JEPY: 0DTE has lower implied volatility and higher yield, not yet tested | Private Equity Weekly

Zero-day expiration options, or 0DTE options, now account for nearly half of the total options market.As speculation and bullish sentiment return to markets after the 2022 bear market, and as the S&P 500 rose 26% last year, there were plenty of doubters total return. A new ETF seeks to take advantage of put options on the 0DTE market.

I have a Hold rating on the Defiance S&P 500 Enhanced Option Income ETF (New York Stock Exchange: Forever). So far, this options-based fund has done exactly what it was supposed to do in its less than six-month lifespan. Since its inception last September, the index has underperformed the S&P 500 Total Return Index – which was expected given the stock market’s sharp rise since last year’s fourth-quarter lows. Additionally, levels of implied volatility, which translate directly into JEPY yields, have remained subdued for several months.

0DTE Options Trading Volume surge relative to overall S&P 500 options market

By way of background, JEPY’s goal is to provide investors with a consistent monthly yield distribution combined with stock market exposure to the S&P 500 Index. JEPY is an actively managed ETF designed to enhance income and is comprised of Treasury bonds and S&P 500 Index options. The goal of this strategy is to generate excess monthly distributions by selling option premiums on a daily basis.According to reports, the fund uses daily options to achieve rapid time decay by selling currency put options at 0DTE Defiance ETFs.

JEPY is making a big push into the ETF market. As of March 11, 2024, its total assets under management were only $139 million. The fund is also expensive, which is to be expected considering the complex strategy and active management—JEPY has an annual expense ratio of 0.99%. The highlight of this fund is undoubtedly its high current 12-month yield of 23.9%. Now, investors must realize that the yields simply don’t compare to traditional long stock ETFs. Total allocations come from selling 0DTE puts, as well as taking synthetic long positions in the S&P 500 using options.

Momentum is weaker relative to the S&P 500, but its liquidity position isn’t too bad considering its median 30-day bid-ask spread is 6 basis points. Nonetheless, I still encourage investors to use limit orders to avoid bad trades during the less liquid parts of the trading day.

JEPY: recent releases

JEPY’s most recent dividend was $0.60, which represents about 3.4% of the market price. I should also point out that JEPY is priced very close to its net asset value per share. JEPY accurately claims that its allocation ratio is currently just over 40%. JEPY works similarly to the broader traded $33 billion AUM JPMorgan Equity Premium Income ETF (JEPI), which uses a covered call approach as opposed to JEPY’s 0DTE covered put approach. The returns between the two are comparable because they are both effectively selling option premiums while going long S&P 500 stocks.

I expect that if there is a correction, or if we simply see the market rally extend and shift in favor of small and mid-cap stocks, JEPI will outperform the SPX. Generally speaking, puts/puts perform well when the underlying asset is flat or up slightly – it should outperform during stock market corrections and underperform in strong uptrending markets.

One negative aspect of today’s market for JEPY is that options are priced very cheaply. Although the 1-day VIX jumped to a new high since October ahead of the February CPI report, I expect short-term fluctuations to remain moderate. So far, we haven’t seen the usual bearish seasonality play out in Q1 – which I think is likely to happen.

JEPI would benefit from periods of higher short-term implied volatility and lower realized volatility, but since the 1-day VIX (shown in the chart below) typically fluctuates between 9 and 15, there isn’t much power to be squeezed out of the puts. Then, when a volatility event occurs, JEPI can be harmed by selling cheap, in-the-money puts that are actually very valuable. The sweet spot is after a volatile event, when realized volatility falls back faster than implied volatility.

1-day VIX Index History: Implied volatility low recently

Currently, the VIX forward curve is upward sloping. As the November election approaches, the problem becomes more difficult. But also take a look at the VIX Central chart below – it shows that historical 10-day volatility is significantly higher than the 9-day VIX index (a measure of implied volatility). This is not an ideal setup for something like JEPY as it is effectively a short relative to realized implied volatility.

While the gap isn’t huge, it suggests that selling near-term S&P 500 puts doesn’t generate much gain despite the very high distribution rates reported by issuers.

VIX term structure: low near-term implied volatility

bottom line

Overall, I have a Hold rating on JEPY. If we assume stocks end the week higher, we’d expect the fund to outperform as stocks pull back after a stellar run — rising 17 of the last 20 weeks. But over the long term, put options have yet to be tested in extremely volatile markets, so this remains a prominent risk.