1 Alpha Opportunity In The Current S&P Skew

In a new report, Bank of America analyst Youssef Brahimi discusses how traders can profit from the extremely narrow trading range and steep skew that the S&P 500 has exhibited throughout 2015. Brahimi suggests one approach to the historically tight trading range using an SPX option strategy.

The pattern
According to the report, the closing high-low range for the S&P 500 so far in 2015 is 1992.67 to 2130.82. That range represents only a 6.9 percent spread, the smallest spread the market has exhibited in 90 years.
 

According to Brahimi, there is plenty of market psychology driving the tight range. Buyers jump in quickly on any small dips the market makes in part because of the high level of global central bank liquidity. On the other hand, fears of lofty equity valuations and the uncertainty surrounding the Federal Reserve’s interest rate hikes have led to sellers jumping in when the market reaches the upper limits of its range.


The trade
Brahimi recommends buying an SPX 3-month 2150 put with a 1950 knock-out (KO). The position indicatively costs about $23.15, or 1.1 percent of spot, which is about a 71 percent discount to a “vanilla” 2150/1950 put spread.


Scenarios
Brahimi outlines what a trader could expect from the KO put described above given the three possible market outcomes:
1. If the SPX rises above the 2150 put strike, the put expires out of the money and the trader loses the premium.
2. If the SPX finishes between 1950 and 2150, the put expires in the money with a maximum potential payout ratio of 8.7-to-1.
3. If the SPX breaches the 1950 KO barrier, loss would be limited to the upfront premium.