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Difficulty: Hard
1) Morgan Stanley sees a 10% correction to S&P 500 in the short-term
2) Short-term US elections and Brexit risks are underappreciated by the market
3) Trade idea: Zero-cost S&P 500 diagonal put spread
The InvestQuest’s View
We expect a short-term market correction before year-end, and a recovery thereafter. In view of US Elections (3rd Nov) and the Brexit transition hard deadline (31st Dec), we believe that the probability of a short-term market correction is more likely to transpire before year-end, than at the start of 2021. In particular, we are not convinced that a fiscal agreement will be concluded prior to the US election.
Markets are complacent currently. Despite upcoming event risks, the S&P 500 Index has been grinding higher in the past month on fiscal stimulus optimism, and is now just 4% short of record highs. We believe that short-term portfolio hedges are warranted.
Our zero-cost idea to hedge US election risk: We have enacted diagonal put spreads on the S&P 500 ETF on 21 Oct to express our view. A variation of our strategy (with updated pricing as of 22 Oct) can be found in Section 3.
1) Morgan Stanley sees a 10% correction to S&P 500 in the short-term
After the S&P 500 failed to break above its long-term resistance lines (see charts below), Morgan Stanley turned tactically bearish earlier this week. Their base-case view is that a 10% correction is the most likely outcome in the near-term, with the 200-day moving average being the next substantial support.
Their rationale is that the lack of a deal on fiscal stimulus, election uncertainty and the second wave of the virus are key concerns and that the market should trend lower to reflect that. We agree with this view.
2) Short-term US elections and Brexit risks are underappreciated by the market
3 indicators showing that investors are complacent:
Indicator 1: The VIX Index hasn’t risen much despite the impending US Election event risk
The VIX Index is often used as a “fear index”, as it represents the market’s expectations for S&P 500 Index volatility over the coming 30 days. You can read more about the VIX in this Investopedia article.
Despite being two weeks away from US Elections, we have not seen a significant rise in the VIX (chart below), which we think is a result of investor complacency. While a Biden win (our base case view) is generally seen as market positive, we think that such a scenario has already been largely reflected in current stock index levels. A Trump win or a close vote count (which may result in a contention to the election results) are risks that seem to be underappreciated at the moment.
Indicator 2: Put-to-Call ratio indicates bullishness at extreme levels
Our view that the market is currently underappreciating short-term event risk is also supported by current investor positioning within the US Equity Options market. Looking at the Put-to-Call ratio (chart below), which is calculated by dividing the number of traded put options by the number of traded call options for US stocks, we see that investor interest is very much extremely skewed to buying call options.
Indicator 3: VIX Futures indicate that investors are pricing in lower risk for US Elections now vs three months ago
Another way to look at how investors are currently positioned is to look at the VIX Futures Curve (chart below). The VIX Futures contract represents the expected volatility for the S&P 500 Index, 30 days following the contract expiration.
- The horizontal x-axis shows the VIX Futures Contracts by their expiry dates.
- The vertical y-axis shows the VIX Futures Contract price level across the varying contract expiry dates.
We show how the curve looks now (red line) versus what the curve looked like three months ago (black line). We can see that the black line was significantly higher for the Oct-2020 contract (indicated by the arrow and text in blue). This means that the market had been pricing in a higher risk on US Elections 3 months ago, relative to the present.
The consequence is that S&P 500 put options expiring in December 2020 are not overpriced, in our view. We will show the put option pricing in the next section.
Separately, after the passing of the year-end event risks, the VIX Futures (red line) still remains elevated with only a very gentle downward slope into 2021. We think that this creates an attractive backdrop to be selling put options that expire in Mar 2021, where you can monetize a decent amount of option premiums.
We run through some possible option trades in the next section.
3) Trade idea: Zero-cost S&P 500 diagonal put spread
In Section 1, we highlighted our short-term bearish view on the S&P 500, with a view that any pull back will be transitory in nature.
In Section 2, we highlighted that after accounting for the event risks, S&P 500 put options expiring in Dec-2020 are not expensive, while put options expiring in Mar-2021 are quite expensive.
With these two thoughts in mind, we think that a diagonal put spread on the S&P 500 makes sense. This trade would involve two parts:
- BUYING an “at-the-money” put option — expiring in Dec 2020
- SELLING an “out-of-the-money” put option — expiring in Mar 2021
We have structured the trade as zero cost using the SPDR S&P 500 ETF (SPY US) across two iterations, where the option premium received from selling the longer-dated put option fully covers the option premium payments to buy the shorter-dated put option. Note that the SPY ETF’s share price is approximately one-tenth of the S&P 500. For example, the S&P 500 Index closed at $3,435.56 while the SPY ETF closed at $342.73 last night.
For iteration 1:
- If SPY ETF trades BELOW $343 on 18 December 2020, you have the OPTION to SELL SPY ETF at $343 (0.1% above last night’s closing price)
- If SPY ETF trades BELOW $320 on 19 March 2021, you are OBLIGATED to BUY SPY ETF at $320 (6.6% below last night’s closing price)
For iteration 2:
- If SPY ETF trades BELOW $343 on 18 December 2020, you have the OPTION to SELL SPY ETF at $343 (0.1% above last night’s closing price)
- If SPY ETF trades BELOW $285 on 19 March 2021, you are OBLIGATED to BUY 2x SPY ETF at $285 (16.8% below last night’s closing price)
Key risk: If the near-dated SPY ETF put option expires out of the money and the stock market subsequently declines in a big way, you will hold the obligation of having to buy the SPY ETF at the strike price, which may result in a principal loss.
The InvestQuest’s View
We expect a short-term market correction before year-end, and a recovery thereafter. In view of US Elections (3rd Nov) and the Brexit transition hard deadline (31st Dec), we believe that the probability of a short-term market correction is more likely to transpire before year-end, than at the start of 2021. In particular, we are not convinced that a fiscal agreement will be concluded prior to the US election.
Markets are complacent currently. Despite upcoming event risks, the S&P 500 Index has been grinding higher in the past month on fiscal stimulus optimism, and is now just 4% short of record highs. We believe that short-term portfolio hedges are warranted.
Our zero-cost idea to hedge US election risk: We have enacted diagonal put spreads on the S&P 500 ETF on 21 Oct to express our view. A variation of our strategy (with updated pricing as of 22 Oct) can be found in Section 3.
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