Know Unknown

by | 11.28.2022 | Lime Newsletters

Event-Specific Inflection Points – More Frequent Than One Thinks

Events happen. As a result, some of the most impactful occasions are scheduled – elections, black Friday, Fed meetings – so we know when to expect them. But anticipating their “directional effect” (i.e., whether the market will react up or down) is a different story. At best, investors can expect, with some conviction, that the catalyst will either trigger a big relief rally or a disappointment dump but cannot predict which one. It’s a bit like flipping a coin – we know it will fall head or tails, but we can’t anticipate how it will land.

We have presented a similar case before  in Issue 1– a longer-term bifurcated trend for the equity driven by slow-but-steady drivers like inflation or interest rate cycles. But the same phenomenon can happen in very short period (i.e., under 5 trading days).

Examples vary – a general election, Fed meetings, rate announcements (specifically, Federal Open Market Committee), inflation and employment numbers, etc. But the logic extends beyond those big events: black Friday and sales volumes, earnings calls from flagship corporates (Apple, Amazon, JP Morgan, etc.), OPEC meetings, etc.

To identify these impactful “bifurcated outcome” events, look for common indicators; for example, if the market is paying attention (i.e., currently, inflation is top of mind for most investors), and if the range of expectations is wide (again, the breadth of inflation expectations is wide).



(Very) Short-Term Options Strategy Ahead of Anticipated Events

Investors that anticipate if an event is likely to trigger a >3% change in 10 days or less (for example, an election, the release of Fed minutes, an inflation announcement), can deploy a simple straddle strategy.

It is very important to keep in mind that this is an “all or nothing” trade that only lives for a few days. Investors that engage in this strategy typically invest amounts that are marginal to their net worth. The upside has the potential to be significant if the investor’s anticipation of a big market reaction is successful.

The plain vanilla straddle is a very simple trade: buy put and call option contracts that accrue a profit if a security moves more than a certain threshold. Because the expiration date is within a few days, investors can pay a relatively small amount to replicate the performance of a large amount of underlying. For example, using the SPY as underlying (ETF that tracks the SP500), replicating the performance of $39.1k of principal moving more that 2% over 8 days would cost approximately $740.

In this example, we present two alternatives: (1) using the market-wide SPY as the underlying for top-down macro events using Nov 25 expirations and (2) using the tech-heavy QQQ (tracks the Nasdaq). Since the SPY has lower relative volatility compared to the QQQ, we are using a 2% threshold for the SPY and 4% for the QQQ.



What could go wrong with this type of strategy?

The VIX and the 2yr-to-10yr spread are indicators of the market’s risk aversion or appetite more than direct investment strategies. Investors that trade the VIX– either long or short– are effectively trading in an indirect, highly complex measure of volatility in the options market with very limited visibility for most investors (nearly everybody except highly trained specialists).


© 2022 Securities are offered by Lime Trading Corp., member FINRA & SIPC, NFA, Lime Advisory Corp is an investment adviser registered with the SEC. and Lime FinTech is a technology business. Collectively known as “Lime Financial” or “Lime” provide various trading, investment advisory services, and technology solutions including web and mobile trading applications, to retail and institutional investors. All investing incurs risk, including but not limited to loss of principal. Further information may be found on our Disclosures Page.

Please read the Options Disclosure Document titled “Characteristics and Risks of Standardized Options” before trading options.

Options trading entails significant risk and is not appropriate for all investors. Certain options strategies carry additional risk and investors may lose 100% of funds invested in a short period of time. Investors should consult with a tax advisor as to how taxes may affect the outcome of any options strategy. Options trading privileges are subject to Lime Trading Corp. review and approval. Transaction costs may be significant in multi-leg option strategies, including spreads and straddles, as they involve multiple commission charges.

This material has been prepared for informational purposes only and is NOT intended to provide nor should it be relied on for tax, legal, or accounting advice. Please consult your own tax, legal, and accounting advisors before engaging in any securities transactions as each individual investment(s) may result in diverse/adverse tax implications that will affect the outcome of any investment strategy. No information presented herein should be considered an offer to buy or sell a particular type of security. This is not an offer or solicitation in any jurisdiction where we are not advertised to do business. Other fees, such as regulatory, service, or other fees, may apply. Please visit our Pricing Page for further information. Investments involve risk, past performance does not represent future results. Diversification may help spread risk but does not protect in a down market. You may lose all of your investment. Investors should evaluate their financial situation, investment objectives, and goals before investing. Substantial risks are involved with electronic trading. Day trading involves significant risk and is not suitable for all investors. Please see our Day Trading Risk Disclosure Statement for more detailed information. Trading on margin is not appropriate for every investor. Please see our Margin Disclosure Statement for information on risks. System response may vary due to multiple factors including but not limited to trading volumes, market conditions, system performance, and other factors. Access to electronic services may be limited or unavailable during periods of peak demand, market volatility, systems upgrades, maintenance, or for other reasons.

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