Options Trading is Not about the Greeks
CME: E-Mini S&P 500 Options (
ES1!)
On March 24th, I published a trade idea, “Buckle Your Seatbelt for a Market Correction”, where I suggested that the US stock market was due for a major correction. Buying a Put contract on CME E-Mini S&P 500 Futures would be a trade to express this market view.
How is this trade panning out?
• On March 24th, the June S&P futures contract (ESM4) was settled at 5,289.75. The out-of-the-money (OTM) put strike 5,100 was quoted at 63.
• To purchase a Put, a trader would pay an upfront premium of $3,150 (= 63 x 50).
• On April 18th, the S&P has been down for five straight days, and ESM4 was settled at 5,49, losing about 4.6% since we first placed the trade on. Meanwhile, the 5100 put is now trading at 150.75.
• Our put position is valued at $7,537.50 (= 150.75 x 50). If we were to close the trade now, we would realize a hypothetical return of +139.3% (= 150.75/63 -1) in less than a month, excluding transaction cost.
While the underlying stock index is lowered for less than 5%, and the put strike is barely in-the-money (5049 is 51 points below 5100), the value of the put contract has been more than doubled. This trade showcases the attractiveness of an options strategy.
Firstly, there is time value on the put contract. We have two more months to trade until the options expire on June 21st, the 3rd Friday of the contract month. The probability that the S&P could go significantly lower than 5100 makes the put options very valuable.
Secondly, there is a multiplier of 50 built into the options contract. Each index point that the S&P moves in-the-money, the Put position will gain $50 per contract.
Thirdly, the volatility of the S&P 500 index has increased 50% in the past month, from 12-12.50 to 18-19.50. Higher volatility makes options contracts more valuable.
Options Greeks are Lagging Indicators
My trade idea did not price in volatility increase. In fact, it did not even mention any of the options Greeks – Delta, Gamma, Theta, Vega, and Rho.
In my opinion, the Greeks are concurrent indicators or lagging indicators. Take the VIX index as an example. It captures historical volatility about the S&P 500. However, options are priced by the implied volatility. It is the market consensus, or collective sentiments from all the buyers and sellers, about what volatility would be in the future. In this case, historical volatility is not very useful in gauging future volatility.
All sophisticated options pricing models eventually bog down to a subjective estimate of the implied volatility. The Greeks are precise about what the market has been, but they are not useful in assessing how market sentiment will be a month from now.
We could illustrate this with CME Group’s FedWatch Tool, which shows real-time market sentiments in Fed rate cut probability.
• On March 24th, it indicated the probability of a 25-bp cut in June at 75.5%. There was a 77% chance that Fed Funds move to 4.50%-4.75% by year end, indicating a total of three rate cuts in 2024. Four total rate cuts, which would be a full percentage point lower, was priced at 43% probability.
• On April 18th, the probability of a 25-bp cut in June is now down to just 15.3%. The probability for total rate cuts in 2024 are: 2 cuts (32.4%), 1 cut (36%) and no cut (15%). We may recall that only four months ago the market consensus was 6-7 rate cuts.
(Link: cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html)
If you measured the market last month based on the Greeks, you would have expected the S&P to go higher. Instead, market sentiment turned upside down as March CPI and Nonfarm payroll data completely destroyed the hope of near-term Fed rate cuts.
Trading with E-Mini S&P Options
In my opinion, the market correction is not over yet. There is a good likelihood that the S&P to move down 10%-15% from its peak of 5,265, to the range of 4,475-4739. Here are the key drivers:
• US stock market had a spectacular run in the past two years on the back on AI revolution. While the seven Big Tech companies gained over 50%, the remaining 493 stocks registered low single-digit returns. We are now at the breaking point where the Magnificent Seven could no longer carry the heavy burden of the mediocre performance of the rest.
• The lowered expectation of Fed rate cuts results in higher-than-expected future interest rates. This puts downward pressure on company valuation. I had several writings explaining how the discounted cash flow (DCF) valuation works.
• Escalated geopolitical tension triggers a flight to safe-haven securities. Gold would gain in value while the stock market would decline.
CME Group E-Mini S&P 500 Options provide leverage and capital efficiency. Options are based on futures contracts. The contract notional is $50 x S&P 500 Index.
On April 19th, the June S&P futures contract (ESM4) is now quoted at 5,031.75. The 4,850-strike put is quoted at 64.75. To purchase a Put, a trader would pay an upfront premium for $3,237.50 (= 64.75 x 50).
Hypothetically, if the S&P lowered 10% from its peak to 4,739, the put position would be 111 points in-the-money (= 4850-4739). The trader could exercise the options to capture the price difference or sell the put at a higher price.
If the S&P ends up with a smaller correction, the trader could lose money, up to the full amount of the upfront premium.
Options traders could find CME’s Options Calculator an easy-to-use tool in structuring their options strategies. The best part, it is free.
cmegroup.com/tools-information/quikstrike/options-calculator.html
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/
ES1!)On March 24th, I published a trade idea, “Buckle Your Seatbelt for a Market Correction”, where I suggested that the US stock market was due for a major correction. Buying a Put contract on CME E-Mini S&P 500 Futures would be a trade to express this market view.
How is this trade panning out?
• On March 24th, the June S&P futures contract (ESM4) was settled at 5,289.75. The out-of-the-money (OTM) put strike 5,100 was quoted at 63.
• To purchase a Put, a trader would pay an upfront premium of $3,150 (= 63 x 50).
• On April 18th, the S&P has been down for five straight days, and ESM4 was settled at 5,49, losing about 4.6% since we first placed the trade on. Meanwhile, the 5100 put is now trading at 150.75.
• Our put position is valued at $7,537.50 (= 150.75 x 50). If we were to close the trade now, we would realize a hypothetical return of +139.3% (= 150.75/63 -1) in less than a month, excluding transaction cost.
While the underlying stock index is lowered for less than 5%, and the put strike is barely in-the-money (5049 is 51 points below 5100), the value of the put contract has been more than doubled. This trade showcases the attractiveness of an options strategy.
Firstly, there is time value on the put contract. We have two more months to trade until the options expire on June 21st, the 3rd Friday of the contract month. The probability that the S&P could go significantly lower than 5100 makes the put options very valuable.
Secondly, there is a multiplier of 50 built into the options contract. Each index point that the S&P moves in-the-money, the Put position will gain $50 per contract.
Thirdly, the volatility of the S&P 500 index has increased 50% in the past month, from 12-12.50 to 18-19.50. Higher volatility makes options contracts more valuable.
Options Greeks are Lagging Indicators
My trade idea did not price in volatility increase. In fact, it did not even mention any of the options Greeks – Delta, Gamma, Theta, Vega, and Rho.
In my opinion, the Greeks are concurrent indicators or lagging indicators. Take the VIX index as an example. It captures historical volatility about the S&P 500. However, options are priced by the implied volatility. It is the market consensus, or collective sentiments from all the buyers and sellers, about what volatility would be in the future. In this case, historical volatility is not very useful in gauging future volatility.
All sophisticated options pricing models eventually bog down to a subjective estimate of the implied volatility. The Greeks are precise about what the market has been, but they are not useful in assessing how market sentiment will be a month from now.
We could illustrate this with CME Group’s FedWatch Tool, which shows real-time market sentiments in Fed rate cut probability.
• On March 24th, it indicated the probability of a 25-bp cut in June at 75.5%. There was a 77% chance that Fed Funds move to 4.50%-4.75% by year end, indicating a total of three rate cuts in 2024. Four total rate cuts, which would be a full percentage point lower, was priced at 43% probability.
• On April 18th, the probability of a 25-bp cut in June is now down to just 15.3%. The probability for total rate cuts in 2024 are: 2 cuts (32.4%), 1 cut (36%) and no cut (15%). We may recall that only four months ago the market consensus was 6-7 rate cuts.
(Link: cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html)
If you measured the market last month based on the Greeks, you would have expected the S&P to go higher. Instead, market sentiment turned upside down as March CPI and Nonfarm payroll data completely destroyed the hope of near-term Fed rate cuts.
Trading with E-Mini S&P Options
In my opinion, the market correction is not over yet. There is a good likelihood that the S&P to move down 10%-15% from its peak of 5,265, to the range of 4,475-4739. Here are the key drivers:
• US stock market had a spectacular run in the past two years on the back on AI revolution. While the seven Big Tech companies gained over 50%, the remaining 493 stocks registered low single-digit returns. We are now at the breaking point where the Magnificent Seven could no longer carry the heavy burden of the mediocre performance of the rest.
• The lowered expectation of Fed rate cuts results in higher-than-expected future interest rates. This puts downward pressure on company valuation. I had several writings explaining how the discounted cash flow (DCF) valuation works.
• Escalated geopolitical tension triggers a flight to safe-haven securities. Gold would gain in value while the stock market would decline.
CME Group E-Mini S&P 500 Options provide leverage and capital efficiency. Options are based on futures contracts. The contract notional is $50 x S&P 500 Index.
On April 19th, the June S&P futures contract (ESM4) is now quoted at 5,031.75. The 4,850-strike put is quoted at 64.75. To purchase a Put, a trader would pay an upfront premium for $3,237.50 (= 64.75 x 50).
Hypothetically, if the S&P lowered 10% from its peak to 4,739, the put position would be 111 points in-the-money (= 4850-4739). The trader could exercise the options to capture the price difference or sell the put at a higher price.
If the S&P ends up with a smaller correction, the trader could lose money, up to the full amount of the upfront premium.
Options traders could find CME’s Options Calculator an easy-to-use tool in structuring their options strategies. The best part, it is free.
cmegroup.com/tools-information/quikstrike/options-calculator.html
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/
Jim W. Huang, CFA
jimwenhuang@gmail.com
jimwenhuang@gmail.com
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