Turn Your Investing “What Ifs?” into “If; Thens”

Dazed and Confused

The Nasdaq-100 Index (NDX®) wrapped up October with its seventh consecutive higher monthly close. The “benchmark for the 21st century” economy gained ~24% through the first ten months of the year. Keep in mind that in early April NDX was down ~21%. Put another way, between April 7 and October 31, NDX jumped by more than 50%. Markets are exceptional!

Global equity measures reversed course last week. The NDX suffered the worst weekly setback since April. European and Asian markets, which had recently broken out to new highs declined between 1% (Topix) and 4.1% (Nikkei 225). There’s been no clear catalyst for the turnabout. Ultimately, this is what markets do.

Investors look for tidy and compelling narratives. Equity markets don’t operate like a standard sitcom or drama. There’s no season finale. No end credits. Capital markets are much more opaque and sometimes surreal, like a David Lynch or Terrence Malick film. If you’re left scratching your head these days, you’re not alone.

If early November showed investors that markets can be surreal, derivatives remind them they can still write part of the script.

“What If?” into “If; Then”

Passive long investors are subject to the ambiguous nature of markets. They are like “extras” in a production. They are sort of involved, but with limited agency. They “get paid” when the markets move higher. In previous generations, investors might worry: “What if the market sells off 20%?”

That “script” is linear, and chances are their portfolios will lose ~20% of their value.

Industry data increasingly tells a unique story for younger generations. They are often introduced to markets via derivative products as opposed to the spot market. The dynamics that were once considered a byproduct of the pandemic have become the expectation.

Their dollar risks and the time frames tend to be smaller. The feedback loop is accelerated. Market participants are often engaging with financial products by the end of high school. The months or years of saving to buy 100 shares of IBM or Exxon Mobile appear to be “Gone with the Wind.”

By college, many have experience with fractions of a cryptocurrency, fractional shares of stock, prediction markets, and, increasingly, listed options. 60 million in average daily options volumes and consistent double-digit year-over-year growth speaks to the expanding appetite for derivative based exposure.

Those who choose to use index options to express a view or manage portfolio risk can more prescriptively influence the narrative. As opposed to being “extras” in the narrative, they are able to turn the, “What if?” 20% market decline concerns into a more active, “If NDX falls by 20%, then my put spread collar should offset much of my dollar risk.”

Options allow you to turn those “What if?” questions into “If; then” statements.

“What if the NDX rallies 2% on Monday from expectations of a government reopen?” becomes…

“If NDX pops 2% on Monday, then my call butterfly structure should work well.”

As is often pointed out, index options need not be managed as actively as their ETF counterparts. The practical implications are real in an increasingly short-duration market.

Using our hypothetical “call butterfly structure,” let’s imagine two exposures. During the trading session, they are largely indistinguishable, but at expiration, the same cannot be said.

An ETF tracking NDX closed Nov 7 ~$609.75

• Long the Nov 10 615/620/625 call butterfly (long one 615 and 625 call; short two 620 calls)
• Net debit on close ~$0.87

NDX Index closed Nov 7 ~25,060

• Long the Nov 10 25,200/25,400/25,600 call butterfly (long one 25.2k and 25.4k call; short two 25.4k calls)
• Net debit on close ~$36.40

In terms of total premium outlay, if you equalize the exposures notionally, you will need to buy the ETF call fly 41 times for a total premium ~$3,567 (87*41). The index fly settled worth about $3,640.

Equalized on a notional basis, the example index exposure costs about $70 more, but the simplicity of cash settlement and lack of assignment risk makes it a potentially much cleaner trade.

2025: A Settlement (and IRS) Odyssey

What if the underlying goes right to your target? That’s amazing, right?

In the case of the index exposure, it sure is. There’s nothing that needs to be done. You can check back anytime after the close, see where the index settled and then check your account to see the cash roll in. Huzzah.

If you’re exceedingly fortunate and NDX closes right at 25,400 the structure is worth 200 points or $20,000. You theoretically paid $3,640, so, your account value should increase by $16,360.

Now let’s look at the hypothetical ETF example. Let’s, again, imagine the market goes to your target of $620. Fabulous, right?

Well…yes, and maybe not.

The 615 call is in-the-money (ITM) and an automatic exercise, so you’ll get long 100 shares of the ETF for every owned option. That requires enough capital to cover the purchase. If you were long 41 call flies, that’s more than $2.5 million. Not exactly pocket change.

On Tuesday, you have directional risk associated with 4100 shares of the ETF. Market continues higher = great. Market sells off = you’re losing $4100 with every dollar lower.

Here’s the other issue: when an ETF closes at a strike, you’re short on expiration (pins) and the counterparty has optionality. You do not. In this situation, you don’t know if or how many of your 620 strike calls will be assigned. There’s a 90-minute window after the cash close where liquidity providers make decisions about whether to exercise options like the one described.

So, in reality, you could end up short 4,100 shares of the ETF on Tuesday when you anticipated being long. You have no clarity on your go-forward risk. The assignment uncertainty is a risk that’s mitigated by using index options.

Beyond that, there’s the potentially preferential tax treatment associated with “1256 contracts.” There’s plenty of materials covering the distinction and you should always consult a tax professional, but as G.I. Joe reminded me in my youth, “knowing is half the battle.”

One Battle After Another

With derivatives increasingly becoming the “on ramp” for investing and holding periods shrinking, it’s no surprise to see NDX volumes continue setting daily, monthly, and quarterly records. Sometimes markets zig when you expected a zag. There’s not always a satisfactory denouement. Options can afford you the flexibility to be wrong, often for relatively small dollar amounts, and learn. The feedback loop is powerful, and investors continue to sharpen their skills.

Markets may never offer tidy endings, but the ability to turn uncertainty into structure, to transform “What if?” into ”If; then” is what keeps many coming back to NDX.