UBS Recommends Options Pair Trade to Ride S&P 500's Grind Higher

Yahoo

4 days ago

(Bloomberg) -- The slow and steady march higher in the US stock market has been a painful ride for traders expecting President Donald Trump's tariffs to derail a rally that's lasted for more than four months.
While there's no guarantee the quiet climb to fresh records will continue, those willing to bet it will should consider putting on a moderately bullish options trade known as a call ratio spread, according to Maxwell Grinacoff, head of US equity derivatives research at UBS Group AG.
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The strategy involves buying a call option that's near-the-money, meaning it will profit if the S&P 500 goes up by a relatively small amount in the next month. To fund the trade, he suggests selling twice the number of calls at a significantly higher level. The key to putting on the trade is picking a point where you believe the S&P 500 will be in a month, while correctly choosing a higher level that it's unlikely to hit.
'What ends up happening is, as the market is slowly grinding higher, the one that you're long makes money,' explained Grinacoff. 'And the two that you're short, you typically strike it at a level where you just don't think the S&P is going to get to by expiry.'
Grinacoff first suggested the trade to clients in early June and it has performed well. There are good reasons to believe it could continue to be profitable as the index quietly scales new heights following a surprisingly strong earnings season and mostly in-line inflation data that has fueled anticipation of upcoming Federal Reserve rate cuts.
Elsewhere in options markets, traders also appear to be expecting further gains ahead. Those who had hedged are abandoning pessimistic positions, pushing the Cboe Volatility Index (VIX) — which gauges the expected volatility in the S&P 500 over the next month — to its lowest level since Christmas Eve of last year. The VIX dropped to the same level as the S&P 500's 10-day realized volatility on Tuesday for the first time since late May, indicating concerns over a tariff-driven selloff are fading.
The plunge in the VIX — which has dropped to about 14 from over 20 at the start of the month — was driven by 'capitulation' among those hedging for an August tariff tantrum that has yet to arrive, according to Mandy Xu, head of derivatives market intelligence at Cboe Global Markets Inc. The continued move higher in stocks has been 'frustrating a lot of hedgers, who are throwing in the towel at this point,' Xu told Bloomberg.
There is one risk on the horizon that could interrupt the continued slow and steady march higher in the S&P 500 in the next month. Fed Chair Jerome Powell is scheduled to speak at the central bank's Jackson Hole Economic Symposium on Aug. 23, an annual event that is often used to signal the near-term outlook for US monetary policy.
While fed-funds futures traders are currently fully pricing in a quarter percentage point reduction in the benchmark rate in September, and 2.5 cuts of that size by the end of the year, an especially hawkish speech by Powell could suddenly cause expectations to shift and create market volatility. Still, even that event is not expected to shake up the S&P 500 too much: Options markets are pricing in an impled move of about 0.67% on the day of the speech, less than the 0.83% implied move after Nvidia Corp.'s earnings report the following week, according to Citigroup equity trading strategists led by Stuart Kaiser.
The call ratio spread recommended by Grinacoff is 'pretty standard trade in this environment,' said Xu. 'What you are looking to express is that the market is going to grind higher.'
--With assistance from Jessica Menton.
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