Fed Fund Futures rate hike probability has widened post Warsh’s Jackson Hole commentary. While the probability stands at c60%, and we lean closer to a “hold”, a number of leading institutions are calling a rate hike. The reality is a coin-flip in our view.
Combine this with an index that has done largely nothing for three months and in a tight narrow range, especially in August. Arguably a market that appears complacent, as also reflected in a very normal VIX reading in the 15-16 area. We outlined a must defend level of 7400 for S&P (740 on SPY) and a blue skies above 7800 (780 on SPY) in our recent note - FOMC is likely to be a binary event that will wake this market out of its somnolence.
How does one protect the downside and yet retain the upside?
The Smirk To The Rescue
The chart above shows option positioning for 18th Sep expiry (2 days after FOMC) and is telling - Upside calls are cheap and the IV at the 740 level is still not excessive.
The Trade
Long Strangle (740-780)
Expiry 18 Sep 2026
Net Debit = $2.365/share = 0.31% (absolute)
Max Loss = 0.31%%
Delta = 104
Vega = 55
Why This Trade Works - If the FED hikes, we expect the market to sell off rapidly, increasing the value of the Long Put, aided by the expansion in implied volatility (this is a positive Vega trade). A FED on hold is likely to calm markets and likely to create conditions for a breakout.
The “dead zone” - risks - The risk an investor carries in this trade is capped at the premium paid - should the market continue to grind in its range, then the structure loses value rapidly.
What The Trade Looks Like if You Hold SPY
The following chart adds a long SPY position as a proxy for a broadly held diversified equity portfolio. The structure provides an effective low cost protection while retaining upside.
