UBS Equities-US Equity Derivatives Strategy _Something old, something new...-108423211.pdf

ab28May2024GlobalResearchandEvidenceLabUSEquityDerivativesStrategySomethingold,somethingnew:AdigestibleprimeronS&P500dividendoptionsTradeideastoconsider(pricingindicativea/o23May):•Downsideprotection:2025/2026dividendfutures(ASDZ25/26)70-strikeputcalendars,pay$1(selling2025;1.2%premium;~90%moneyness;flatdelta)•Limitedupsidepotential:2025dividendfuture(ASDZ25)77/80-strikecallspreads,pay$1.5(2%premium;~100/104.5%moneyness;15%netdelta)(Total)returnofthemack:Dividendsareenvogueagain[Figures1-6]BuybacksstillreignsupremeforUScorporates,butdividendsaremakingacomeback.Cash-rich,largecapGrowthnameslikeGOOG(L)andMETAjustinitiatedadividend;AMZNprojectedtostartpayingadividendin2025;NVDAandAAPLrecentlyannouncedadividendincrease.Thesecompaniesrepresent>20%ofS&P500marketcap,strengtheningprojecteddividendgrowthfortheoverallindex.Dividendsareforecastedtogrowinaggregateby~7%annualized(bottom-up)overthenextfiveyearsasafunctionofsustainedearningsgrowth.ThiscouldacceleratefurtherasmoreUScorporatespotentiallylooktoenhanceshareholdertotalreturninahigherinterestrateenvironment.Technology,ConsumerDiscretionary,andCommunicationServicessectorsareprojectedtoseethestrongestdividendgrowth.Odds&(divid)ends:AbriefrefresheronS&P500dividendfutures[Figures7-11]S&P500dividendfutureshavebeenaroundsince2015.TheyaremoreprolificinEurope,butthemarkethasgrownconsiderablyintheUS(especiallypost-Covid).Dealershavetraditionallyutilizedthemtohedgedividend(epsilon)riskstemmingfromstructuredproductissuance.Dealersareleftlongdividendrisk,thustheywillselldividendfuturestohedgethisexposure.Thisinherentlycreatesastructural"discount"atwhichfuturestrade,particularlyatthelonger-endofthetermstructure.AlongS&P500dividendfuturecontractcaneffectivelybeconsideredalowerbetalongS&P500position–Lowerbetadoesnotalwaysmeanlowerrisk,however.WestressS&P500projecteddividendsonabottom-upbasistoseewherethegreatestopportunitylies,here.Ifgiventheoption…:Whyusedividendoptionsoverfutures?[Figures12-15]Listedoptionsondividendfutureswerelaunchedearlierthisyear.Themarketisnascent(unlikethefutures),whichcreatesgreateropportunity,inourview.Giventhe"one-way"riskposedbydealeractivitydescribedabove,dividendfuturesaresubjecttosignificantdrawdowns,sometimestoanevenhigherdegreethantheindexitself–Perhapsunsurprisinginamarketwithmorenaturalsellersthanbuyers,particularlywhendealershavebeenforcedtooffloadinventoryamidstrecentcrises.Alongoptionpositionistheoreticallyrisk-limitedrelativetotheunderlyingfuture–Thisisthecaseforutilizingdividendoptionstohedgedownsideconvexityintimesofmarketstressorcaptureupsidepotentialinalowerbetaformat.Theappledoesn"tfallfarfromthetree:Wefinddividendfuturestobestructurallymispriced,dividendoptionsarenodifferent[Figures16-18]Wemodelavolatilitysurfacefordividendoptionsandcompareittothesurfacederivedfromlistedoptions.Wealsocomparethelisteddividendoptionsurfacetothestandardindexoptionsurface,bothhere.Theformertradeatavolatilitydiscounttotheindex,aswewouldexpect.Ourmodelsuggestsbothupsideanddownsidetailsindivid