US stocks rebounded after a volatile session. How to use options to protect profits?

Source: CME Group

In recent weeks, the three major US stock indexes have experienced a rebound followed by a decline. As of September 4th, the Dow Jones Industrial Average closed at 34,721.91, down 2.36% compared to the previous month. The Nasdaq Composite closed at 14,034.96, down 2.17% month-on-month, and the S&P 500 Index closed at 4,507.66, down 1.77% month-on-month.

Overall, the US economy remains resilient, with the service sector relatively strong. At the same time, inflation levels in Europe and the United States remain high, and the attitudes of the central banks in both regions remain neutral with a slight hawkish bias. Short-term US bond yields are unlikely to decline. However, concerns about a September rate hike by the Federal Reserve have eased, and the yield on the 10-year US Treasury bond has fallen, leading to a rebound in US stocks. It is likely that there will be a period of range-bound volatility.

Options Market Changes

In the derivatives market, as of September 1st, the E-mini S&P 500 futures had a position of 2.26 million contracts, slightly down compared to the previous month. The E-mini S&P 500 options had a position of 2.03 million contracts, an increase compared to the previous month.

Looking at the distribution of options positions, the strike prices with the highest trading volume for call options and put options of the ESU3 options are 4,600 and 4,500, respectively. The strike prices with the highest open interest for call options and put options are also 4,600 and 4,400, respectively.

Overall, the key resistance and support levels are relatively clear, and the range has expanded.

Chart 1: E-mini S&P 500 Index Futures Market

Chart 2: Daily Trading Volume and Open Interest of ESU3 Futures Options Contracts

Volatility Index and Implied Volatility of Options

Looking at the volatility index, the VIX gradually increased from late July to early August, reaching a high of 17.89%, and then continued to decline, with the latest value at around 13%.

As for option volatility, as shown in the chart, the orange line represents the implied volatility of at-the-money ESU3 options, which reached a relatively high level of 15% in mid-August and then fell below 10%.

The blue line represents the historical volatility, which peaked at around 12% and exceeded the implied volatility. Correspondingly, the S&P 500 futures price (yellow line) has experienced a decline followed by an increase since August.

Stock Index Options Strategies

Regarding the trend of the underlying asset, the stock index has rebounded and recovered 50% of its previous losses. Whether it will continue to rise and break through still needs to be observed.

For those who hold long positions in futures, it may be advisable to take partial profits and secure gains. Otherwise, if the stock index declines, as it did in early August with a 9% pullback, it could significantly erode profits. In investment trading, it is always important to pay attention to risk prevention. As mentioned in the previous report, the covered call strategy was proposed, which involves holding a long position in stock index futures while selling call options. By selling out-of-the-money call options, one can generate income from the option premium and enhance the position.

Currently, the implied volatility of options is relatively low, making it cheaper to buy options. One can also purchase put options to protect the long position in futures.

If the stock index continues to rise after experiencing volatility, the long position in futures will still generate profits, albeit with the cost of buying options deducted. If the stock index declines, the profits from buying put options can offset the losses in the long position in futures, or even result in an overall gain. This is because options have a non-linear structure, and when the direction is correct, the profits can increase exponentially.