Event-Specific Inflection Points – More Frequent Than One Thinks

Event-Specific Inflection Points – More Frequent Than One Thinks

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?

This is a high-risk strategy − 100% hit or miss − with very little time to expiration. Because of this, investors will not have enough time to undo this strategy before expiration. Thus, when they commit to the strategy, they must ride it to the end. Moreover, if the market does not move significantly the investor is highly likely to book a loss of 100% of the invested capital.

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