Introducing The Adaptive Regime Compass: Measuring Equity Market Similarities With ML Algorithms

Asia Pacific Quantitative &
Derivatives Strategy
04 August 2021
Introducing the Adaptive Regime

Compass
Measuring Equity Market Similarities with ML
Algorithms
 It is well recognized that financial investment returns vary greatly in a variety of Global Quantitative and
macroeconomic and market regimes. This empirical experience prompts us to Derivatives Strategy
develop a quantitative measure of regime similarity tailored for equity Tony SK Lee AC
investment. We introduce a framework to systematically and scientifically (852) 2800-8857
identify regime similarity, i.e. the Adaptive Regime Compass (ARC). Investors tony.sk.lee@jpmorgan.com
can apply this approach and gauge market environment based on the return J.P. Morgan Securities (Asia Pacific) Limited/
distribution and risk profile in similar periods, and can thus navigate across J.P. Morgan Broking (Hong Kong) Limited
market conditions. Haoshun Liu AC
(852) 2800-7736
 With the ARC framework, we leverage machine learning techniques to shortlist haoshun.liu@jpmorgan.com
relevant market drivers from a broader list of variables concerning market risks, J.P. Morgan Securities (Asia Pacific) Limited/
investors’ positioning and economic backdrop. By focusing on key dimensions J.P. Morgan Broking (Hong Kong) Limited
of a dataset that defines a market regime, we apply a distance measure that Yukun Zhang AC
enables us to quantitatively measure similarity to historical periods. The (852) 2800-5148
development of a vector representation of the regime as well as the similarity yukun.zhang@jpmorgan.com
measure can be used to derive a conditional return distribution for financial J.P. Morgan Securities (Asia Pacific) Limited/
J.P. Morgan Broking (Hong Kong) Limited
assets.
Marko Kolanovic, PhD
 By systematically drawing parallels to historical periods that exhibit similar (1-212) 622-3677
features, investors can make more informed decisions from a market timing marko.kolanovic@jpmorgan.com
perspective (increasing or decreasing exposure to an underlying asset J.P. Morgan Securities LLC
considering the regime signal) and an asset allocation perspective (rotating into Davide Silvestrini
assets that will likely perform better for a given market regime). (44-20) 7134-4082
davide.silvestrini@jpmorgan.com
 From this perspective, the ARC framework can have a wide array of J.P. Morgan Securities plc
applications, including equity risk scaling, dynamic recommendations for
systematic hedging, risk on/off signals for carry strategies to asset allocation,
risk premia allocation etc.
 As proof of concept, we systematically back-tested a trading strategy on S&P
500 and Nikkei 225 where equity exposure is determined by the distribution of
investment returns under similar periods in the past. Our analysis shows
adjusting equity exposure in response to outputs of our regime model can
materially outperform a benchmark strategy of buy and hold on a risk adjusted
basis.
 Based on the ARC framework, we find expected return of US equities slightly
below long-term average, while downside risks are relatively limited. In this
environment, we think investors should maintain a long bias although with light
hedges. On the other hand, we find risk reward for NKY relatively attractive due
to relatively high sample average return of similar periods. Considering the
event risks ahead (Jackson Hole and Sep21 FOMC), we think it is prudent to
add light hedges. Our favored protection strategies include 1) resettable put
spreads and 2) short-dated knock-out puts; both structures take advantage of
current elevated skew.
See page 14 for analyst certification and important disclosures, including non-US analyst disclosures.
J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the
firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in
making their investment decision.
www.jpmorganmarkets.com
This document is being provided for the exclusive use of Giorgio Borelli at Emirates NBD Bank PJSC.
Tony SK Lee Asia Pacific Quantitative & Derivatives Strategy
(852) 2800-8857 04 August 2021
tony.sk.lee@jpmorgan.com
Introducing the Adaptive Regime Compass

- Measuring Equity Market Similarities with
Machine Learning Algorithms
It is well recognized that financial investment returns vary greatly in a variety of
macroeconomic and market regimes. This empirical experience prompts us to
develop a quantitative measure of regime similarity tailored for equity investment.
We introduce a framework to systematically and scientifically identify regime
similarity, i.e. the Adaptive Regime Compass (ARC). Investors can apply this
approach and gauge market environment based on the return distribution and risk
profile in similar periods, and can thus navigate across market conditions.
Figure 1: Illustration of the regime identification process by the Adaptive Regime Compass
framework
Source: J.P. Morgan Equity Derivatives Strategy
Main challenges for modelling equity market regimes

The country specific nature of market drivers are among the main challenges for
measuring equity market similarities. For example, in the US, the role of rebalancing
flows from volatility targeting funds, CTAs, actively managed and multi-asset
portfolios are well documented by our global strategists (example here). Similarly,
global economic activity momentum and exchange rate volatility often produce
strong implications on Japanese equity investment outlook due to the exporter
orientation of the economy (example here). As a result, variables such as equity
momentum, implied volatility, and hedge fund beta may have greater power in
explaining variations in US equity market returns while variables such as exchange
rate volatility may be of higher importance to Japanese equity investors. Thus, it is
imperative to tailor the variables for regime modeling for a given country
market.
(852) 2800-8857 04 August 2021
Drivers for the equity market could also change over time. For example, retail
investors have become a major source of equity buyers post the COVID sell-off.
According to our US colleagues, investors trading on the Robinhood platform
commonly exhibit the following behavior: they are attracted to stocks that are in the
news, experiencing extreme returns and abnormally high trading volumes (example
here). Market impact of retail investors can be found in technical indicators (RSI,
market breadth, inter-stock correlations etc) and sentiment measures. The rising
influence of retail investors is a recent example that underscores the importance of
capturing the temporal changes in market drivers in modelling regimes for
equities investing.
High correlation in variables needs to be accounted for in distance-based

similarity measures. A common adoption of measuring similarity by Euclidean
distance between two points in time is hampered by highly correlated financial time
series. Figure 2 shows pair-wise relationships between monthly observations of ten
variables for the SPX. One will notice many variables are inter-correlated: For
example, valuation (PE) displays a negative correlation versus implied volatility.
Consider a naive example that market regime is purely defined by PE and implied
volatility and the difference of each variable over two dates is large. If we were using
Euclidean distance then the distance might become much smaller if we were to
remove one of those variables. In calculating similarities between two points in time,
we prefer using the Mahalanobis distance. The measure is inherently equivalent to
the Euclidean distance on the PCA-transformed datasets. It helps to suppress impact
of highly redundant time series.
Figure 2: Pair-wise scatter plot of some common US equity performance drivers
Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg Finance L.P. * Diagonal cells display the distribution of the variables, lower triangle cells display the cross variable scatter plot, the
upper triangle cells display the cross variable correlation. Analysis is based on monthly data in the past 10 years. Variable definition is the same as Figure 2, equity underlying is SPX.
(852) 2800-8857 04 August 2021
Methodology overview
With the ARC framework, we leverage machine learning techniques to shortlist
relevant market drivers from a broader list of variables concerning market risks,
investors’ positioning and economic backdrop. By focusing on key dimensions of a
dataset that define a market regime, we apply the Mahalanobis distance measure
that enables us to quantitatively measure similarity to historical periods. The
development of a vector representation of the regime as well as the similarity
measure can be used to derive a conditional return distribution for financial
assets. By systematically drawing parallels to historical periods that exhibit similar
features, investors can make more informed decisions from a market timing
perspective (increasing or decreasing exposure to an underlying asset considering
the regime signal) and an asset allocation perspective (rotating into assets that will
likely perform better for a given market regime).
Select relevant equity market drivers with Random Forest

In developing a vector representation of the regime, our first task was to build a
universe of drivers that equity markets traditionally respond to. Figure 3
summarizes a list of such drivers, which include equity-centric drivers, (valuations,
spot momentum, equity risk pricing, equity technical and hedge fund beta), cross
asset drivers (cross asset spot levels and risk pricing), econ backdrop, (country
specific economic revisions-FRI and economic surprises-EASI) and local market
drivers (local sentiment, flow, positioning, FX and rates). In the local market
drivers, we include factors that are specifically relevant for the country market but
might not be available or relevant elsewhere. For example, in Japan, we introduce
factors such as foreign flows, retail margin balance, USDJPY price and risk as well
as JGB rates. While the list of variables are more equity specific and they are not
exhaustive, the universe can be easily expanded and tailored for a different task (e.g.
modelling regimes for volatility trading or cross asset investing). We plan to compile
a more complete factor database in the future.
Figure 3: Various factors for US and Japan equity performance
Global variables
Futures positioning CME SPX + MSCI EAFE + MSCI EM (non-commercial)
Cross asset PX US 10yr yield, US 2yr yield, US 5yr5yr forward breakeven, Gold, Crude Oil, Dollar Index
Cross asset risk MOVE, Gold 3M ATM vol, Crude oil 3M ATM vol, JPM FX volatility index, ,
Country specific variables
Valuations 1yr fwd PE
Momentum 1M return, 12M return
Risk pricing 3M ATM vol, 3M 90% - 110% skew
Technicals 14d RSI, MACD, Breadth,
Positioning HFR Index beta,
Econ Econ revision, Econ surprises
Local sentiment AAII Bull - Bear (US)
Local flow Foreign flows to cash equities (JP), Foreign flows to cash NKY futures (JP), Margin buy - sell positioning (JP)
Local cross asset USDJPY (JP), USDJPY 3M ATM vol (JP), JGB 10yr yield (JP)
Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg Finance L.P. * We use S&P 500 Nikkei 225 as underlying equity indices
for US and Japan respectively; data is as of month end; appropriate lags are applied to data with delivery delays. For CME futures
positioning, we focus on non-commercial positions. We define Breadth as % of stocks trading above 200d moving average.
(852) 2800-8857 04 August 2021
From the universe of equity market drivers, the next step is to determine the more
relevant features for a given country market. Our preferred feature section algorithm
is Random Forests (see here). Random Forests are essentially a collection of a large
number of decision trees, each trained on a different bagged sample. Predictions are
then obtained by averaging all the trees. One may think: if the trees are correlated
and give similar predictions, then they will look like the same tree and taking the
average will not help much. Random Forests actually use a better way to generate
(grow) the trees so as to ensure that they are not highly correlated. This is achieved
by splitting variables at random: before splitting each node, instead of considering all
p possible variables, the algorithm selects only m < p variables at random, and
considers those variables for splitting. This can de-correlate the trees, and improve
the predictions by reducing variances. In general, choosing ≤ is good enough.
Features selection with Random Forest: When we split a node with a variable, we
can measure the expected improvement (i.e. decrease in the impurity in the node) due
to this particular split. For each variable, we can record this improvement over all
nodes and all trees in the Random Forest model. In our exercise, we feed month-end
data over a rolling 10-year window for variables in our universe (global + country
specific variables in Figure 3) for the prediction of 1M forward equity return. We
normalize the forward returns as well as each of the input factor by transforming
them into Gaussian distributions. We then run the Random Forest regression
algorithm to estimate the model, and record feature importance (Increase in Node
Purity) across the variables. Figure 4 and Figure 5 display the feature importance for
SPX and NKY respectively. The top 15 variables (out of a total 23 variable for US
and 28variables for Japan) are kept for similarity calculation in the next step. We
notice the importance ranking varies for the two indices, local market variables such
as USDJPY level, USDJPY volatility and retail margin balance attain relatively high
scores for Japan, in line with our expectations.
Figure 4: Random Forest variable selection for SPX based on past Figure 5: Random Forest variable selection for NKY based on past
10yr history (the higher the more important) 10yr history (the higher the more important)
PE Econ_FRI
CL1 Feature importance EQ_Vol Feature importance
USGG5Y5Y Foreign_flow
JPMVXYGL
EQ_HF_beta MACD
MACD PE
Positioning Breadth
Econ_EASI JGBS10
Bull_bear CL1
USGG2YR EQ_HF_beta
Ret_12M
Econ_FRI XAUUSDV3M
EQ_Skew RSI
DXY MOVE
XAUUSDV3M Margin
Ret_12M USGG2YR
Positioning
XAU USDJPYV3M
Ret_1M Econ_EASI
JPMVXYGL EQ_Skew
USGG10YR Ret_1M
MOVE USGG5Y5Y
IVOLCRUD DXY
IVOLCRUD
Breadth USDJPY
RSI XAU
EQ_Vol USGG10YR
0 2 4 6 8 10 12 0 1 2 3 4 5 6 7 8
Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg Finance L.P. * We remove variables Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg Finance L.P. * We remove variables
ranked below 15 in terms of importance score. ranked below 15 in terms of importance score.
Measuring equity market similarity based on Mahalanobis distance

Having identified a list of equity market drivers, we measure similarity to historical
periods by Mahalanobis distance. As highlighted by our FX Strategy colleagues (see
here): Mahalanobis distance is a multi-dimensional z-score with the multi-
dimensional vector being the difference between a reference (e.g. today) and another
date, and where the components of the vector are at various market and economic
(852) 2800-8857 04 August 2021
data points at time T. The method is equivalent to the Euclidean distance in the
most important directions in the PCA transformed factors. In doing so, the
distance function suppresses the effect of the historically correlated time series
resulting in the distance measure being based on less correlated market variables.
The distance function would rescale the data by the covariance matrix, so that a
variable with a relatively large variance will not dominate the resulting value and
vice versa.
Most similar periods to current: We perform the Mahalanobis distance

computation on the aforementioned factors using past 10-year data. We then select
the most similar historic periods based on 10% of periods (12M data out of 120
observations) with the tightest distance versus the current snapshot. Figure 6 and
Figure 7 display the similar historical periods identified by the aforementioned
framework for SPX and NKY respectively. For SPX, we identify periods in 2017,
late 2019 and 1H2021 which are most similar to current environment. For NKY, the
most similar periods are 2012 – 2014, 1H18 and 1H21.
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Figure 6: Most similar historical periods for SPX based on past 10yr Figure 7: Most similar historical periods for NKY based on past 10yr
history history
5000 30000 Similar periods
Similar periods
4500 NKY
SPX
25000
4000
3500
20000
3000
2500 15000
2000
10000
1500
1000
5000
500
0 0
Jun-06 Jun-08 Jun-10 Jun-12 Jun-14 Jun-16 Jun-18 Jun-20 Jun-06 Jun-08 Jun-10 Jun-12 Jun-14 Jun-16 Jun-18 Jun-20
Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg Finance L.P. * Shaded area indicate Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg Finance L.P. * Shaded area indicate
periods most similar to current environment. periods most similar to current environment.
Figure 8: Monthly return distribution of most similar historical periods Figure 9: Monthly return distribution of most similar historical periods
versus past 10yr monthly return distribution for SPX versus past 10yr monthly return distribution for NKY
35% 30%
10yr history 10yr history
Probability of historical monthly returns
Probability of historical monthly returns
30% 12 most similar 12 most similar

25%
25%
20%
20%
15%
15%
10%
10%
5% 5%
0% 0%
-15% -13% -11% -9% -7% -5% -3% -1% 1% 3% 5% 7% 9% 11% 13% 15% -15%-13%-11% -9% -7% -5% -3% -1% 1% 3% 5% 7% 9% 11% 13% 15%
Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg Finance L.P. Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg Finance L.P.
Derive conditional equity return distributions: Having constrained the

Mahalanobis distance to 10%tile, we have now narrowed down the 1M forward
return scenarios to a much smaller range and can thus infer the potential outcomes
based on historical distribution. For SPX, average monthly return in the most
similar periods (+0.7%) is below the unconditional average (+1.1%) in the last 10
years. The left tail risk is higher than that of the unconditional distribution due to a
relatively sharp drawdown in one period in the sample (Feb20 start to min drawdown
of -8.4%). Excluding the Feb20 observation, the conditional return distribution
appears skewed towards the positive side as 83% (10 out of 12 periods) of the
conditional sub-samples recorded positive monthly returns. Taking into account the
return profile of historical precedents, we think US investors should maintain a long
bias although with light hedges (Figure 8).
For NKY, the return profile of past similar periods points to a more attractive risk
environment: average monthly return in similar periods (+2.3%) is more than twice
the unconditional average (+1.0%) in the last 10 years, and 11 out of 12 periods
delivered a positive return. Downside risk potential is also relatively limited
(852) 2800-8857 04 August 2021
considering maximum intra-month drawdown of -6%. We find risk reward

relatively attractive in this environment (Figure 9).
Merits and pitfalls of the Adaptive Regime Compass framework

In a nutshell, the ARC framework systematically draws parallels to historical periods
that exhibit similar features. In doing so, the tool helps investors more ‘accurately’
understand the market environment, and thus make more informed decisions from a
market timing perspective (increasing or decreasing exposure to an underlying asset
considering the regime signal) and an asset allocation perspective (rotating into
assets that will likely perform better for a given market regime).
From this perspective, the ARC framework can have a wide array of applications,
including equity risk scaling, dynamic recommendations for systematic hedging,
risk on/off signals for carry strategies to asset allocation, risk premia allocation
etc.
Despite its flexibility and adaptive nature in identifying market environment, the
ARC framework is not perfect. By design, the regime identification can only yield
signals with relatively low frequency; our framework hence is unable to capture
intra-month changes and event risks. From a variable perspective, we might miss out
on emerging drivers or fail to incorporate drivers with less history. In future updates,
we look to further expand the universe of variables.
Prototype risk scaling strategy for equity investment

To demonstrate the effectiveness of the ARC framework, we devised a simple
stylized long-only delta trading strategy on the back of the return distribution of
similar historical periods identified by the ARC framework. Applying the variable
selection and distance computation method each month using 10-year rolling
history, we identified similar periods across history for each period at month end.
We designed the below trading rules for exposure adjustment for the following
month based on the distribution of the forward returns in those similar periods:
 Cautious environment: If average forward return of similar period is below 10yr
average monthly return, and sample largest drawdown is below 5%tile of that in
the past 10yrs, we see equity risk / reward relatively unattractive and increased
probability of material downside, we apply minimal risk exposure to 25%;
 Conservative environment: If average forward return of similar period is below
10yr average monthly return, and sample largest drawdown is below 10%tile of
that in the past 10yrs, we see less attractive equity risk/reward although downside
risk potential is relatively limited, we apply reduced risk exposure to 75%;
 Attractive environment: If average forward return of similar period is more than
twice the 10yr average monthly return, we see relatively high risk reward in
equity investment, we thus extend exposure to 125%;
 Benign conditions: In other scenarios, we see the risk environment as overall
benign, we use 100% full exposure.
(852) 2800-8857 04 August 2021
Figure 10: SPX market environment as identified by the proto-type risk control trading strategy
5000
4500
4000
3500
3000
2500
2000
1500
1000
Jun-16 Dec-16 Jun-17 Dec-17 Jun-18 Dec-18 Jun-19 Dec-19 Jun-20 Dec-20 Jun-21
Attractive Benign Conservative Cautious SPX
Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg Finance L.P. * Back-test result is not indicative of future performance.
Figure 11: Proportion of periods selected for each equity environment Figure 12: Monthly return distribution of most similar historical
periods versus past 10yr monthly return distribution for NKY
40%
SPX NKY SPX NKY
35% Start End
Drawdown Exposure Drawdown Exposure
30%
% regime is identified
25% 28-Sep-18 31-Oct-18 -6.9% 125% -9.1% 75%
20%
30-Nov-18 31-Dec-18 -9.2% 25% -10.5% 25%
15%
30-Apr-19 31-May-19 -6.6% 25% -7.4% 25%
10%
5% 31-Jan-20 28-Feb-20 -8.4% 100% -8.9% 25%

0%
Attractive Benign Conservative Cautious 28-Feb-20 31-Mar-20 -12.5% 25% -10.5% 25%
Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg Finance L.P. * Back-test result is not Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg Finance L.P. * Back-test result is not
indicative of future performance. The analysis incorporates 5bps t-cost on monthly rebalances. indicative of future performance. The analysis incorporates 5bps t-cost on monthly rebalances.
Back-test performance: With the help of the ARC framework, we tuned the trading
strategy towards risk scaling in environments with relatively unattractive risk reward,
and more acute downside risks. Our analysis shows such a stylized trading strategy is
potent at flagging risk environments ahead of major drawdowns. Indeed, our
model would have flagged 'Cautious environment' ahead of major market drawdowns
such as Mar20, Dec18 and May19 (Figure 12). Due to lower risk exposure in these
sell-off episodes, the prototype trading strategy would have materially reduced
performance drawdowns compared to a vanilla buy & hold strategy (maximum
drawdown reduces from -34% to -19% for the SPX, from -31% to -15% for the
NKY). Accordingly, the risk scaling strategy would have attained materially higher
risk-adjusted returns (info ratio improves from 0.88 to 1.26 for the SPX, form 0.76 to
1.08 for the NKY, Figure 13 and Figure 14).
We note the ARC framework and the trading rules were unable to flag drawdowns
driven by event risks, e.g. the Oct-18 pull-back on Hawkish Fed and the Feb20 pull-
back on emerging COVID concerns. As discussed earlier, this is mainly due to the
use of month-end variable data which are unable to capture intra-month risk events.
(852) 2800-8857 04 August 2021
This suggests to us investors should use the framework in conjunction with

forward looking expectations to formulate an investment view.
Figure 13: Prototype risk-control strategy performance versus Buy & Figure 14: Prototype risk-control strategy performance versus Buy &
Hold strategy for the SPX Hold strategy for the NKY
240 240
Strategy B&H Strategy B&H Strategy B&H
Strategy B&H
220 220 Ret 15% 14%
Ret 18% 16%
Vol 14% 18% Vol 14% 19%
200 200
Info 1.26 0.88 Info 1.08 0.76
Max DD -19% -34% Max DD -15% -31%
180 180
Calmar 0.91 0.47 Calmar 1.03 0.46
160 160
140 140
120 120
100 100
80 80
Jun-16 Dec-16 Jun-17 Dec-17 Jun-18 Dec-18 Jun-19 Dec-19 Jun-20 Dec-20 Jun-16 Dec-16 Jun-17 Dec-17 Jun-18 Dec-18 Jun-19 Dec-19 Jun-20 Dec-20
Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg Finance L.P. * Back-test result is not Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg Finance L.P. * Back-test result is not
indicative of future performance. The analysis incorporates 5bps t-cost on monthly rebalances. indicative of future performance. The analysis incorporates 5bps t-cost on monthly rebalances.
Add light hedges via resettable put spreads and knock-out

puts
Fundamentally, our global strategists remain bullish on equities (see here) and have
recently upgraded their year-end price target (see here). However, considering our
ARC framework currently flags a ‘Conservative environment’ for US equities for
August, and also the upcoming event risk on potential Central Bank language /
policy changes (Jackson Hole Economic Symposium on Aug 26 – 28, September
FOMC meeting on Sep 21 - 22), we think it is prudent for investors add light hedges.
Hedging strategies: Our favoured hedging strategy is buying resettable puts,

partially financed by selling more OTM vanilla puts (see more details here). The
structure helps mitigate market timing risks, as the put strike would adjust higher as
the market rallies. Elevated skews and normal term structures suggest that the
likelihood of further gains in equity markets in the near term is cheaply priced, and
so is the reset feature (as reflected in a reasonably narrow premium in resettables vs.
vanilla equivalents). Please refer to below indicative pricing:
 SPX 6M 90% resettable put with a 2M lookback window (monthly observed)
outright and vs. a 6M 85% vanilla put: offer 1.24% (for comparison, vanilla
6M 90% 85% put spread costs 0.73%)
 NKY 6M 90% resettable put with a 2M lookback window (monthly
observed) outright and vs. a 6M 85% vanilla put: offer 1.30% (for
comparison, vanilla 6M 90% 85% put spread costs 0.91%)
For investors targeting a shorter protection horizon, we like strategies that exploit
current elevated volatility such as put spreads and put ratios. Alternatively, investors
can also consider a light-exotic implementation via buying short-dated knock-out
puts. The structure is also attractively priced currently due to elevated skew. In a
moderate sell-off scenario (barrier is not triggered), the knock-out put offers hedging
benefits equivalent to a vanilla put option. However, in case of a material sell-off,
where the knock-out barrier is breached, the structure will cease to exist. The
maximum loss on the option is limited to the upfront premium paid (Figure 16). We
10
(852) 2800-8857 04 August 2021
recommend 2M tenor to cover the periods post the Jackson Hole Symposium as well
as the Sep21 FOMC meeting. Please refer to below indicative pricing:
 Buy SPX 2M 97% puts knocking out at 85% (continuous barrier): offer
0.51%, -9% delta, 0.00% Vega
 Buy NKY 2M 97% puts knocking out at 85% (continuous barrier): offer
0.75%, -10% delta, -0.01% Vega
Figure 15: Illustration of resettable mechanism for a 6M 90% resettable Figure 16: Terminal payoff illustration for knock-out puts
put with 2M lookback window (monthly observed, hypothetically
traded at year start)
115 15%
KO barrier not triggered
110 KO barrier triggered
10%
105
100 Terminal net PnL 5%
95
0%
90
85
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec -5%
85% 90% 95% 100% 105% 110% 115%
Montly Observation Date Spot Put Strike Spot relative to initial
Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg Finance L.P. Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg Finance L.P. * We use current
pricing of SPX 2M 97% puts knocking out at 85% for the analysis.
11
(852) 2800-8857 04 August 2021
Risks of Common Options strategies

Risks to Strategies: Not all options strategies are suitable for investors; certain
strategies may expose investors to significant potential losses. We have summarized
the risks of selected derivative strategies. For additional risk information, please call
your sales representative for a copy of “Characteristics and Risks of Standardized
Options.” We advise investors to consult their tax advisors and legal counsel about
the tax implications of these strategies. Please also refer to option risk disclosure
documents.
Put Sale. Investors who sell put options will own the underlying asset if the asset’s
price falls below the strike price of the put option. Investors, therefore, will be
exposed to any decline in the underlying asset’s price below the strike potentially to
zero, and they will not participate in any price appreciation in the underlying asset if
the option expires unexercised.
Call Sale. Investors who sell uncovered call options have exposure on the upside that
is theoretically unlimited.
Call Overwrite or Buywrite. Investors who sell call options against a long position
in the underlying asset give up any appreciation in the underlying asset’s price above
the strike price of the call option, and they remain exposed to the downside of the
underlying asset in the return for the receipt of the option premium.
Booster. In a sell-off, the maximum realized downside potential of a double-up

booster is the net premium paid. In a rally, option losses are potentially unlimited as
the investor is net short a call. When overlaid onto a long position in the underlying
asset, upside losses are capped (as for a covered call), but downside losses are not.
Collar. Locks in the amount that can be realized at maturity to a range defined by the
put and call strike. If the collar is not costless, investors risk losing 100% of the
premium paid. Since investors are selling a call option, they give up any price
appreciation in the underlying asset above the strike price of the call option.
Call Purchase. Options are a decaying asset, and investors risk losing 100% of the
premium paid if the underlying asset’s price is below the strike price of the call
option.
Put Purchase. Options are a decaying asset, and investors risk losing 100% of the
premium paid if the underlying asset’s price is above the strike price of the put
option.
Straddle or Strangle. The seller of a straddle or strangle is exposed to increases in

the underlying asset’s price above the call strike and declines in the underlying
asset’s price below the put strike. Since exposure on the upside is theoretically
unlimited, investors who also own the underlying asset would have limited losses
should the underlying asset rally. Covered writers are exposed to declines in the
underlying asset position as well as any additional exposure should the underlying
asset decline below the strike price of the put option. Having sold a covered call
option, the investor gives up all appreciation in the underlying asset above the strike
price of the call option.
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(852) 2800-8857 04 August 2021
Put Spread. The buyer of a put spread risks losing 100% of the premium paid. The
buyer of higher-ratio put spread has unlimited downside below the lower strike
(down to zero), dependent on the number of lower-struck puts sold. The maximum
gain is limited to the spread between the two put strikes, when the underlying is at
the lower strike. Investors who own the underlying asset will have downside
protection between the higher-strike put and the lower-strike put. However, should
the underlying asset’s price fall below the strike price of the lower-strike put,
investors regain exposure to the underlying asset, and this exposure is multiplied by
the number of puts sold.
Call Spread. The buyer risks losing 100% of the premium paid. The gain is limited
to the spread between the two strike prices. The seller of a call spread risks losing an
amount equal to the spread between the two call strikes less the net premium
received. By selling a covered call spread, the investor remains exposed to the
downside of the underlying asset and gives up the spread between the two call strikes
should the underlying asset rally.
Butterfly Spread. A butterfly spread consists of two spreads established

simultaneously – one a bull spread and the other a bear spread. The resulting position
is neutral, that is, the investor will profit if the underlying is stable. Butterfly spreads
are established at a net debit. The maximum profit will occur at the middle strike
price; the maximum loss is the net debit.
Pricing Is Illustrative Only: Prices quoted in the above trade ideas are our estimate
of current market levels, and are not indicative trading levels
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(buy) (hold) (sell)
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IB clients** 54% 48% 39%
JPMS Equity Research Coverage* 49% 39% 13%
IB clients** 77% 69% 55%
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services within the previous 12 months.
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Introducing The Adaptive Regime Compass: Measuring Equity Market Similarities With ML Algorithms

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Introducing The Adaptive Regime Compass: Measuring Equity Market Similarities With ML Algorithms

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Asia Pacific Quantitative &

Introducing the Adaptive Regime

Introducing the Adaptive Regime Compass

Source: J.P. Morgan Equity Derivatives Strategy

Main challenges for modelling equity market regimes

High correlation in variables needs to be accounted for in distance-based

Figure 2: Pair-wise scatter plot of some common US equity performance drivers

Select relevant equity market drivers with Random Forest

Futures positioning CME SPX + MSCI EAFE + MSCI EM (non-commercial)

Country specific variables

Valuations 1yr fwd PE

Momentum 1M return, 12M return

Risk pricing 3M ATM vol, 3M 90% - 110% skew

Technicals 14d RSI, MACD, Breadth,

Positioning HFR Index beta,

Econ Econ revision, Econ surprises

Local sentiment AAII Bull - Bear (US)

Measuring equity market similarity based on Mahalanobis distance

Most similar periods to current: We perform the Mahalanobis distance

Probability of historical monthly returns

30% 12 most similar 12 most similar

Derive conditional equity return distributions: Having constrained the

considering maximum intra-month drawdown of -6%. We find risk reward

Merits and pitfalls of the Adaptive Regime Compass framework

Prototype risk scaling strategy for equity investment

25% 28-Sep-18 31-Oct-18 -6.9% 125% -9.1% 75%

5% 31-Jan-20 28-Feb-20 -8.4% 100% -8.9% 25%

This suggests to us investors should use the framework in conjunction with

Add light hedges via resettable put spreads and knock-out

Hedging strategies: Our favoured hedging strategy is buying resettable puts,

110 KO barrier triggered

100 Terminal net PnL 5%

Risks of Common Options strategies

Booster. In a sell-off, the maximum realized downside potential of a double-up

Straddle or Strangle. The seller of a straddle or strangle is exposed to increases in

Butterfly Spread. A butterfly spread consists of two spreads established

J.P. Morgan Equity Research Ratings Distribution, as of July 03, 2021

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