Covered Calls: XSP and CELH

Using Changes in LIQ as a Screener

Setting the Table:

• Market liquidity is a measurement of an investor's ability to enter and exit a trade effectively. It determines the price you pay and the size you can move. When liquidity is high, prices are much more likely to remain stable, and low liquidity means less volume will push markets more sharply. 

• The way we measure liquidity is through the LIQ index, and it’s designed to not only capture the absolute levels of market liquidity, but also serve as an indicator of when there are shifts in motion.

  • LIQ tracks spread width, volume, and open interest and compares daily shifts to the expected baseline. Market widths tend to drive high scores in liquid names, while volume surges tend to create big jumps in opportunistic names. 

• This week we’ll be using the LIQ to help better contextualize the opportunities for both trades and investments. 

Covered Calls: LIQ

• Depending on your objective, there are two ways to think about using the LIQ score to identify covered call opportunities. 

  • When comparing longer term investments, there are fundamental considerations that dictate the first level of screening. Covered call traders want to buy stocks that are going to go up. But when parsing between choices here, you will get a better options structure from targeting a name that also has consistently high liquidity. More expirations and more strikes make strategy selection significantly easier both now and as you roll the trade in the future. 

  • For opportunistic trades, a jump in LIQ is likely to be volume driven, and volume moves prices. This often correlates with higher volatility and higher risk, but options writers can be well paid for this exposure. 

• On longer time scales, liquidity tends to be correlated with overall market levels, but if you’ve been following along here you know that’s not always true. 

  • Higher asset prices often come alongside greater confidence, which tightens up markets and begets activity. The late summer of 2023 is a good example, where the S&P 500 rally brought tight markets and activity. 

  • BUT… market turbulence also generates a lot of activity which also drives LIQ, which we saw later that fall. And for much of 2024, the trend we’ve been discussing here has been towards lower liquidity as indices hit all time highs. (Though it has firmed up this month.)

    

• Every day we look at the Top 25 changes in LIQ at TheTape.Report. Subscribers can view these in the LIQPicks report. While we might expect all the action to take place in high vol names, there are plenty of “blue chip” companies that appear here. 

• In the options universe everything is relative. 30 vol in SPX has preppers buying precious metals and building bunkers, but puts a NVDA trader to sleep. The same is true for volume and open interest turnover, so we use a ratio of the previous day's volume to the prior 30 day average to create the score. 

YIKES: NVDA

• NVDA has been the market darling in an AI boom. Every new high is ephemeral, with a new one coming just down the pike. 

• Stock split 10:1 last week, so we would expect to see a jump in volume assuming the same amount of capital is trading there. This artificially inflates the LIQ score, but it does offer another benefit - significantly more strikes. 

• While ultimately an overwrite in NVDA wins if stock goes up - we’ve seen a drop in that call premium (COVC30) over the past few weeks.

  

• No matter what the indicators say, you have to frame any trade here against the hype. 

Investments: XSP

• XSP is one of those products that market participants want to see grow in popularity, but has long struggled to get over the hump. A cash settled index based on the SPX, this has the same notional value as SPY, but with the benefits of an index - cash settled with 1256 tax treatment. 

  

• Markets here have historically been wide and not attractive enough to overcome those benefits. SPX and SPY have dominated this S&P 500 liquidity pool. But currently XSP liquidity is sitting 39% over the average for the past month (LIQ22D = Ratio of LIQ to 22 trading day average). 

• Much of this is driven by the improvement in VolWidth.  We can see that’s been choppy in the longer past, but the past two weeks are the early stages of a paradigm shift.

  

• While LIQ and VolWidth have gotten better, they’re still not quite SPX/SPY levels. Here the XSP score of 429 compares to averages for those others in the 1000+ range. 

  • If we go out two weeks, we’re talking about a market width of about $0.08 vs. $0.03. Depending on your horizon, that may or may not matter. Especially if you can find improvement between the spread on small lots, the benefits of an index are likely to trump the pennies saved. For an actively traded strategy that can’t afford slippage, the calculus shifts. 

  • Remember, this score is based on an average of the implied volatility width. A score of 1000 equates to an average of .1% wide markets (1000 = 1/.001)and 100 = 1% wide;  it’s an inverse relationship where wider markets get lower scores. 

• Using options as an overlay on the most popular broadly diversified index is a time tested investment strategy. With several different products in the ecosystem to achieve this, LIQ is one of the nuances that could shift your calculus from one to another. 

Trades: CELH

• When we’re looking for a shorter term trade using LIQ, we want to focus on issues that have seen the volume component of the LIQ score increase. Volumes in SPX change, but not as much as TSLA or PEP. The coefficient of variation (standard deviation / average) is 17% for the index, but 37% and 91% respectively for the equities. 

• Volumes in CELH have been popping off periodically, and yesterday saw another one. The makers of the Celsius energy drinks are set to release earnings at the end of the month, but more imminently the CEO and CFO are presenting on a panel this afternoon (6/11/24).