Ahead of the key FOMC decision on Wednesday, I wanted to discuss a few themes and trades that I like the volatility setup for as we head into the new week:
Market (SPY) vol looks cheap ahead of the meeting.
The weekly at the money SPY straddle is pricing in a roughly 1.6% move. Considering the market has had realized moves of 4%+ in the last two weeks, and we have the FOMC decision and a few other economic data points, this looks very attractively priced. I also favor owning vol ahead of the meeting because the market has once again rallied back to just below the July/August highs and is sitting right below a key technical level (chart 1). A breakout to new highs on the rate decision/press conference could spark further momentum/short-covering buying, while a disappointing reaction could see the market give back a decent portion of the 4% gains we saw this past week. Regardless of the market viewpoint, I think owning vol into the event this week makes a lot of sense. Here are 2 specific trades to consider:
Buy SPY Sept 20th 555 puts for $2.50 (SPY 562 ref) – buying the 1% out of the money weekly puts (after factoring in the dividend on 9/20). SPY closed a week ago Friday at $540, so a failed breakout from the prior highs could see a meaningful decline after the strong rally last week. This is a cheap hedge to protect market gains on what should be a market moving event.
Buy SPY Sept 20th 566 calls for ~ $2.10 (SPY 562 ref) – buying the 1% upside weekly calls (also factoring in the dividend on 9/20) at a level right above the prior highs. Whether it’s looking to protect a market short position, or as an added cheap upside “kicker”, this is the level where you would want to own the upside from on a market breakout.
Bonds (TLT) look susceptible to a pullback with yields at/near the lows. October collars offer a very attractive way to hedge long exposure.
Bonds have also enjoyed a sharp rally with TLT up over 12% from the July lows and they are now back at the December highs (chart 1). We could be setting up for a “sell the news” event in treasuries as the expected rate cut announcement has been clearly telegraphed for quite some time now. With the hotter than expected CPI and PPI data this past week, as well as the continued weakening US$ and treasury supply concerns given the deficit, it wouldn’t be a huge surprise to see bonds selloff regardless of if they cut 25 or 50.
Making the TLT collar trade even more interesting is that upside calls continue to trade “rich” to puts. That call to put skew exploded higher on the August carry trade concerns. While it has come in somewhat, calls remain “rich” to puts and continue to trade at a decided premium (chart 2). If looking to hedge long bond/duration exposure into the Fed, here is a trade I suggest:
Sell TLT Oct 104 Calls
Buy TLT Oct 99 Puts
Costs ~ $0.50 (TLT 100.41 ref)
With calls trading rich to puts, this trade allows for nearly 4% upside (after factoring in the expected dividend on 10/1), while owning the 1% downside put. Selling the upside call covers half the cost of owning that protective put. I believe this is a very attractive way to hedge exposure through the Fed meeting and for more than a month after.
Upside gold (GLD) calls for November look super cheap relative to the closer to the money calls.
Gold continued to trade very well and closed at another all-time high on Friday. However, even as gold continues to climb, upside call vol remains “cheap” relative to the higher-delta, at the money calls in GLD (chart 1). This dynamic is rather surprising to me since gold upside call skew tends to move higher with gold in much the same way that market (SPY) puts tend to get more expensive as the market goes lower. I believe as gold continues to rally we should start to see this upside call skew normalize, especially as we get closer to the election. I am also closely watching the declining US$ index (DXY) as a break below the 2023 lows could be the catalyst to really set gold flying (chart 2). Here is a low-cost trade I really like to play for both further upside in GLD, while also capturing the above-mentioned attractive call skew:
Sell GLD Nov 242 calls 1x
Buy GLD Nov 250 calls 2x
Costs ~ $0.45 (GLD 238.68 ref)
Selling 1 Nov call to buy 2 of the upside Nov calls. This structure has long delta notional, positive gamma and vega to start. This long exposure will grow as gold moves higher and I fully expect to see the bid/vol on the upside calls move up much more than on the lower-delta calls should we continue to see gold make new highs. I especially like the November expiry since gold should see some elevated volatility as we head into the election as well.
