Market Volatility Bulletin: Back In The Kennel

Summary

• After last week's attempted breakdown, SPY is substantively higher and volatility has fallen rapidly.
• There's quite a bit of action in a variety of markets in today's trade.
• VIX term structure takes on an odd shape.

CNBC: 10:52 EST

S&P (NYSEARCA:SPY) futures opened bullish in the overnight session, and have remained so the entire pre-Holiday session. There was a very interesting end-of-quarter drawdown in the major indexes that took place in the last ten minutes or so of last Friday’s trade; that said, shares quickly rebounded. The Nasdaq (NASDAQ:QQQ) is basically flat, while the DOW (NYSEARCA:DIA) just hit an all-time high.

Oil (NYSEARCA:USO) is continuing its strong upward trend of the last week or so; precious metals (GLD, SLV) are getting hammered on the continued increase in treasury yields and concomitant dollar strength (NYSEARCA:UUP). For a holiday week, there’s actually a pretty decent amount of activity in the morning session so far as moves are concerned!

CNBC: Friday Close

After rather range-bound action, US stock indexes closed mixed on Friday as the Nasdaq and Russell (NYSEARCA:IWM) just barely moved. The S&P rose slightly, led by rebounds in both Industrials (NYSEARCA:XLI) and Consumer Discretionary (NYSEARCA:XLY).

On a weekly basis, the S&P lost about 14 points as only Financials (NYSEARCA:XLF) gained meaningfully, perhaps on the sharp increase (bullish) of 10-year US Treasury yields. Technology (NYSEARCA:XLK) took a drubbing last week, which largely acted as a counterweight to the strong gains experienced by Financials. Given oil’s big week, Energy stocks reacted in fairly modest fashion: up less than 1%.

Source: Bloomberg

Likely the largest “mover” for the market this week is the jobs number come Friday morning. We also have the Fed minutes release, which can be a market mover from time to time (August 2015, May 2016, even April 2017 come to mind).

Given the strong run-downs and subsequent rebounds to oil, it will be interesting to see how the commodity responds to this week’s Petroleum Status Report.

Shout-Out

Today’s mention goes to a piece penned by Silent Trader called Buy the Bubble.

In it, he discusses that at a time when many are calling the current US stock market environment a “bubble,” there is a strong rationale either for participation… maybe it can get a lot bubblier… or pulling money out: “I’m taking my gains and riding into the sunset before this gets grizzly.”

Silent Trader (“ST”) takes the approach that perhaps it is exactly times like these when optionality becomes valuable.

For simplicity sake I assume we have an original portfolio equivalent to the S&P 500 (NYSEARCA:SPY) and use this as the benchmark to compare the strategy to. As the current volatility is low, options are cheap. So, I propose to sell the stock portfolio and buy an equal amount of exposure through options.

To minimize time decay also known as theta, we buy the longest dated options available to us. We will buy at the money option as these offer generally the cheapest market exposure and provides the highest gamma, which is the change in market exposure with a changing price. In this case, we will buy the 245 strike with an expiration on 20 Dec 2019 for $22.50. As we like the same exposure as the S&P 500, we will buy 10 contracts.

We like that ST suggests a specific trade as a way of working a view. In his piece, he mentions that he is not literally suggesting this position, but using it as a starting point for discussion.

He details out his rationale for the particular options and strikes of choice, and mentions how to potentially alter the baseline position in the event of an adverse move.

He deals briefly with objections - namely that theta is maximized at the money - and discusses how he deals with such qualms (buying LEAPS as opposed to short-dated options).

It’s good reading for someone who wants to think more carefully about how to craft a strategy. Good job ST; now give us more articles to feature!

Thoughts on Volatility

After last week’s quick run-up in VIX on Thursday morning, short vol positions have once more caged the beast.

It is somewhat interesting that the M1-M2 contango sits at a lower level than M2-M3, and by a meaningful margin.

While the current state of contango is consistent (we see it in every month), it appears to be getting quite “choppy.” Not to go overboard here, but the most common shape tends to feature large contango on the front end, that gradually declines, forming a curve that looks not unlike the standard Treasury yield curve.

What we see here instead is a term structure that is all over the place. M5-M6 is at 1.7%, while M6-M7 is at 7.23%. M7-M8 is only marginally lower than M1-M2.

Today we’d like to give a little thought to today’s levels of spot-M1 roll yield, within historical context:

Bear in mind that volatility has been quite calm going back to perhaps June 2012. Not every day or every week, but to our minds, June 2012 is when the new “low-vol” era began. Really July 2012, when ECB chair Draghi pronounced the commitment to do “whatever it takes.”

We digress. Even since that period, we have encountered times where spot-M1 slipped into backwardation (albeit briefly). Between early 2013 and the end of 2016, we counted 17 such instances. Granted, in the majority of cases this state was quite short-lived. Still, it is worthy of mention that in 2017, we have only had one “meaningful” incidence of this phenomenon. This is particularly interesting given the reality that 2013-2016 were themselves by and large tranquil years.

That said, Spot-M1 visually appears to be right in the middle of the range for the YTD period.

A question for readers: with M1 and M2 at quite low absolute levels, and M1-M2 contango quite low, does this motivate anyone to consider a long-vol play? Something really basic such as BATS:VXX? Any NASDAQ:XIV holders looking to unload any of their inventory?

Vol came crashing down over the weekend at the weekly and monthly expiry. Granted, we have a holiday-shortened week, in which case, we’re always just a little suspicious of the weekly vol figures. Still, this appears “reasonable.”

We got a flavor last week for what these at-the-money vols can do if there were a breakdown. For now, however, calm is the iron order of the day, and volatility traders see no reason to adjust this stance (for long).

“Buy the vol dip” seems to have been working pretty well so long as you pick up weekly vol around 5.8, monthly vol around 7.5, or quarterly vol around 9.8… You just cannot hold any sudden rise for very long (maybe a couple of hours) before these figures get beaten back down.

Any way you want to slice it, vol is cheap across the board.

Tracking The Trade

On June 20th, we will begin a new trade to keep an eye on over the next couple of weeks. The trade summary is as follows:

As can be seen in the table, the trade ends this week.

Strategy (laid out June 20 - this segment will largely stay the same so readers can see what we were thinking at initiation)

Remember, these are thought experiments, not real trades. It's less important that you actually agree with thesis. A lot of learning takes place from the vantage point of imagining that you did agree!

Volatility is basically in its bottom 1%. For perspective, from a percentile standpoint, this is the polar opposite extreme of say October 2008 when spot VIX was around 80. This is the "anti GFC."

Buy the dip has become the order of the day. There may be quite a bit of upside left in the ES's most recent move. We think there may be a dip lower that allows us to do some modification; but if there's not, we want to own some potential upside up into the 2525 region. Maybe we've got a blow-off top in store?

The market sure seems to want to push higher; as such, we'll put on a trade that positions accordingly. That said, we want it to flatten out in the event of a drop, at least for a time.

Because no dip has become too small to buy, we will supplement our call butterfly with a put sale. Now, we are not looking for anything too exciting on this front; just a way to add on a little extra time value. Also, we want something to "trade around" in case this market does indeed march higher.

As a final point - this is more of a "if you can't beat 'em, join 'em" kind of trade; it's going with the flow rather than fighting it. That said, the spread represents a relatively low-risk approach to going long the S&P (at least over a certain range of values).

Note: The ES currently trades at 2430, 12 points below where we discussed this trade at last week’s initiation.

Tactics

We will trade the following overall structure (this view is on the June 20th initiation day):

There are a number of ways to pick this trade apart. The individual legs are as follows:

• Sell the Jul31 2425 call

• Buy two Jul31 2465 calls

• Sell the Jul31 2525 call

Those are the ingredients of the call butterfly: sell one, buy two, sell one.

As mentioned, we will supplement this spread with a (conservative) put sale:

• Sell the Jul7 2300 put

If you observe the visual payoff profile on this trade, it looks almost halfway between a long futures (a 45-degree diagonal line) and a call option (hockey-stick shape that is flat up to a corner point and then rises).

We will follow this spread until Jul 7, when the 2300 put expires. For now though, observe that theta is quite mild on this, as is the delta profile.

"How is the initial position looking?"

We broke the trade into two different segments:

A strangle (Jul7 2300 Jul31 2525) and a call 1x2 (Jul31 2425 2465).

The strangle (which was always cheap given how far the strikes are and the low-vol environment we currently inhabit) has traded from a mid credit of $2.65 to a current mid credit of $.50, for a $2.15 gain.

The call 1x2 has not been as kind. We initiated at a credit of $9.50, and the current mid is $14.00, for a $4.50 loss.

Net loss on the initial position is therefore $2.35

“What about last week’s trade modification?”

Last week we suggested adding an iron condor to enhance gains and limit losses if the ES made a larger move in either direction: it looked like this:

With nearly a week since this trade was made, the ES trades almost unchanged from where it was, the IC trades down about $.30 from where we initiated. That’s actually quite good.

When the bottom really dropped out for about 20 minutes last week, this IC blew up. We were covering a different spread, so we didn’t check this; but based off comparable spreads we saw, $8.50 for this IC wouldn’t surprise us. Alas! We’ve settled back into the same sleepy range with subdued volatility - that’s the nature of the beast.

“What would you like to do from here?”

The Iron Condor we sold last week was really about taming our position in the event of a big move. Given that our strangle is basically dead, we will close it out and sell the strikes that we bought last Tuesday, leaving us with a new call strangle.

Mechanics - trade modification

We’re buying back our old strangle, and selling the long strikes of the July 14 IC that we traded last week. This action will effectively leave us short the Jul14 2325 2500 stgl.

As you can see, getting this trade done at or near the mid should not be a problem. It’s $.50 wide in pre-market on a holiday-shortened week.

“Why these strikes”?

Really for the sake of simplicity, on two fronts. First, we want to demonstrate that you can modify the existing position by actually trading out of something that you’re long (short) and into something else. Secondly, when we close at the end of the week, we have traditionally used “hard closes,” literally exiting any and every held position. By trading four options that we currently hold, that’s less closing to do come the end of the week (compared to four new strikes and/or maturities).

Conclusion

That's a wrap - thank you for reading. We appreciate it when readers share their thoughts. These are big markets, and different individuals trade their own pet products using their own strategies. Please do add what you are doing (or thinking about doing) in the comments section.

As a final mention before we leave you to a hopefully festive and/or restful Fourth of July, we offer this YTD S&P performance by sector heat map for your perusal. We like these heat maps because they demonstrate not only the size of the move (by color), but also the relative size of each sector.

Please consider following us - and have a happy Fourth!

Analyst’s 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.