I have been exercising patience in the face of this move up and refraining from positioning to the downside too early, given that I was expecting that at least SPX 1710 will get hit and the structure to the upside looked incomplete. At this stage, with SPX having hit 1710 today and soon to be bumping up into the TL off 2009 lows, I am now ready to position for the bigger move down, and wanted to share how I think about it.
One aspect of my market view that affects such positioning is my uncertainty of whether we are completing the entire move off June lows most likely this week, or whether this is only wave 3 off June lows and after a pullback to 1670ish, we make another run at the highs. I’m leaning slightly in favor of the latter, although the current attractiveness of skew makes me not want to miss the opportunity in case if the former plays out.
So, in structuring this trade I am taking the conservative approach of preparing to hold the position through a potential wave 5 yet to come, which would likely chew up much of the remainder of August.
Given the very real potential for that wave 5 yet to come, I am only considering downside plays starting with September expiration and further out, to December. As I’ve said many times, when I buy options I first and foremost look at it from the standpoint of buying implied volatility, and as such, I try to find a point on the volatility surface (surface consisting of maturities on one axis, and strikes on the other) that has appealing pricing while fitting with my directional view for SPX.
The attached table provides implied vol for SPY puts across several strikes and maturities, as an abbreviated version of the vol surface, captured this afternoon when SPY was at 170.60. When I look at the vol structure, I first compare ATM vol across maturities. For the purposes of this exercise, 170 can be considered ATM. The contango structure of implied vol, with further-out maturities offered at a premium to near-term maturities, is a standard term structure for equities. The slope of term structure is rather flat, part of of the “compression” dynamic that LB has been writing about.
Next, I look at skew — the difference between downside implied vol relative to ATM implied vol. The “160-170 skew” column captures the difference in vol for these strikes, across maturities. Though it appears that skew gets cheaper as you go out further on the time spectrum, it’s really due to the fact that ATM vol becomes more expensive, as the column “160 vol relative to Sept” shows that vol implied vol at that strike is actually rather stable across maturities. I also look at shape of downside skew across different strikes for a given maturity. For instance, looking at October, I notice that the steepening of the skew slope picks up noticeably at around 164 strike.
Lastly, I look at significant support regions in the underlying that will likely contain the first wave of the move. The highly contested 1590-1600 SPX (~159-160 SPY) region is a clear pivot region that sticks out. The goal is to have strikes be no further than ATM (where vega becomes most pronounced) relative to a significant support.
Triangulating the current setup and structure, the plays I like most are:
164-166 strikes for October
161-162 strikes for November
Keep in mind that the goal is not necessarily to hold these to maturity for their intrinsic value, a big part of the bet is that implied vol for these lines will get bid up.
Challenges are welcome, as are other approaches… this is by no means the “one right way,” merely a window into how I think about it.
Originally published on ElliottWaveTrader.net , posted by contributing analyst Xenia Taoubina.
