SPY Holiday Calendar Spread

Since it now appears a phase one trade agreement with China has been documented and translated, and according to Treasury Secretary Mnuchin, would not be subject to renegotiation, the early enthusiastic bulls got it right on the December 12 breakout to new S&P 500 Index highs.

The Market Review below updates the details along with the closing tally for the SPDR S&P 500 ETF (SPY) put spread hedge, followed by a new Calendar Spread idea as traders, analysts and perhaps even those running "algos" wind down for the holidays, reducing the probability for large moves in the major indexes, thereby increasing opportunities to sell time premium, although option implied volatility dropped to a 52-week low last week.

S&P 500 Index (SPX) 3221.22 marched higher adding 52.42 points or +1.65% last week, making new closing and intraday highs every day except Wednesday including a gap open higher on Friday. It seems phase one China trade agreement skeptics were stampeded by the bulls. Although some of Friday's advance could have been due to options and futures expiration as positions were unwound, sentiment going into the holidays could be described as cheerful or even gleeful and certainly better than this time last year.

CBOE Volatility Index® (VIX) 12.51 slid .12 points or -.95% last week. Our similar IVolatility Implied Volatility Index Mean, IVXM using four at-the-money options for each expiration period along with our proprietary technique that includes the delta and vega of each option, declined .31 points or -3.33% ending the week at 9.00%, after making a 52-week low at 8.98% on Monday, December 16, compared to 9.31% for the week ending December 13. The chart below shows the new low along with the closing price. While regression to the mean remains conceptually valid, the chart shows it remained around 10% for two months last March and April before finally jumping up in May. Until something begins to change market sentiment and the many positive fundamentals volatility is likely to remain low.

VIX Futures Premium

This next chart shows as our calculation of Larry McMillan’s day-weighted average between the first and second-month futures contracts.

With 22 trading days until January expiration, the day-weighted premium between January and February allocated 88% to January and 12% to February, for a 20.06% premium, in bullish green zone, vs.18.48% for the week ending December 13, the Friday before the December 18 expiration.

The premium measures the amount that futures currently trade above or below the cash VIX, (contango or backwardation) until front month futures contract converges with the next VIX futures expiration on Wednesday, January 22.

For daily updates, follow our end-of-day volume weighted premium version located about halfway down the home page in the Options Data Analysis section on our website.

Hedging Strategy Update – Put Spread Closed

The long SPDR S&P 500 ETF (SPY) put spread from Digest Issue 46 "VIX Correlation Indicator Confusion [Charts]" (Long one Jan 17 305 put and short one Jan 17 295 put) booked for 1.70 ended its usefulness last Monday when SPY continued higher after the China trade agreement announcement the prior Thursday.

Closed at .50 for a total decline in value of 1.20. Since the objective was to hedge other long positions that continued higher, it should be considered as the cost of insurance against the chance of a negative market reaction to the China trade agreement news on December 12. Unlike some other types of insurance like fire or flood, put spreads can be canceled (unwound) when no longer needed.

Now overbought by most technical measures SPY will pullback as it always does, but unless there is some important fundamental change pullbacks will likely be limited so hold off on a new February put spread until after the holidays. In the meanwhile, consider a short-term Calendar Spread as a strategy to sell time premium in an attempt to offset hedging costs and provide a bit more Holiday Cheer.

While the 11-25 sounds more like a commuter train schedule it actually describes a calendar strategy borrowed from a special guest contributor some time ago. Sell the at-the-money January 3 321 call with 11 days to expiration and buy the Jan 17 321 call with 25 days to expiration. Here were the prices on Friday.

Using the Ask for the buy and Mid for the sell the debit was 1.56. Ideally, the short call will lose time value faster than the long call so the spread will widen. Use a spread value decline of more than 10% as the SU (stop/unwind) since unexpected SPY moves of more than 1% will hurt the position.

Strategy

Presuming the news reports and commentary saying a documented and translated China trade agreement is a done deal and ready for signature consider selling time premium. Typically market volatility and volume decline in the period just before Christmas and until after the New Year, with last year being a notable exception. Accordingly, the probability of success selling time premium with Calendar Spreads, Butterflies, Covered Calls and Short Puts increases even with low implied volatility. While risks of large moves remain, sentiment turned constructive in the last two weeks along with forecasts for 2020. However, remember the old adage 'buy the rumor and sell the news." In this case, the news could be the actual signing of the agreement at a date to be determined after the New Year

Summary

According to news reports and commentary, a documented and translated China trade agreement that would not be subject to renegotiation awaits signature at a date to be determined. Equity market bulls are believers as the S&P 500 Index made new closing and intraday highs four of five days last week. In the meanwhile, the next two weeks will likely be quiet with small changes, low volatility and on low volume, offering an opportunity to implement strategies to sell time premium.