Goldman Recommends Buying November 1,125 SPX Puts, Dec VIX Puts, Selling Dec VIX Call Spreads

From Goldman's Krag Gregory (Ph.D): "Expectations for QE2 and the election are high and fear as measured in options has been cut in half. We analyze the “optimal put” to buy for those who are fully invested, have participated in the recent market rally, and are concerned that the Fed or the election may disappoint. In a scenario where the market pulls back -2.5% by market close Wednesday, the optimal hedge is buying SPX November 1125 puts for $6.6, in our view." Yet the top recommendation by Goldman, based on some ironclad technical analysis, is that "VIX Futures are at 24.3, a hefty 12 points above or 2x the average realized vol level of 12 post midterm elections. If the FOMC and election results meet expectations, we see a scenario where implied vol could fall notably. We like using VIX options to position in a limited loss fashion." Therefore Goldman's two recommended trades: Trade1: Sell Dec-10 20-22.5 VIX call spreads for a credit of $1.2 (sell 20 calls/buy 22.5 VIX calls). Trade 2: Buy Dec-10 VIX 21 puts for $1.1. Of course, the past 12 midterm elections all occurred during an unprecedented market regime in which overall vol was trading in the 9-11 range, and as a result killed the swaption market. But who cares. All that matters is that Goldman wants to buy vol from its clients.

And what is it selling?

The “optimal” downside hedge: Buy Nov-10 1125 SPX puts for $6.6 to position for a potential decline (112 SPY puts). A downside scenario could occur if the FOMC underwhelms the market in terms of the amount of QE2 and election results disappoint, in our view. Given lower vol and skew levels and an upward sloping term structure, we prefer owning OTM November put options to hedge. Assuming a conservative no shift in by strike vol, our results indicate the “optimal” put to own assuming a 2.5% down-move in the SPX by close of market Wednesday November 3 would be the 1125 S&P 500 put strike (corresponding strikeon SPY: 112 ). Assuming a -5% move by Friday’s close (November 5) would suggest owning an 1100 strike put (corresponding strike on SPY: 110). Details of our analysis are provided on page 8. Option buyers risk losing the entire premium paid.

Thus, to be on the same side of the trade, one should be buying vol and selling a market dump (with big theta). Which means the sweet spot for a move lower will be one starting some time next week... Or something. Squid logic, after all, is impenetrable.

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