Market Volatility Bulletin: Jobs Number Impresses
- Equities are up on the positive jobs report; commodities are having a rough morning.
- A question for readers about divergence in near vs. far-dated contango.
- Trade wrap up on our Tracking the Trade segment.
CNBC: 11:06 EST
The response to today's positive jobs number has been fairly muted. Buyers of US equities (SPY, DIA, QQQ, IWM) have tried rebounding off yesterday's lows, but with limited success so far - most notably the Dow. The reality is that while the number was strong, it wasn't that far away from expectations. The 14k increase from last month's doozy of a miss was to our minds more meaningful.
Commodities generally are getting a whipping this morning. Silver is trading at 52-week lows. The markets have summarily wiped away crude's big rally from last week. Oil appears soft, and that may impact forward guidance on upcoming earnings calls.
The dollar has gotten a boost over the last couple hours. As a counterbalance, Q2's dollar weakness may offer earnings guidance a tailwind to offset softness in commodities.
Sector SPDRs: Jul 6
Yesterday saw markdowns for all ten S&P sectors. While weakness in Tech has been a common reason for SPY spills of late, movement in XLK was not a particular "hot spot" for yesterday's losses.
Today's Shout-Out goes to Charlie Bilello's piece entitled Tall Tales and Transports.
The piece is brief. Mr. Bilello methodically debunks the reasonably famous notion that 52-week highs in transports means strong performance for the overall market (the S&P 500 index).
Mr. Bilello's piece is particularly worthwhile because the transportation index just hit an all-time high on Wednesday. He warns, however, that rather than seeing a large tailwind for equities, an outcome such as July 2011 is certainly possible also:
The reader is treated to simple charts that compare today's "set up" against 2011, 2008, and early 2001… all where new highs on the part of the transportation stocks were followed up by large declines in the broader indices, and the transports themselves for that matter.
Mr. Bilello finishes the piece with a readable table whereby he seeks to demonstrate that he's not trying to demonstrate that strong performance on the part of transports does not somehow spell doom for the S&P 500; instead, the performance of this subset is not particularly telling or special one way or the other (at least since 1970).
Thoughts on Volatility
With SPY modestly higher in morning trade, spot volatility has tamed. The term structure does appear (to us anyhow) to flatten out a bit early. Even with prior discussions on the peculiarities of Dec vol aside, the curve appears modestly "misshapen" from its more classic form. Still, you need to trade VX spreads for that to really matter at this point. What we were looking for were any real distortions as these can act as precursors to a larger shift in the overall curve, which may have important implications for global equities.
We'd like to now discuss something that we recently saw on VIXcentral.com
Here we have highlighted F1-F2 contango alongside F4-F7 contango. It appears that this graph can really be broken into three "regimes".
Mid 2011 to perhaps September 2012: both curves rising
Sep 2012 to Feb 2016: both curves falling.
Feb2016 to present: F1-F2 having risen alongside F4-F7 for a time, but really having peaked near Brexit and the US elections, and now on the downswing; meanwhile F4-F7 is steadily moving higher.
This appears strange to us. Contango moving lower tends to indicate that longs are not willing to "pay up" for protection. What does it mean when VX longs are increasingly willing to pay for deep out protection, while simultaneously they are less willing to pay for exposure to the more day-to-day spikes that can and do occur?
We have our idea as to what this means, but we'd like to open the floor for others to speak first. Please do add your ideas in the comments section.
Organic at-the-money vol has toned down a good bit since yesterday, particularly at the weekly expiration. Recall that weekly vol tends to be the most influenced by recent realized volatility. This is interesting, because markets have actually gotten choppier over the last couple weeks. In fact we've seen some pretty large moves, just in a very small range.
Monthly vol has come down substantially also, while quarterly is holding tight. It is interesting that the quarterly vol figure does not seem to want to budge lower. Now, it is not at all uncommon for quarterly vol to move slower than do shorter expiries.
We wonder if the quarterly market sniffs more sustained shifts in the volatility surface from what we've witnessed of late.
Tracking The Trade
On June 20th, we began a new trade to keep an eye on for about a three-week period. Today marks the end of that trading period.
Note: fuller discussion on "wrap up" near the end of the day's piece.
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!
As we write on June 20, volatility is basically in its bottom 1% of historic observations. 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 our position to quickly 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 2413, 29 points below where we discussed this trade at initiation.
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).
Mechanics - wrap up
"What the trade look like right now?"
Yesterday we bought back the Jul14 2325 2500 strangle for $1.30.
So really we're just left with the Jul31 2425 2465 call 1x2. That is, short the more valuable 2425 call, long the two less valuable 2465 calls.
This is the current IB quote on that spread:
The P&L for the strangle side of our modified butterfly trade was a modest $2.05 profit.
In contrast, on June 20 we entered the call 1x2 at a $9.50 credit; the mid is now $11.25 - a $1.50 loss.
We'll seek to close this 1x2 at the mid. Given that the market is bouncing to and fro in a modest range in morning action, we're quite likely to get our fill.
The P&L for the trade, once consideration is given to commissions, is essentially flat (ever so modestly profitable).
"What are your thoughts on this trade?"
Consider the strategy. Almost every trade that gets made (even for long term investors) begins with some kind of hypothesis. The hypothesis that we modeled out - and have kept for readers to view since trade inception - was quite incorrect.
The hypothesis posited that the monster move higher that we saw June 20th was going to get some follow through: it never did. ES was 2442 when we initiated, down only eight points or so from its all-time high. Sure we saw middling levels higher over the days ahead, but never anything that stuck for any length of time.
Anyone who trades - or invests - is going to be wrong quite often. The strategy here was off considerably.
The tactics, however, were pretty decent. Now, given the very tight range we've traded in since Jun20, one could easily criticize the strangle we sold. The low was last week's Jun29th bottom at 2402. Our put sales effectively amounted to Jul7 2300 and later Jul14 2325. Not exactly high on bravado.
On the other hand, we wanted a very modest balancer for what started out as the Jul31 2525 call sale. The fact was that we really had sold those puts - both times - near localized market tops. Even then we managed to walk away from our strangle transactions with a modest profit.
We will say that our purchase of the iron condor last Tuesday really was a great buy. We were covering a different trade on Thursday's piece when the market dumped abruptly. This was a great trade that we didn't get to execute on.
Most importantly, however, is the fact that we walked away from this bullish trade with a very modest gain, even though the trade action was against us the majority of the time. Moreover, we did so with only modest alterations throughout the trading period.
This is why we believe it can be worthwhile for people to learn how to use these trade instruments. Naturally it's not always a happy ending, and we're not here to tell you otherwise. But walking away from a trade where you were profoundly wrong in terms of strategy, without frantically trading every little pivot point, and still holding an after-commission gain of any kind yields (we hope) a valuable lesson.
"Why did this trade work?"
Basically for two reasons. First, though our thesis was bullish, we positioned initially with only a very modestly positive delta ($.06). The higher our original delta, the harder it would have been to walk away unscathed today. On the other hand, had we been correct and the market continued higher, we would have been less correct.
The next reason is that we had a nice blend of gamma and theta. The reality of the situation is that the ES has been heavily range-bound, and we were in a low-vol environment (re-read that strategy segment: bottom one percentile on initiation day). We knew were were not going to churn in and out of anything for the purposes of these pieces, and so we left things to percolate; generally you only want a modest negative theta if that's your tactic. We find that modest negative thetas frequently "self-correct" - effectively making your trade adjustments for you.
"Why didn't this trade work?"
First, the strategy itself was the wrong way to be positioned. Calling a top would have been far more productive. But we frequently cover more bearish, put-style strategies in Tracking the Trade, and wanted to offer something different. And frankly, even if you are a bear, sometimes you want to know how to take more of a bullish view: I've personally never heard of a "blow-off bottom".
This trade really could have benefited from "gamma hedging"... buying some deltas in when the market fell and selling some of those deltas back when the market rebounded. There's nothing wrong with that, but it's just not the way we tend to write these pieces.
Thanks for reading. Please add your thoughts.
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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.
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.
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