cliff

We have profitably put on a similar trade in the past, but we believe selling ATM March 10th SPY Puts at $2.72 vs buying ATM March 17th SPY Puts at $3.53 (net price of ~$0.81) provides an excellent asymmetric risk/reward given the potential debt ceiling catalyst on March 15th, 2017. Given the current SPY price of $229, this net price of $0.81 equates to a roughly 0.35% move in the index. These March 10th and 17th SPY options are just being priced with a simple term structure, and are not taking into the potential vol associated with the potential debt ceiling deadline. In fact, these March 10th options just started trading on Friday, and we imagine this spread will tighten slightly to $0.70-$0.75 as volume picks up over the next week.

As long as this trade is managed correctly (taken off in a selloff before March 10th), there is no risk of losing more than the net premium, as options with a longer time value always should be worth more than an option with an earlier expiration with the same strike.

mar-10

http://finance.yahoo.com/quote/SPY/options?p=SPY&date=1489104000

mar-17

http://finance.yahoo.com/quote/SPY/options?p=SPY&date=1489708800

There has been minimal coverage of the March 15th, 2017 debt ceiling deadline, and the limited coverage has to do with money market rates:

Because of a deal struck to avoid a debt-ceiling showdown during the election season, the Treasury Department will have to cut its cash balance from about $370 billion to $23 billion, the previous level when the limit was suspended in November 2015. To put that in perspective, the Treasury estimates it needs to maintain a weekly cash cushion of about $150 billion just to pay its bills. [1]

“The existence of the debt limit is hard to defend; it is a purely political construct,” Lew said. “No longer a tool for simplifying the borrowing process, the debt limit has morphed into a weapon that irresponsible actors in Congress can wield against our economic well-being.”[1]

While Congress is controlled by the Republicans, there still is disagreement amongst the party over raising the debt ceiling:

Votes to raise the debt ceiling are the most-onerous ones a member of Congress can cast. No one wants to vote to “raise” the debt ceiling because it looks fiscally irresponsible. Yet failing to vote to raise the debt ceiling could send a shock through the bond market and roil global financial markets. Such a phenomenon unfolded in August, 2011 even though Congress managed to hike the debt ceiling.[2]

This combined with controversial executive orders and trillions in proposed infrastructure spending in just the first week of the Trump administration may cause law makers to use the debt ceiling as a time to take a stand, causing some uncertainty and vol in the markets reminiscent of what happened at the end of 2012.

The scenarios of this trade are as follows:

  1. The market stays flat through March, and the debt ceiling is resolved with no issue. Lose $0.81 net premium.
  2. The market sells off hard before March. The spread between the two puts should widen, making some money. However, this trade needs to be managed and reset to the ATM lower strikes after a selloff, otherwise there is a risk of the market ripping during the week of March 10th, causing a large loss.
  3. The ideal scenario is that the market stays roughly flat until the puts which were sold expire (March 10th). Then you have created a very cheap option for the week of March 10th-17th, where politicians/the new administration can create uncertainty in the market by waiting until the last minute to act. A 2% move down in SPY would result in this trade being up roughly 6x.
  4. The market rallies hard before March. Vol most likely goes lower and the spread narrows, causing a small loss. The options should be rolled into the new ATM higher strikes if appropriate.
  5. The debt ceiling is raised March. Take the trade off, the spread is most likely unchd.

Additionally with this trade you are essentially owning vol at almost historic lows with a real catalyst. This is an event which other politicians can use to push their own agenda against the new administration, and while we do expect a deal to ultimately get done, there is real risk that it could come down to the last minute and there will be jawboning from both parties.

While there are plenty of macro events which can cause the market to move before this event, it is easy to roll into new ATM strikes if appropriate. Not many investors are talking/thinking about the debt ceiling, making this opportunity interesting. Again, we put on a similar trade in 2012, making ~5x.

[1] https://www.bloomberg.com/news/articles/2017-01-18/debt-ceiling-dilemma-redux-gives-u-s-treasury-bills-a-squeeze

[2] http://www.foxnews.com/politics/2016/11/10/trumps-first-order-business-daunting-debt-ceiling.html