a potential for higher-than-expected CPI, which leads to sector rotation, is this something that traders are already thinking? I like to turn to the Commitment of Traders report, particularly the Leveraged Investors section, to better understand how faster money might be leaning for these types of catalysts. I have two pictures here, with E-mini S&P 500 positioning on top and E-mini Nasdaq-100 positioning on the bottom. In both cases, I can see that the short positioning has been reduced over the course of the last year, but in both cases, I still see that traders are net short futures. The short positioning appears to be quite a bit larger in the E-mini S&P 500 futures than in the E-mini Nasdaq-100 futures. I think this is important to try and understand how markets could react on moves in either direction, because the reversal of extended relative performance could happen on a directional move higher or lower. The larger E-mini S&P 500 short positioning leads me to believe that the E-mini Nasdaq-100 futures might be more responsive on a move to the downside, with E-mini S&P 500 futures more responsive on a move to the upside.

If I am right and the Nasdaq-100 is truly more sensitive to downturns than the E-mini S&P 500, any correction might see the Nasdaq-100 performance fall faster, followed by a rebound in the S&P 500. The E-mini Nasdaq-100 has less relative moves but on any move to the downside, the E-mini Nasdaq-100 could begin to accelerate faster. Another way to say this might be that the E-mini Nasdaq-100 could take the stairs up but the elevator down. This suggests to me that it could be a lower volatility move on the upside, but a higher volatility move on the downside. My next step is to look at the E-mini Nasdaq-100 implied volatility surface and see if the skew that is priced in reflects this same view or not. QuikStrike has functionality that allows me to look at the implied volatility by strike, comparing at-the-money with the out-of-the-money calls and puts. However, it is nice that I can also look at this across different expirations to see if any differential pricing stands out. While puts trade at a premium to both calls and at-the-money options, the spread between puts versus at-the-money and calls versus at-the-money is narrower than it may typically be, perhaps a reflection of the lower absolute level of implied volatility at this time.

Implied volatility may be low, but what am I willing to spend? To have a sense for that, I compare implied volatility to the actual movement, or historical volatility, in the market. Again, I turn to QuikStrike, which quickly lets me see that the spread between implied and historical volatility is small. This makes me feel that a position that is long gamma or vega might be a good opportunity because the risk premium I am paying in terms of spread to historical volatility is not too high.

Putting this together, I am looking for an idea that might take advantage of my view that the E-mini Nasdaq-100 might grind higher but be faster to react on moves lower given the positioning. If there is a catalyst of economic data that leads to an acceleration of inflation measures and the market responds with sector rotation, this could lead to a more rapid move lower. Also, given the relative pricing of puts versus calls, but also implied volatility versus historical volatility, I am inclined to be long optionality or convexity, and to prefer my longs to be on the downside since I am not paying much of a premium relative to be long vega. These views all lead me to look to be long puts but to fund this using a short call spread. I have used the February month-end options as this expiration allows me to capture a wide range of economic data that could ultimately be the catalyst. The expected return chart above shows where the breakevens for this spread are at expiration, but I am more interested in the payoff diagram for this spread before expiration, as it looks like a lower beta short to the upside, and a higher beta short to the downside, which is consistent with my view.

Ultimately, I could use a spread like this, which is zero cost, to hedge an underling long position in the market. A zero-cost spread would not be the drag on returns that outright long options can have. In addition, since I am short a call spread and not outright calls, if the underlying market were to move up substantially (i.e., about 17,900 strike), I wouldn’t have my long position called away. I would lose the difference between the strikes, but my risk is defined to be this amount maximally. On the downside, I do enjoy long convexity, which will help offset any losses in my underlying position. 

I could also use this as a directional idea that has defined loss amount and unlimited potential gains if the directional view is correct. That sort of defined reward to risk is appealing for directional ideas. I could also set this up as a volatility trade, knowing that on a grind higher, I might want to be relatively neutral theta and vega. However, on a move lower, I would like my position to move into a long vega or long gamma position that I can trade out of. 

I see many ways this spread can be used based on the underlying views and underlying responsibility of the trader. It can be a set it and forget it idea run to expiration, or one that can be traded out of opportunistically. While there are clear risks, namely that on a move higher, I would lose the difference between the strikes and the fact my loss is defined makes me more comfortable. 

The flexibility of option spreads can add another dimension to a trader’s portfolio. When there are potential inflection points in the market, such as a turn higher in inflation, which could impact relative sector and relative index performance, option ideas can be a great way to take advantage of potentially large moves. 

Good luck trading!

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