Market Volatility Bulletin: And The Livin' Is Easy
- Equities trade flat, but Russell hits a soft patch. Pay attention to the US Dollar Index.
- DoctoRx provides insights into the risks of "reverse QE" - will Dr. Yellen take his prescription?
- Some back and forth on the shape of the current term structure; contango coming back in on the front end over the last couple days.
The major US equity indices (SPY, DIA, QQQ, IWM) are trading about flat in morning trade, with the exception of the Russell 2000. VIX has meandered in a tight range, looking for direction.
Precious Metals are giving back some of yesterday's gains. The dollar trades lower against the Pound Sterling.
The dollar (UUP) is still searching for its footing: the US Dollar Index trades at about a 10-month low.
This matters quite a bit because earnings season is upon us: a weaker dollar will act as a tail wind to US earnings (not necessarily equities themselves, but certainly earnings). Currency expert Marc Chandler has a piece this morning on the topic. Keep an eye on it.
The major indices closed higher yesterday with a sweeping victory for bulls on the session. A curious combo of tech (XLK), Real Estate (XLRE) and Materials (XLB) led the charge; yesterday's trade offered up good news to owners of commodities, stocks and bonds.
DoctoRx penned New Data Shows the Fed's Reverse QE Plans are Risky on Jul10. In our view, this was well worth a read particularly because of yesterday's rally. Maybe Chair Yellen read it also and had a change of heart?
The piece features a great deal of visuals, which make the case that even the official unemployment rate is quite low, there may in fact be a decent amount of slack in the US labor market. That being the case, wage growth may not be the "threat" that Fed officials deem.
As mentioned, there are a large number of interesting charts, but we'll treat you to one that we enjoyed on this segment of the piece:
This chart would indicate that wage growth - with the unemployment rate at 4.4% - is not exactly soaring higher.
DoctoRx goes on to make the case that not fighting the Fed may mean raising some cash, as reverse QE may well have the (intended?) consequence of reducing asset prices, equities in particular.
Thanks DoctoRx for the informative read!
Thoughts on Volatility
As we move to publication, spot VIX trades low, but is still hanging on to a ten-handle. Peaks for the day thus far are kicking in at about 10.4. Naturally, spot VIX is subject to great change on a moment's notice.
The term structure is reverting back to its more usual shape - that where contango is steep on the front end, and then flattens out. We've discussed in past MVBs how the December contract trades low, and therefore how it could be more sensible to consider F5-F7 as a whole rather than the individual segments.
A couple days ago we were discussing generalized divergence in the overall levels of contango in the front vs. long-end VIX futures. Namely we had this to say:
We asked readers what their thoughts were on this phenomenon, and we received an excellent comment from atom&humber ("A&H"). After responding (you can read the full discussion here), A&H followed with the following:
This comment speaks to some interesting and relatively sophisticated points. And we do not agree entirely. A&H appealed earlier to the notion that basically the "known unknowns" are pretty docile, and so now when one goes long vol they are just buying insurance against "unknown unknowns". Give how very low the actual realized vol pattern has been of late, traders are just not all that willing to pay the premium for "what might be". As a quick aside, it's always dangerous to paraphrase someone, and we apologize if we are mischaracterizing his argument.
We would respond that perhaps implied volatility (as measured by spot VIX) ought to be lower than normal. But currently it is trading more or less in the bottom 0-5% percentile of its historic levels. Of the lowest 20 spot-VIX closes on record, nine have occurred since this past May.
President Trump offers headlines on an almost hourly basis; N. Korea flexes its muscles; much harder EPS comps are coming up; nearly every central bank on the planet is making the gradual pivot to hawkishness in a heavily debt-laden economy: bottom three-percentile of volatility?
Our take is that narratives matter tremendously in determining what does or does not count as news. The current market environment is one where bad news, while it does register, simply is not permitted to register for long. We're not here to tell you about the Plunge Protection Team or the Illuminati or accuse such-and-such or so-and-so group for this pattern. We're merely observing that it exists, and moreover it is our belief that the pattern has itself become the real news.
In sum, we agree with A&H that the VIX does not "deserve" to currently spend much in the way of tie over its long-term average of around 19.25. We take reservation with his perspective insomuch as we do not think that VIX "deserves" to trade at that rock-bottom of its historical trading range. To our view, that's a mismatch. This is especially the case if there actually is evidence of tightening liquidity.
The monthly straddle has reached the vol where - even over the last six weeks - has been a great time to buy. Speaking only for the period going back to early May, weekly and quarterly vol are still trading above their "buy zones". Vol appears to be trading heavy this morning - we think we'll see lower weekly and quarterly levels from here unless vol vigilantes take up the torch very soon. Given past trading action, we think you'll see quarterly dip below 10 again: it's a buy around 9.6.
"Contango" (look down column two) is steepening out on the expiration dimension.
Of course, in the larger scheme of things, all three of these vol levels are extraordinarily low.
Tracking the Trade
Yesterday we checked in on a trade that had been suggested to us back in early June that have been monitoring every so often. We'll keep this segment very brief today, and feature just the pricing updates and the trade modification that we made.
First, a quick explanation on what precipitated the trade to begin with:
This led to our initiation of the following position.
Remember, Tracking the Trade is meant to be educational. We do not put these positions on in reality, and we are not recommending that you trade these spreads. They're really meant to give you the reader exposure to different ways of thinking about risk and the richness of views the options market can uniquely accommodate.
Here is what the "baseline" looked like yesterday with the ES around 2440:
At a mid of -$25.25, the baseline was down substantially from its highs put in a back in early June of about $35; the original mid that we initiated the trade was $12.25. Clearly, this trade is choppy, and has suffered from low vol and a great deal of theta.
What is very interesting, however, is the fact that the theta and delta on the position have each come off their high levels. The delta that was once as high as 1.3 is now down to -.22: moves lower in ES will actually help the position. Theta, which at one point stood at almost $1.50/day of harmful spread impact, is now down to a more manageable $.24. In other words, the trade's risk profile is muting.
Based on Pierr's tactic description, he may well have sold a futures contract when the ES pushed higher over the past several weeks, and bought an ES futures (or perhaps a couple) when the market had gone lower.
One thing that we did not mention yesterday is just how profitable this baseline is in the event of a continued march higher. This is by no means a prediction, but if we could get five percent higher on the ES in short order - with no meaningful drawdown in implied vol - the baseline would enjoy a very substantive increase.
We modified the initial approach by scaling into the position, and also by selling calendar spreads (Aug18-Sep15 2600-strike) rather than naked calls. Finally, we sold a Jul7 2340 2450 strangle.
Since then, we scaled in with another 22 of the calendar spreads at an average cost of $95 over the course of three weeks or so. The Jul7 strangle that we sold to cover some of our theta expired on Friday, and so we are left with the following exposure:
Our position (using midpoint prices) is down a grand total of about $8.50, including all adjustments vs. down $37 for the baseline. We were harmed by the fact that we scaled into eight calendar spreads at unattractive prices, but helped by selling the strangle and trading the calendars to begin with.
It is well worth noting that had ES continued to scale higher way back in early June, the baseline trade would have significantly outperformed our modified version.
Mechanics - adding to our scaled position
We must now be careful of our position: selling a strangle was quite defensible five weeks ago; now we could find ourselves in trouble on a move if we broke out to the upside.
We'll trade the following spread, which will last only a few weeks. This will help us to prepare in the event of a breakout to the upside. We want to capture as much market action as possible, while keeping our theta in a strong position.
Here is a visual on the payoff, along with the associated Greeks:
Each of these options expires in twenty-three days. For the time being, this spread supplies us with a modest theta across the entire range of ES values.
That's a wrap!
We look forward to your comments, and wish you well in your financial and personal endeavors.
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This article was written by
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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