Event-Specific Inflection Points – More Common Than You Think

Event-Specific Inflection Points – More Common Than You Think

Events happen. As a result, some of the most momentous occasions are on the way – 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 another story. At best, investors can expect, with some conviction, the catalyst to trigger either a big relief rally or a disappointment, but they can’t predict which. It’s a bit like tossing a coin – we know it will come up heads or tails, but we can’t predict how it will fall.

We already presented a similar case in issue 1 – a longer-term bifurcated trend for equities, driven by slow but steady factors like inflation or interest rate cycles. But the same phenomenon can happen in a very short time (i.e. in less than 5 trading days).

Examples vary – a general election, Fed meetings, rate announcements (specifically, the Federal Open Market Committee), inflation and employment numbers, etc. , Amazon, JP Morgan, etc.), OPEC meetings, etc.

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

(Very) Short Term Options Strategy Ahead of Expected Events

Investors anticipating whether an event is likely to trigger a >3% change in 10 days or less (e.g. an election, Fed minutes release, 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 lasts a few days. Investors who 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 expectation of a significant market reaction materializes.

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

In this example, we present two alternatives: (1) use the market-wide SPY as the underlying for macro descending events using November 25 expiry dates and (2) use the technology-heavy QQQ ( followed by the Nasdaq). Since SPY has a lower relative volatility than QQQ, we use a threshold of 2% for SPY and 4% for QQQ.

What could go wrong with this type of strategy?

This is a high risk strategy – 100% pass or fail – with very little time until expiration. For this reason, investors will not have enough time to undo this strategy before expiration. So when they commit to the strategy, they have to see it through. Moreover, if the market does not move significantly, the investor is very likely to book a loss of 100% of the capital invested.

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