CNBC 8:15 EST
US equities (NYSEARCA:SPY) are down modestly in a slow overnight session to kick off the week. Nonfarm payroll numbers are released this upcoming Friday; until then we have a relatively light news week.
Futures market expectations for a March rate hike are up significantly from early last week, sitting at just under 80% at the time of this writing. Early last week expectations were only pricing in about a one in three chance of a rate hike in March. The Federal Open Market Committee meets next week, on March 14-15, with a press conference to follow.
The VIX is up about 3% in overnight trading. Given the Saturday's Trumpian Tweetstorm, we believe this is a fairly muted reaction.
Stocks in Asia closed mostly up despite rising geopolitical tension, as news out of Japan late Sunday evening suggested ballistic missiles were fired into the sea by North Korea. So far markets are shrugging off this development. Not at all to sniff out a story that is not there, but North Korean "testing" like this was a feature in the January 2016 sell-off.
CNBC Asian Session, Monday Close
To close out last week, US stock indexes finished higher on Friday despite pulling back from the weekly (and all-time) highs around 2400. The Dow Jones (NYSEARCA:DIA) managed to close out the week above 21,000, after breaching the milestone for the first time earlier in the week. Once again, the financial sector (NYSEARCA:XLF) led the bullish charge on Friday, gaining 0.48%, with consumer staples (NYSEARCA:XLP) weighing most heavily.
CNBC: Friday Close
Today we feature an article from PLM Investments, titled " Overoptimism Signals Market Trouble Ahead". The article, published earlier this morning on Seeking Alpha, delves into both current consumer and business sentiment, and makes the comparison between now and the years prior to previous market downturns.
Initially, the author makes note of the February levels of the University of Michigan Consumer Confidence Index representing 15-year highs. When displayed with GDP per-capita growth though, PLM makes the case that it is a bearish signal for the overall market.
The chart above shows four examples of Consumer Sentiment at extremes relative to GDP growth, with the last two cases preceding sharp drops in GDP, and coinciding with large market sell-offs. The author also makes note of the ISM Manufacturing Inventories Index, arguing that rises in inventories only mark a preparation for growth, rather than growth itself.
Over a longer-term, we see several occurrences of rising inventories before heading into a recession.
To be clear, we are not of the mind that an imminent recession is right around the corner, and neither is the author of the above article. Our interest in this piece then, comes from the deeper looking analysis of seemingly positive news events. As we'll explore more below, the recent odd movement in the VIX may be a signal of lower market expectations in the future, even given the recent milestones reached in the market indexes.
Thoughts on Volatility
To start, let's look at the current term structure of VIX futures.
Last week one of our readers pointed to a possible trading opportunity given historical extremes in VIX front-month contango:
This is a great question, and one that likely goes hand in hand with a reasonably high level of understanding in how the VIX futures curve can move.
Currently, VIX front-month contango sits just under 15%, which is not extreme, but also hitting the high end of its five-year range. Thinking through these types of scenarios beforehand can help one's understanding of the situation when they do actually show up.
To expand on our response to commenter DDIV, the person long the front-month VIX contract would likely (though not certainly) benefit from a flattening of the futures curve, as contango came down from historically high levels, all else being held as equal. If this position was held as an outright long, meaning no back-month contract sold against it, timing would become extremely important. If one is bullish on volatility though, playing the contango back to historical norms could be a way to increase your probability of a successful trade. Personally we would hold off a bit on this before initiating: let it hit a reasonably high level, and then just sort of drift and rest. People talk a lot about "timing" these products. In our experience patience is the most important ingredient if success in these strategies is to have any longevity to it.
Finally, as we've noted previously, the expected correlation between SPX and VIX seems to be breaking down recently: we have seen a string of days in which the two have moved at least partially in the same direction. While this is indeed interesting, it does happen from time to time, and should not be overly surprising to market participants or observers. Our view is that the VIX is currently in a recalibrating stage, where it refuses to settle back into the ultra-low end of its historical range, and is seeking a new short-term "normal." There is a meaningful (negative) correlation between the two instruments, especially in large market downturns; but the relationship does not exert itself in some sort of mechanical sense like many investors either explicitly or implicitly believe.
VIX measures the implied volatility associated with S&P 500 options looking forward 30 days. For this reason, in our "Tracking the Trade" section, we always display ES straddle prices for one-week, one-month, and one-quarter outlook periods. When the options market begins to price in a higher likelihood of large moves in the S&P, market participants can charge (and others are willing to pay) higher prices for options, and the VIX rises as a result.
Generally, when an equity market falls, price-action gets choppier. As such, options get more expensive, and therefore the VIX moves higher.
ES implied volatility shows a bit of a move higher on the one-week contract. While a seven-handle on IV is nothing to get excited about, it does suggest that perhaps vol was priced a little too low for the one-week on Friday.
The one-month handle stayed put, acting as a fulcrum point: unchanged and resting between the one-week and the one-quarter contracts, whose vol readings respectively moved up and down.
We think that vol is getting to look more and more like a buy. Somewhere between the one-month and one-quarter region looks pretty good. Perhaps not a straddle, but a strangle, DD, iron butterfly/condor, something that gets long some vol in that region appears to have decent prospects.
Tracking the Trade*(please read disclosures):
In last Tuesday's bulletin we began a new trade idea.
In this idea, we will delve to see where VIX contango is "hiding" in ES options via the trading of double diagonals.
- Trade Horizon - Mar 10
- Trade Instrument - ES
- Trade Spread: Double Diagonal
Strategy: Thesis (Set out on Feb 28)
We're more interested in demonstrating where the VIX' contango is hiding than in some actual strategy for this particular trade. We even thought about flipping a coin to determine which side of the trade we'll take.
We ultimately decided to take the perspective of someone who is long a product like VXX, waiting for a big move.
Our contention is that VIX contango shows itself by how near-dated out-of-the-money (OTM) options decay relative to farther-dated options. We believe that the shorter-dated contracts will get killed, while the more distant (both in time and in terms of moneyness) will retain a good deal of their time value.
We'll explore the tactics of scaling and rolling in this trade: something that could be helpful for someone who is long ETPs such as VXX.
To conceptualize this contango, we will utilize the double-diagonal trading structure. As you can imagine, traders waste no time in coming up with clever names for this position, such as "double-D's". We will refer to them as "DDs".
A DD amounts to an iron condor with different expirations for the near vs. far strangle. More simply:
- Long an OTM put and an OTM call with nearer strikes and expiration
- Short an OTM put and an OTM call with more distant strikes and expiration
At initiation, the June Futures (all the options we'll be dealing with are tied to June futures, not March) was trading at 2361. After Wednesday's monster move where they reached a high of 2396, June now trades down at 2374.
Given that we want to demonstrate scaling and adjustment over the next couple weeks, we began with a standard DD and go from there.
On Tuesday we initiated with the following specific DD:
- Long the Mar24 2310 2410 strangle
- Short the Apr21 2260 2460 strangle
Here was the visual off the payoff diagram for one DD as of initiation:
The solid line shows P&L for varying levels of this trade as of Tuesday (we'll update this periodically); the dotted line shows how this trade plays out through at the Mar 24 expiry (assuming static levels of implied volatility). Recall that our trade horizon is Mar10; regardless of how things play out, we will be done with this trade a couple weeks before expiration.
For contrast, this is where the trade sits now:
"Where does the spread trade now?"
We opened for a $1.95 credit. We took the "trade mod" of actually fully closing in Thursday's piece for a $.55 credit; we had some extra color on this in Thursday's "Tactics" segment.
The spread now trades at a $4.15 credit mid. Simply getting out Thursday was the cleanest move. We booked a $1.40 profit, and can now re-enter at a much better price (if we wanted to).
"So what are you going to do now?"
We'll tell you, but first:
We warned on Wednesday that theta was the most significant reason that time would act as the enemy of this trade; last Thursday we demonstrated that the VIX's contango is actually sourced from S&P options, and that this would act as a drag on our position as well.
Without rehashing all the details, we'll give you the Implied Vol chain for ES options for different expiries (taken from Thursday's post):
Now for considering a path back in.
We'd first consider the current nature of the spread. If we were to continue to trade this DD as-is (some strikes, same expiries), it would be from the other side, gradually scaling from short to long.
- Short two DDs today
- Buy one back tomorrow
- Buy another on Wednesday…
You get the idea.
"Why do you want to play it that way?"
The SPX still appears to reside in a state where it cannot really fathom down-moves; that may change quite suddenly. But taking a position that collects theta, that has a moderately negative delta, and that is long vega, appears pretty reasonable to us given the way that the facts are aligning themselves.
"How do you use the Scenario chart above to determine your exposures?"
It's fairly simple. The chart above corresponds to having sold one single DD with the strikes and expiries that we specified last week.
To reverse the position, and double it, simply take every cell in the Scenario chart, reverse its sign, and double its magnitude.
For example, to see what the spread would more or less do if the S&P drops by 1% today (hasn't happened in forever, but hey): look down Column 3, flip the signs, and double the magnitude.
P&L would rise (instead of fall) by $164 Delta would be +10 Vega would sit at +2.24 Theta would collect at a rate of $36/day
"Couldn't you get in trouble if the market shoots higher?"
We could indeed. That's the most dangerous aspect of the trade. Truly though: the SPX failed pretty hard at using 2400 as a launch pad for new highs. We do not suspect it will be able to swiftly scale right through it, especially given the looming uncertainty over the budget, Deutsche Bank, the rate hike, the wire tap scandal, etc. Not that the market has to dive, but it hardly feels like we're going to simply leap higher.
To the downside, we have more room (trade actually has a negative delta for about 30 handles or so), and then we have a fairly desirable vega position. While it may not be optimal, we think this is a pretty decent position unless the ES simply careens lower.
We'll consider trade adjustments as we buy back in tomorrow.
We gave ourselves until Mar10 for this entire trade to play out. The idea we expressed above looks like the high probability trade, and so we're going to take it. That said, it looks a little busy.
The reality is that this isn't a bad set of tactics, but we'd likely give each scale-in a couple extra days. We're not fans of overtrading, and this runs close to a move in that direction.
Regardless of whether you are a "trader" or an "investor" (whatever those words mean!), consider how breaking your ideas down into strategy, tactics, and mechanics could help you incrementally improve in whatever it is you do (or don't do) in the markets.
Have any questions or suggestions? Let us know! We really enjoy reader comments, and post strong comments from our readers with regularity. We appreciate that.
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Disclosure: I am/we are short SPY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: We actively trade the futures markets, potentially taking multiple positions on any given day, both long and short. It is our belief that the S&P 500 is meaningfully overvalued. As such, we typically carry a net short position using ES options and futures.