Buyside Strategies EQD Research Volatility
May 29, 2020
By Russell Rhoads, head of research
Very seasoned option traders can recall a time when they would never even consider taking time off during the third week of each month. Specifically, the week that contained the third Friday of each month, which was, and still is, standard option expiration. There are trading strategies that are best utilized when expiration is close and traders have a short-term outlook. With options on most actively traded stocks expiring each Friday, these types of short-term trades can now be executed each week. Some markets, such as Nasdaq-100 (NDX) Index options, offer the chance to benefit from an outlook of just a day or two more than once a week, as there are NDX options expiring on each Monday, Wednesday and Friday. The following examples take a short-term outlook and turn it into a short-term option trade that expires the day after the trade is initiated.
First, a short-term bullish outlook, even for just a day, can be traded using NDX options. For example, on Friday, May 15, NDX closed at 9152. Shortly before the close the NDX May 18 9150 put could be sold at 97.00 points and the NDX May 18 9100 put purchased for 72.00 points resulting in a credit of 25.00 points. The payoff at expiration, one trading day later, appears below.
The risk/reward for this one-day trade is a loss of 25.00 points versus a gain of 25.00 points. NDX closed just above the short 9150 strike price on May 15, so even a slightly lower NDX close on May 18 would result in the trade profiting by the full 25.00 points trade credit. The worst-case scenario is NDX closing under 9100 which results in the maximum loss of 25.00 points. Finally, a partial profit can be realized if NDX closes over 9125 on May 18, again a profit being realized when the trader gets the direction wrong.
The time value crush that occurs near expiration also makes iron butterflies and iron condors attractive, especially with the current elevated levels of volatility. On Thursday, May 21, NDX closed at 9377.99. If a trader thinks Friday, May 22, would be a relatively quiet (pre-holiday weekend) day for the NDX he or she might consider a neutral spread with a defined risk and reward scenario. For example, the NDX May 22 9300 put could be sold for 33.00 points and the May 22 call sold for 20.00 points. The NDX May 22 9280 put could be bought at 28.00 points and May 22 9470 call purchased for 16.00 points netting out a credit of 9.00 points and a trade that has an outcome on the close, May 22, shown in the diagram below.
The risk for this trade is a loss of 11.00 points if NDX closes below the 9280 or above the 9470 price levels. The sweet spot for this trade falls between 9300 and 9450 with break-even levels 9.00 points lower and higher at 9291 and 9459 respectively.
An alternative to this trade is the iron butterfly. Many traders are reluctant to trade an iron butterfly due to the almost certainty that one of the options will be in the money at expiration. However, with cash settlement this concern should not discourage traders from considering this neutral spread.
Again, on May 21 with NDX at 9377.99 a trader decides to go the iron butterfly route with a neutral outlook for NDX the following day. The closest strike is 9380 which results in selling the May 22 9380 put for 60.00 points and the May 9380 call for 46.00 points. The May 9280 put is bought at 28.00 points and the 9480 call at 14.00 points resulting in a net credit of 64.00 points and a payout on the May 22 close that appears below.
The dollar risk on this trade is a loss of 36.00 points if NDX is below 9280 or above 9480. The break-even levels are slightly narrower than the break even for the iron condor at 9316 and 9444. An NDX close at 9380 would result in a gain equal to the 64.00 points credit taken in when the trade was initiated, which of course is an unlikely outcome.
The consideration of using the iron condor or iron butterfly may come down to confidence around the price forecast. More certainty of a neutral day for NDX favors the butterfly, while lower confidence in the forecast would lead a trader to the condor.
In this case, the butterfly would be the better of the two trades as NDX was up 36.00 points to close at 9413.99 on May 22. All four legs of the iron condor would expire out of the money and the result is a profit of 9.00 points. The short May 22 9380 call expires 33.99 points in the money while the other three contracts expire out of the money. The cash settlement process debits the trader’s account by 33.99 points which is offset by the 64.00 points credit taken in the day before making the iron butterfly profit 30.01 points.