Image Source: Pixabay

By: Steve Sosnick Chief Strategist at Interactive Brokers

There are some weeks when we look ahead and wonder what might drive markets over the coming days. This week is not one of them. The key event is of course on Wednesday when the FOMC announces its rate decision at 2 PM EST and is followed by Chairman Powell’s press conference.  My gut says that Powell reverts to “less Goldilocks, more Jackson Hole mode”, though I’m not sure the market agrees.  But that is far from the only event that should grab traders’ attention.

Tomorrow, we get a read on housing prices (S&P CoreLogic and FHFA data), wages (Employment Cost Index), and sentiment (Conference Board Consumer Confidence).On Wednesday morning, we get a preliminary look at the job market (ADP, JOLTS) and a wide range of PMI data. Thursday’s data is likely to be overshadowed by the after-effects of the FOMC meeting, but it includes weekly unemployment claims, productivity, durable goods, and factory orders. And of course, on Friday we have the monthly Nonfarm Payrolls report and unemployment rate. Whew! And that’s just the economic data.

Earnings season continues apace as well, reaching a climax on Thursday when Apple (AAPL), Amazon (AMZN), and Alphabet (GOOG, GOOGL) are all scheduled to report after the close. That’s nearly a quarter of the weight of the NASDAQ 100 Index (NDX) in one afternoon. During the course of the week, about 20% of the S&P 500 (SPX) will release results, bringing us to about 50% for the season as a whole. This week represents a key peak for earnings.

It is customary for traders to begin prepping for key earnings in the days leading up to an announcement. Market makers and experienced traders know when earnings are coming and how the stock price reacted after recent earnings reports, so they modify their prices accordingly. When I was actively involved in options market-making, we would typically enter an “earnings boost” into our market-making models to account for that history. That was structured in a manner that put extra volatility into the days immediately surrounding the earnings report. It grew in prominence as the day approached, then largely disappeared after the news was disseminated.

As a result, timing options trades around earnings can be tricky. Those who are inclined to trade options from the long side – buying calls or puts – want to find the “sweet spot” before implied volatilities increase but not so early that decay takes too big of a toll. Remember that if one is trading short-term options, their decay grows exponentially as they approach expiration. Those write options face a similar question of timing. They want to maximize the premium that they receive in those fast-decaying derivatives. I wish I could give an exact best time, but it is more art than science. The optimal time is subject to general market condition and supply and demand for the specific options.

The confluence of a heavy economic calendar, an FOMC meeting, and mega-cap tech earnings is leading to a very steep set of implied volatilities for short-term options. For this, I prefer to analyze the term structure of implied volatilities for SPX or the SPY ETF rather than the CBOE Volatility Index (VIX).VIX is calculated to offer the market’s best estimate for SPX volatility over the coming 30 days. That is of less value when looking at events in the next week than simply checking implied volatilities of very short-term options. The advent of daily expirations makes that observation even more granular than it once was. Note the curve for SPY below:

SPY Implied Volatility Term Structure

(Click on image to enlarge)

Source: Interactive Brokers

Note the spike leading into Wednesday, the slight decline on Thursday, then another bounce on Friday before falling off sharply. The market is pricing in over 2% moves for each of those three days. The Wednesday spike corresponds to the FOMC announcement, and the Friday spike corresponds to payrolls and the market’s reaction to the earnings released after Thursday’s close. Notice also that the implied volatilities don’t revert immediately to their longer-term lower levels. This is because implied volatilities reflect the average daily volatility that is anticipated over the corresponding time period. An option expiring next week still must account for this week’s potential volatility. As those dates recede in importance by being average in with a series of more normal days, the curve adjusts downward.

My plan for this week is to stay nimble. We are seeing some normal profit-taking after some exceptional weeks and perhaps some nervousness that investors might have been a bit too sanguine about a pause in rate hikes. Although the market has been somewhat sanguine about earnings thus far, rewarding beats and not thrashing misses too harshly, it could also mean that the bar has been raised for what level of beat or guidance is required to impress angsty investors. 

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