Friday the December 18th 2015 brought us a quadruple witching day, which was the expiration of index futures, index options, stock options, and single stock futures all on the same day. Such a day was always expected to bring much greater volatility to the markets.
According to JP Morgan regarding Friday’s (December 18th 2015) quadruple witching event the following was gleaned.
The (FOMC) Federal Open Market Committee’s announcement about the possible interest rate hike on Wednesday, the 16th December 2015 fell at a peculiar time — less than 48 hours before the largest option expiry in many years. There were $1.1 trillion of S&P 500 options expiring on Friday morning, the 18th December 2015. $670 billion of these were puts, of which $215 billion were struck relatively close below the market level, between $1900 and $2050 strike prices. Clients were net long on those puts and would likely hold onto them through the event and until expiry. At the time of the Fed announcement, these put options were essentially looking like a massive stop loss order under the market conditions. What this meant was that majority of the option traders were expecting the market to go down and were using the long puts as hedges or stop losses.
Throwing oil scenario into the mix, investors weighed low oil prices and worse than expected economic data as the causes for the weakness in the market and made the month of December 2008 the most volatile December for markets since the start of the recession back in 2008.
Digesting all the possible high volatility and the news that might come up in the week starting Monday the 14th December, the following one-directional trade which was a ATM BPS (at the money bull put spread) was set up for the Russell 2000 Index (RUT) and was executed on Monday with only 5 days until expiration.
Buy to Open RUT Dec 2015 1120 Put
Sell to Open RUT Dec 2015 1125 Put
The RUT Index price $1123.60.
for a credit of $2.35 for 1 contract. The order was placed for 10 contracts.
Total premium collected $2350.
In order to make a decision whether or not to place this very aggressive trade let us calculate the return on investment and also run the Kelly Criterion and see what the results are. Kelly Criterion calculates the odds, the edge and the percent of the bank roll that one can bet on the trade based on the probability of success.
YEAR
2015
UNDERLYING
RUT
DATE
14-Dec
EXPIRATION
Dec 18, 2015
DAYS until expiration
5
PROB OTM (out of the money)
50%
DELTA
50%
SHORT STRIKE
$ 1125
STOCK PRICE
$ 1123.60
%OTM
-0.12%
LONG STRIKE
$ 1120
SPREAD
$ 5.00
CREDIT
$ 16.85
DEBIT
$ 14.50
Commission
$ 0.10290
NET CREDIT
$ 2.24710
%Comm
4.38%
RC (Risk Capital)
$ 2.75
RORC (Return on Risk Capital)
81.63%
Multiplier for the year
73.00
ARORC (Annualized Return on Risk Capital)
5959%
Kelly Criterion
Probability of Success (p) = 0.4741 (probability of the short strike out of the money at expiration)
Probability of Failure (q) = 0.5259 (1 – p)
Net Profit per share = $2.247
Potential Loss per share = $2.75 ($5 – $2.25)
Odds (b) = 2.247/2.75 = 0.817
Edge = p.b – q = (0.4741). (0.817) – 0.5259 = – 0.13856
Oops we are getting a negative edge
Kelly betting % = Edge / Odds = – 0.13856 / 0.817 = – 0.169
We shouldn’t go forward with the trade.
Here is where the trader has to think further and realize that the probability of success is based on normal distribution. Kelly Criterion does not know about the FOMC meeting for the interest hike. This hot news on Wednesday afternoon can skew the probability distribution in our favor. Let us assume the news skews the probability of success to 80%.
Recalculating the edge
(0.8) . (0.817) – 0.2 = 0.45
Kelly betting % = 0.45 / 0.817 = 0.55
Now I can bet 55% of my bank roll!
I am only betting 2% of the portfolio!
This is how the trade went in our favor.
On the 14th Dec 2015 RUT opened at 1123 and slid to 1117. This helped to get into the trade and collect the sizable premium we wanted.
On the 16th Dec 2015 RUT opened at 1134 and closed near 1149 following the FOMC announcement.
On the 17th Dec 2015 RUT dropped to 1135 at the end of the day.
On the 18th Dec 2015 Friday RUT opened near 1135 but ended the week at 1121. Luckily the RUT closing price is decided based on the opening prices of the components of the RUT index called RLS at the opening of the expiration. RLS was calculated to be 1130 and so our Bull Put Spread survived the drop (short strike at 1125, follow the two red lines in the graphic above) even though at the end of the day RUT closed at 1121!
Bottomline
Cash in the volatility, time and hot news for Moola. Options play lets you do just that. But proper judgment suitable to the circumstance is required and that comes from experience and keeping abreast of the latest news.
Prize at stake is 5959% return on investment.
The Fed decision on Wednesday, the 16th December 2015 was well signaled and the 0.25 rate hike initially had a positive effect on equities. For the week ending on the Friday the 18th December 2015, the S&P 500 Index (SPX) dropped a modest 0.3% but settled below both its 50 and 200-day Moving Averages, which could provide some upside resistance. The Blue Chip-heavy Dow Jones Industrial Average’s ($DJI) fell 0.8% and Friday was its worst session since the beginning of September. The Nasdaq (QQQ) also finished the week down 0.8% while the small caps (RUT, IWM) were off only minimally. The downside pressure we experienced on Thursday and Friday may send waves through Global markets to start the Christmas Holiday week.
As stocks dumped to end the week, volatility on the S&P 500 (VIX) rose into Friday’s close. The ‘Fear Gauge’ was elevated to start the week and fell sharply into the Fed decision on Wednesday but quickly rose into the close on Friday.
Amidst all the price action and volatility, the trade was successfully executed with a return on investment of 5959%! Whola!
