Although banks’ earnings were better than anticipated, sone figures indicate that the broader economy is declining, as retail sales and manufacturing output fell more than projected. Despite the challenges, most believe the Federal Reserve will raise interest rates next month.
Loretta Mester of the Federal Reserve, explained there should be another rate hike as the monetary policy will need to be more restrictive this year, with the fed funds rate rising above 5% and the real fed funds rate remaining positive for an extended period.
Thus far, monetary policymakers’ efforts to work liquidity out of the system have been complicated, particularly with rates at the back end falling, said Kai Volatility’s Cem Karsan in a conversation with TD Ameritrade Network. CrossBorder Capital confirms. Liquidity has been on an upward trend since October, partly due to China’s efforts to recover from Covid-19 restrictions and the collapse of the UK gilts markets.
Graphic: Retrieved from CrossBorder Capital via Bloomberg.
“Our original conjecture that Central Banks have effectively split their policy tools to use quantitative or balance sheet policies (QE) to ensure financial stability, whilst targeting inflation with interest rate policy is becoming more widely discussed in the media,” CrossBorder Capital’s Mike Howell said. “This splitting of roles can explain why interest rates have risen at the same time that Global Liquidity is turning higher.”
Accordingly, with the recent response to the bank issues cutting down tail risks for the S&P 500 (INDEX: SPX), markets are positioned to stay contained with falling implied volatility (IVOL) and correlations, as well as the passage of time, positioning-wise, key market boosters, Karsan added.
It’s appears the SPX may strengthen before it weakens with risk indicators, including IVOL measures, rising with the SPX. Physik Invest agrees: buy call structures on any weakness and monetize them into strength to finance long dated put structures.
It is better for traders to limit their expectations and stay the course, despite the big gap between IVOL measures like the Cboe Volatility Index and Merrill Lynch Option Volatility Estimate or MOVE, and big bets on market movement in the VIX complex, potentially to hedge against the breach of the US debt limit as soon as June.
As an aside, recent VIX hedging makes sense given that a breach of the debt limit likely results in recession, a ~20% drop in equities, and a volatility spike, Moody’s said.
Graphic: Retrieved from Nasdaq Inc (NASDAQ: NDAQ).
Quoting The Ambrus Group’s Kris Sidial, “When volatility starts to move, it moves at a higher rate than S&P volatility which is something that’s really important for the call option buyers,” which are stepping in aggressively as we’ve shown in the past letters.
Graphic: Retrieved from Piper Sandler Companies’ (NYSE: PIPR) Danny Kirsch. “With $VIX sitting at lowest level since early 2022, VIX call open interest approaching all-time highs reached in 2017/2018.”
About
Welcome to the Daily Brief by Physik Invest, a soon-to-launch research, consulting, trading, and asset management solutions provider. Learn about our origin story here, and consider subscribing for daily updates on the critical contexts that could lend to future market movement.
Separately, please don’t use this free letter as advice; all content is for informational purposes, and derivatives carry a substantial risk of loss. At this time, Capelj and Physik Invest, non-professional advisors, will never solicit others for capital or collect fees and disbursements. Separately, you may view this letter’s content calendar at this link.
Inflation and employment rates remain high. Additionally, consumers show resilience, and earnings are strong. As a consequence, markets are back to pricing higher rates for longer. This is a pressure on bonds and stocks which appear “overvalued relative to coming bad news on both economic growth and corporate earnings.”
Graphic: Retrieved from Bloomberg via @Marcomadness2. Hedge funds are net short 2Y and SOFR futures.
Morgan Stanley (NYSE: MS) says stocks are at risk of a pullback, accordingly.
Graphic: Retrieved from Goldman Sachs Group Inc (NYSE: GS) via The Market Ear. The indexes have front-run the pause and pivot; Goldman Sachs Group Inc (NYSE: GS) data suggests a statistically significant disconnect between the Nasdaq 100 (INDEX: NDX) and yield.
With the percentage of stocks outperforming the S&P 500 the lowest on record, MS added, a slump in technology is the big risk if yields continue to rise; the bear market is not yet over. “If there is one thing that can throw cold water on the large mega-cap rally, it’s higher yields due to a Fed that can’t stop hiking.”
Graphic: Retrieved from Morgan Stanley (NYSE: MS) via Bloomberg.
Moody’s Corporation (NYSE: MCO) expects a “0.25-percentage point increase to the fed funds rate when the FOMC reconvenes in early May.” Following this hike, there is likely to be a pause at a 5.00-5.25% terminal rate for a few months.
Graphic: Retrieved from CME Group Inc’s (NASDAQ: CME) FedWatch Tool.
From a positioning perspective, Kai Volatility’s Cem Karsan stated that in the past 6-9 months, there has been a significant increase in the volume of options with zero days to expiration (0 DTE), which now accounts for 44% of the total volume. This increase in short-dated options volume has been accompanied by a similarly sized decrease in longer-dated options volume.
Further, the majority of trading activity in these short-dated options is split between hedging and directional trading, as well as yield harvesting via out-of-the-money (OTM) options sales. Though the short-dated activity may prompt cascading events in market downturns, the main issue is the reduced use of longer-dated options; a supply and demand imbalance likely resolves itself with an implied volatility repricing of great size where longer-dated options outperform those that are shorter-dated.
Traders can look to position for a potential IVOL repricing, particularly in the back half of the year when dealer positioning is less clear, buybacks are to fall off of a cliff, and the boost from short-covering has played its course.
Traders can continue to play near-term strength via call spread structures and use those profits to reduce the costs of owning longer-dated bets on markets or rates falling and IVOL increasing. If not interested in directional exposure, traders may allocate funds to T-bills and SPX box spreads which allow traders to create a loan structure similar to a T-bill. If savvy, one could find some structures yielding ~5.5%. Traders can also consider blending T-bills and boxes with directional exposure. This way, they can cut portfolio volatility but still have a bit of leverage potential. Please check out our past letters for trade structure specifics. Have a great day!
About
Welcome to the Daily Brief by Physik Invest, a soon-to-launch research, consulting, trading, and asset management solutions provider. Learn about our origin story here, and consider subscribing for daily updates on the critical contexts that could lend to future market movement.
Separately, please don’t use this free letter as advice; all content is for informational purposes, and derivatives carry a substantial risk of loss. At this time, Capelj and Physik Invest, non-professional advisors, will never solicit others for capital or collect fees and disbursements. Separately, you may view this letter’s content calendar at this link.
Consensus is a tightening cycle that climaxes on May3 with one final 25 basis point hike. Most traders price three cuts after—one in July, November, and December.
Note: After the release of strong bank earnings today, this analysis remains intact.
Graphic: Retrieved from CME Group Inc (NASDAQ: CME).
Though policymakers are successful in walking up traders’ interest rate expectations, the long end of the yield curve hasn’t budged much; despite the response to banking turmoil helping “calm conditions, … and lessen the near-term risks,” many believe the Fed will have to pivot, soon.
The Federal Reserve’s ranks expect a “mild recession,” too, validating people such as Bank of America Corporation’s (NYSE: BAC) Michael Hartnett, who said investors should steer clear of stocks. Hartnett added the expectations of a recession would solidify following the upcoming earnings season, a test of how companies have managed headwinds like the bank crisis and slowing demand.
Graphic: Retrieved from Bank of America Corporation (NYSE: BAC).
Despite billions in redemptions over the past week or so, the market’sstrengthcan continue for longer, though. Here’s why.
Graphic: Retrieved from Goldman Sachs Group Inc (NYSE: GS) via The Market Ear.
Contextually, positioning overwhelmingly supports the market at this juncture. That’s per the likes of Cem Karsan of Kai Volatility have explained.
Falling volatility has led to billions more in buying flows from volatility-controlled funds rebalancing their risk exposures, Tier1Alpha adds, noting “there is a chance realized volatility [or RVOL] will continue to decrease until the end of next week as long as the SPX returns stay muted. If volatility rises beyond the +/- 2% threshold, net equity sales could exceed $5 billion.”
“This is not expected due to favorable CPI data and dealer positioning,” however.
With markets likely to be contained in the short to medium term, and fundamental weaknesses, such as the Fed hiking long-end yields, likely to cause them to fail in the long run—play near- or medium-term strength via call spread structures, and use the profits to lower the cost of longer-dated bets on markets or rates falling.
In support of this view, per The Market Ear’s summary of some Goldman Sachs Group Inc (NYSE: GS) analyses, “the disconnect between Nasdaq 100 (INDEX: NDX) and bond yields has grown to statistically significant levels.” Thus, “owning downside asymmetry” is starting to look “more attractive.”
Graphic: Retrieved from VIX Central. The compression of implied volatility, or IVOL, is a booster for equities. Investors are mostly bullish with a +1 Put, +100 Stock, -1 Call position, while dealers hold the opposite with a -1 Put, -100 Stock, +1 Call position. As the volatility trends lower (e.g., S&P 500 realized volatility or RVOL is ~10), options lose value, and dealers must buy back their short stock to re-hedge. This supports the market.
About
Welcome to the Daily Brief by Physik Invest, a soon-to-launch research, consulting, trading, and asset management solutions provider. Learn about our origin story here, and consider subscribing for daily updates on the critical contexts that could lend to future market movement.
Separately, please don’t use this free letter as advice; all content is for informational purposes, and derivatives carry a substantial risk of loss. At this time, Capelj and Physik Invest, non-professional advisors, will never solicit others for capital or collect fees and disbursements. Separately, you may view this letter’s content calendar at this link.
We’re excited to announce that we will be publishing ultra-detailed notes with context on fundamentals, positioning, and specific trades. Notes will be nearly 3,000 words or more, and will not be in the traditional newsletter format. Though this newsletter will continue to be published, it will not maintain previously long lengths because of time constraints. Notwithstanding, there will be occasional longer issues, we promise! We aim for quality rather than quantity. Stay tuned for future money-making updates.
Market indicators suggest an interest rate hike in May is more likely. This is backed by inflation data and Federal Reserve meeting minutes.
To be more specific, the indicators show traders are betting on higher rates in the near-to-medium term, and lower rates in the longer term. Adding, while inflation has moderated and there have been recent turbulences in the banking sector, monetary policymakers think higher rates for just a bit more are valid. However, they are also aware that a reduction in lending could potentially lead to defaults, recession, and a credit crunch in the worst-case scenario.
Fed President John Williams agreed that bringing down inflation requires more work. Williams suggested that the Fed should consider one more interest-rate hike before pausing, but the actual trajectory of rates will be based on analysis of newer data.
Per Cem Karsan from Kai Volatility, the negative effects of policy decisions will take time to reflect in the market.
He said investors are mostly bullish with a +1 Put, +100 Stock, -1 Call position, while dealers hold the opposite with a -1 Put, -100 Stock, +1 Call position. As the volatility trends lower (e.g., S&P 500 realized volatility or RVOL is ~10), options lose value, and dealers must buy back their short stock to re-hedge. This supports the market.
Thus, Karsan said the markets will be contained in the short to medium term, but fundamental weaknesses, such as the Fed hiking long-end yields, may cause them to fail in the long run. We maintain medium-term strength is monetizable via call spread structures discussed in prior newsletters. Rotating profits into longer-dated bets on markets or rates falling is attractive as well.
About
Welcome to the Daily Brief by Physik Invest, a soon-to-launch research, consulting, trading, and asset management solutions provider. Learn about our origin story here, and consider subscribing for daily updates on the critical contexts that could lend to future market movement.
Separately, please don’t use this free letter as advice; all content is for informational purposes, and derivatives carry a substantial risk of loss. At this time, Capelj and Physik Invest, non-professional advisors, will never solicit others for capital or collect fees and disbursements. Separately, you may view this letter’s content calendar at this link.
A big deal was made surrounding some data that shows investors increasing their bets on US equities falling; net short positions in the E-mini S&P 500 (FUTURE: /ES) are the highest since 2011, Bloomberg reports. JPMorgan Chase & Co (NYSE: JPM) and Goldman Sachs Group Inc (NYSE: GS) concur as their data showsclients betting on stocks falling or reducing stock exposure quickly.
This is happening in the context of some mixed, albeit still robust-leaning, data; payrolls upped bets that the Federal Reserve or Fed would move its target rate to 5.00-5.25%. GS’ Bobby Molavi adds, “the prevalent view seems to be that more things will break on the back of rapid rise in cost of capital.”
In light of the rate expectations, the Nasdaq 100 (INDEX: NDX) appears to be handing over the leadership baton to the S&P 500 (INDEX: SPX), though both indexes remain primarily intact and coiling; the fundamental-type pressures are balanced by follow-on support from those actors that base their decisions on such things as the amount a market moves (i.e., realized volatility or RVOL), says Tier1Alpha and SpotGamma.
The two providers of market insights see falling implied (IVOL) and RVOL as catalysts for buying stocks. This, coupled with the hedging of soon-to-expire large options open interest, particularly on the put side, in a lower liquidity environment, supports the indexes while underlying breadth and correlations are underwhelming.
A large concentration of put open interest near current prices is pictured just below. The eventual removal of this put-heavy positioning will reduce some directional risks to options counterparts; as puts disappear or decline in value, their delta or exposure to direction does too. If a counterparty is short a put and has less positive delta to hedge, they may buy back some of their short-delta exposure in the underlying index, a catalyst for higher S&P 500 prices.
Graphic: Retrieved from SpotGamma.
A large open interest concentration set to roll off this April is pictured just below.
Retrieved from SpotGamma.
This has happened before. Newfound Research explains it best in their paper titled “Liquidity Cascades: The Coordinated Risk of Uncoordinated Market Participants.”
In keeping the indexes and their underlying idiosyncratic baskets in line via arbitrage constraints, while there is a build-up of suppressive and supportive dealer hedging at the index level, “then the only reconciliation is a decline in correlation.”
In this context, Tier1Alpha explains, “lower correlations tend to lead to lower volatility … giv[ing] volatility control funds the go-ahead to augment their risk exposure, with an estimated $14 billion in equities purchases … to be spread out in blocks.”
Consequently, in line with our thesis that positioning and technical contexts support near-term strength, it still makes sense to take the profits of very wide, albeit low- or zero-cost, call ratio spread structures discussed in past letters to cut the cost of our bets on the equity market downside and lower rates with more time to expiry. Should the indexes trade higher, SpotGamma agrees with Kai Volatility’s Cem Karsan that volatility could be sticky.
Hence, call structures could keep their value better and enable us to lower the cost of our bets on the market downside. If the fundamental context supporting the rotation of call option profits into puts is no longer valid, then the losses on such trades are limited; the money is made in not losing it.
Graphic: Retrieved from SpotGamma’s Weekend Note.
Not doing as outlined and blindly buying put options to protect long equity exposure is generally a poor-performing strategy, despite the performance claims of some funds specializing in that practice.
Graphic: Retrieved from QVR Advisors via Bloomberg. “Buying puts is a money-losing proposition when considered in isolation. Chart shows the performance of hedges rolled every quarter with delta hedging, as a percentage of notional amount protected.”
About
Welcome to the Daily Brief by Physik Invest, a soon-to-launch research, consulting, trading, and asset management solutions provider. Learn about our origin story here, and consider subscribing for daily updates on the critical contexts that could lend to future market movement.
Separately, please don’t use this free letter as advice; all content is for informational purposes, and derivatives carry a substantial risk of loss. At this time, Capelj and Physik Invest, non-professional advisors, will never solicit others for capital or collect fees and disbursements. Separately, you may view this letter’s content calendar at this link.
US payroll data has increased the possibility of a rate hike by the Federal Reserve or Fed in early May, leading to higher rates and affecting those who expected a pause or pivot through poorly performing yield curve steepener trades. The market expects the Fed to raise its target rate to 5.00-5.25% and keep it there through mid-year.
Graphic: Retrieved from CME Group Inc’s (NASDAQ: CME) FedWatch Tool.
There is more to the pressure than just yields. Surveys indicate a drop in profits for sensitive areas of the equity market, such as technology and banks; as soon as the labor market starts softening, a credit crunch is expected to accelerate by some.
Graphic: Retrieved from the St. Louis Fed via Cubic Analytics.
Despite the turbulence from earnings, data suggests the S&P 500 (INDEX: SPX) may perform well through year-end. Historically, the full-year return was always positive when the S&P 500 had a positive first quarter. However, there have been exceptions, says Callum Thomas, quoting data gathered by Ryan Detrick.
Graphic: Retrieved from Ryan Detrick via Callum Thomas’ Weekly S&P 500 ChartStorm.
Peeking beneath the hood, only a few (primarily rate-sensitive) stocks have bolstered recent index strength; many components are not participating in the rally, which could be a harbinger of potential post-earnings weaknesses.
Graphic: Retrieved from McClellan Financial Publications.
Notwithstanding, if rates continue to fall, so do borrowing costs; falling inflation cuts pressures on input cost; rising unemployment helps keep labor costs under control, Bloomberg reports. The forecasts (not surveys) actually show earnings holding up better than the narrative suggests.
So what, then? In an annual report, JPMorgan Chase & Co (NYSE: JPM) concludes that if “we have higher inflation for longer, the Fed may be forced to increase rates higher than people expect despite the recent bank crisis.” Compounding the rate hikes is quantitative tightening or QT, the process of a central bank reducing the amount of money it has injected into an economy by selling bonds or other financial assets, which “may have ongoing impacts that might, over time, be another force, pushing longer-term rates higher than currently envisioned.” The net effect, though insights gleaned from the curve may be muddied due to the scale of recent interventions, is an “inverted yield curve [implying] we are going into a recession” and lower credit creation because, as Sergei Perfiliev well puts it, “if capital ends with the Fed, it is dead – it has left the economy and the banking system.”
Graphic: Retrieved from Bank of America Corporation (NYSE: BAC) via TheMarketEar.
How do we position ourselves, given all these narratives? Equity volatility implied (IVOL) and realized (RVOL) decreased. This may continue to be a booster. In fact, “if markets remain within a +/-1.5% range, a drop in volatility could trigger significant buying activity from the vol-control space, with up to $14 billion in notional flows hitting the tape, creating a favorable environment for equities,” says Tier1Alpha.
So, positioning-wise, stocks could trade up into a “more combustible” state where “volatility is sticky into a rally,” as Kai Volatility’s Cem Karsan said would happen.
SpotGamma confirms that, based on current positioning, SPX IVOL is projected to move up as the underlying index moves up; there are likely many people chasing the rally with long calls, “creating a swelling of call skew.”
In this environment, very wide call ratio spread structures discussed in past letters may continue to do well. We can use the profits from those call structures to cut the cost of our bets on the equity market downside and lower interest rates.
Graphic: Retrieved from SpotGamma’s Weekend Note.
About
Welcome to the Daily Brief by Physik Invest, a soon-to-launch research, consulting, trading, and asset management solutions provider. Learn about our origin story here, and consider subscribing for daily updates on the critical contexts that could lend to future market movement.
Separately, please don’t use this free letter as advice; all content is for informational purposes, and derivatives carry a substantial risk of loss. At this time, Capelj and Physik Invest, non-professional advisors, will never solicit others for capital or collect fees and disbursements. Separately, you may view this letter’s content calendar at this link.
Welcome to the Daily Brief by Physik Invest, a soon-to-launch research, consulting, trading, and asset management solutions provider. Learn about our origin story here, and consider subscribing for daily updates on the critical contexts that could lend to future market movement.
JPMorgan Chase & Co’s (NYSE: JPM) Marko Kolanovic believes the equities rally will falter, with headwinds from bank turbulence, an oil shock, and slowing growth poised to send stocks back toward their 2022 lows over the coming months. Kolanovic says this is “the calm before the storm,” adding that the equity rally is masking weaknesses from recent bank collapses and a decline in corporate profits and growth.
As a validation, we can look to ISM’s inventories exceeding that of new orders, and a dip in cost-push prices, Bloomberg’s John Authers explains. The overall ISM measure is recessionary; the upcoming earnings season may be unforgiving, and companies with weaker EPS are likely to be penalized more due to the prospects of a recession.
Graphic: Retrieved from Sergei Perfiliev. “Based on this relationship, today’s PMI reading of 46.3 implies an earnings contraction of about 8% over the next 12 months or an SPX EPS of 204. Using the current forward PE ratio of 18.7, this leads to an index level of about 3,815. A ‘recessionary’ PE ratio of 15 will see the index at ~3,060, assuming earnings don’t fall further.”
Graphic: Retrieved from @countdraghula. “We aren’t seeing the same thing for out-of-the-money calls on front-end futures. BUYING A CALL on front-end futures is taking a bet on Fed rates collapsing, especially if it is considerably out of the money, as below. Pricing for these is still sky high, despite some calm.”
Over the past weeks, we anticipated the markets trading “spiritedly for far longer,” quoting the likes of Kai Volatility’s Cem Karsan, who said the signs of a combustible situation would emerge when options implied volatility is sticky in a market rally.
Typically, as the market trades higher, volatility levels for fixed-strike options should decrease. If broad implied volatility measures are bid and fixed-strike volatility increases, this may lead to a more combustible situation as options counterparties begin to thin out on volatility, resulting in less support.
We maintain that you can monetize the example call structures we provided and roll some profits into bear put spreads (i.e., buy put and sell another at a lower strike), though you may limit your expectations. Some think there is a greater likelihood of a “crash-less selloff, a grinding de-leveraging.”
Don’t use this free letter as advice; all content is for informational purposes, and derivatives carry a substantial risk of loss. At this time, Capelj and Physik Invest, non-professional advisors, will never solicit others for capital or collect fees and disbursements. Separately, you may view this letter’s content calendar at this link.
Physik Invest’s Daily Brief is a free newsletter sent to thousands of subscribers daily. Intrigued about what moves markets and how that can impact your financial wellness? Subscribe below.
Graphic updated 7:00 AM ET. Sentiment Risk-On if expected /MES open is above the prior day’s range. Click here for the latest levels. /MES levels are derived from the profile graphic at the bottom of this letter. SqueezeMetrics Dark Pool Index (DIX) and Gamma (GEX) with the latter calculated based on where the prior day’s reading falls with respect to the MAX and MIN of all occurrences available. A higher DIX is bullish. The lower the GEX, the more (expected) volatility. Click to learn the implications of volatility, direction, and moneyness. Breadth reflects a reading of the prior day’s NYSE Advance/Decline indicator. The CBOE VIX Volatility Index (INDEX: VVIX) reflects the attractiveness of owning volatility. UMBS prices via MND. Click here for the economic calendar.
Administrative
The newsletter format needs to evolve a bit. Feedback is welcomed! If you are looking for the link to the daily chart, see the caption below the graphic above. Take care!
Positioning
Fear of contagion prompted demands for protection. Measures of implied volatility or IVOL rose, and consequently, these demands for protection pressured markets.
Previously, this letter explained for protection to keep its value, there would have to be a shift higher in realized volatility or RVOL. Well, RVOL did not come back in a big way at the index level, as many expected.
Thus, the positive effects of the bank-related stimulation and traders’ pulling forward their timeline for easing were compounded by the unwinding of hedging strategies.
Graphic: Retrieved from Bloomberg via SpotGamma. “This drop in 5-day realized vol (orange) is pretty sharp, given it occurred from such a low relative level. ‘Can’t short it, don’t want to buy it.’ This vol decline comes as SPX put open interest was cleared with March OPEX, and big VIX call interest expired last week.”
Previously depressed products like the Nasdaq 100 or NDX, which are generally very sensitive to monetary tightening, have performed well.
Graphic: Retrieved from Callum Thomas’ Topdown Charts.
As we near month-end, there is a quarterly derivatives expiry. Above current S&P 500 or SPX levels is a significant concentration of soon-to-roll-off open interest held short by investors. This means the counterparties are dynamically hedging a call they own; they’re selling strength and buying weakness, albeit in a less and less meaningful way, as those options near this expiration and their probability of paying out (i.e., delta or exposure to direction) falls.
Some would allege that volatility compression and time decay would have solicited a more meaningful response from options counterparties at those strike prices above; the absence of downside follow-through had traders supplying previously demanded downside put protection and catalyzing a rally. However, there are not many things for the market to rally on, and so much time has passed that the charm effects (i.e., the impact of time passing on an options delta) have lessened dramatically, some explain.
Graphic: Retrieved from Bloomberg via Liz Young. “The Nasdaq’s Cumulative Advance-Decline line has parted ways with index direction in recent days. In other words, the index has rallied despite weak breadth (more stocks falling than rising), the two lines are likely to find their way back together somehow…”
Therefore, it’s probably likely that the market remains contained through month-end. After, movement may increase. This letter acknowledged RVOL might come back in a big way, particularly with the bank intervention doing more to thwart credit creation.
The caveat is that markets can trade spiritedly for far longer. There is a potential for the markets to move into a far “more combustible” position. With call skews far up meaningfully steep, still-present low- and zero-cost call structures this letter has talked about in the past remain attractive.
Graphic: Retrieved from Charles Schwab Corporation-owned (NYSE: SCHW) thinkorswim.
If the market falls apart, your costs are low, and losses are minimal. If markets move higher into that “more combustible” position, wherein “volatility is sticky into a rally,” you may monetize your call structures and roll some of those profits into bear put spreads (i.e., buy put and sell another at a lower strike).
The signs of a “more combustible situation” would likely show when “volatility is sticky into a rally,” explains Kai Volatility’s Cem Karsan. To gauge combustibility, look to the options market.
Remember, calls trade at a lower IVOL than puts. As the market trades higher, it slides to a lower IVOL, reflected by broad IVOL measures. If broad IVOL measures are sticky/bid, “that’s an easy way to say that fixed-strike volatility is coming up and, if that can happen for days, that can unpin volatility and create a situation where dealers themselves are no longer [own] a ton of volatility; they start thinning out on volatility themselves, and that creates a more combustible situation.”
To explain the “thinning out” part of the last paragraph, recall participants often opt to own equity and downside (put) protection financed, in part, with sales of upside (call) protection. More demand for calls will result in counterparties taking on more exposure against movement (i.e., negative gamma) hedged via purchases of the underlying. Once that exposure expires and/or decays, that dealer-based support will be withdrawn. If the assumption is that equity markets are expensive now, then, after another rally, there may be more room to fall, all else equal (a simplistic way to look at this), hence the increased precariousness and combustibility.
Graphic: Retrieved from Callum Thomas’ Topdown charts.
About
The author, Renato Leonard Capelj, spends the bulk of his time at Physik Invest, an entity through which he invests and publishes free daily analyses to thousands of subscribers. The analyses offer him and his subscribers a way to stay on the right side of the market.
You may view this letter’s content calendar at this link.
Disclaimer
Do not construe this newsletter as advice; all content is for informational purposes. Capelj and Physik Invest are non-professional advisors managing their own capital. They will never openly solicit others for capital or manage others’ capital to collect fees and disbursements.
Physik Invest’s Daily Brief is read free by thousands of subscribers. Join this community to learn about the fundamental and technical drivers of markets.
Graphic updated 7:00 AM ET. Sentiment Neutral if expected /MES open is inside of the prior day’s range. /MES levels are derived from the profile graphic at the bottom of this letter. Click here for the latest levels. SqueezeMetrics Dark Pool Index (DIX) and Gamma (GEX) with the latter calculated based on where the prior day’s reading falls with respect to the MAX and MIN of all occurrences available. A higher DIX is bullish. The lower the GEX, the more (expected) volatility. Click to learn the implications of volatility, direction, and moneyness. Breadth reflects a reading of the prior day’s NYSE Advance/Decline indicator. The CBOE VIX Volatility Index (INDEX: VVIX) reflects the attractiveness of owning volatility. UMBS prices via MND. Click here for the economic calendar.
Administrative
Time for something inspiring! Separate from his work at Physik Invest, founder Renato Leonard Capelj is a journalist interviewing global leaders in business, government, and finance. In his desire to learn and apply the methods of those others who are far more experienced, Capelj has a long list of interviews you may find helpful in strengthening your understanding of markets. Check out some recent ones!
Capelj spoke with Simplify Asset Management’s Michael Green about cutting investors’ portfolio volatility while amplifying profit potential.
In response to uncertainty, Green says investors can park cash in short-term near-risk-free bonds yielding 5% or more, as well as allocate some capital to volatility “to introduce a degree of convexity,” risking only the premium paid. Alternatively, investors can take a more optimistic long view and position in innovations like artificial intelligence or next-generation energy production.
Capelj spoke with The Ambrus Group’s Kris Sidial about his market perspectives.
Naive measures like the VVIX, which is the volatility of the VIX or the volatility of the S&P 500’s volatility, are printing at levels last seen in 2017, Sidial explains, noting this would suggest “we can get cheap exposure to convexity while a lot of people are worried.”
“Even if inflation continues, the rate at which it rises won’t be the same. Due to this, CTA exposures likely will not perform as well as they did in 2022, and that’s why you may see more opportunities in the volatility space.”
Capelj spoke with Damped Spring Advisors’ Andy Constan about what investors should focus on and how he creates trades that lose him less money.
Constan’s trades are constructed around two- to four-month time horizons and are structured long and short using defined-risk options trades like debit or credit spreads, depending on whether volatility is cheap or expensive.
“I want deltas and leverage. My macro indicators give me an edge on price and in the worst case, the loss is limited to 10%, if everything has to go against me all at once. I can be 100% invested and only risk 10%.”
Capelj spoke with 42 Macro’s Darius Dale about his Wall Street story and perspectives on life and markets.
“We’re tracking at an above-potential level of output in terms of the growth rate of output. We’re also slowing and the pace of that deceleration is likely to pick up steam in the coming quarters.”
By 2023, that process is likely to “catalyze pressure on asset markets through the lens of corporate earnings and valuations you assign to a lower level of growth.”
Floor traders, according to Reznicek, had low capital requirements. As a result, they could put on strategies like the 1×2 ratio — a debit spread with an extra short option — for a low cost.
(See parts 1, 2, and 3 of ShadowTrader’s how-to series on ratio spreads.)
“On the floor, it is either go big or go home,” he chuckled, remarking that ratio spreads were the way of the casino. “You either get rich or they take your house. So, why would you put on any other spread?”
The next big turning point was Jim Dalton, who’s been a member of the Chicago Board of Trade, as well as a member of the Chicago Board Options Exchange (CBOE) and senior executive vice president of the CBOE during its formative years.
“I’m still in touch with him on a regular basis and I consider him a friend,” Reznicek said in a discussion on Dalton’s works like Mind Over Markets and Markets in Profile, as well as his use of WindoTrader Market Profile software. “I went to Chicago twice to see him teach live … and I came home from those seminars with five, six, 10 pages of notes. The nuances of profile continue to mold me.”
Capelj spoke with Kai Volatility Advisors’ Cem Karsan about the implications of record valuations and the growth of derivatives markets on policy, the economy, and financial markets.
“It’s not a coincidence that the mid-February to mid-March 2020 downturn literally started the day after February expiration and ended the day of March quarterly expiration. These derivatives are incredibly embedded in how the tail reacts and there’s not enough liquidity, given the leverage, if the Fed were to taper.”
Capelj spoke with The Ambrus Group’s Kris Sidial to understand how to capitalize on volatility dislocations.
Unlike standard tail-risk funds which systematically buy equity puts, Ambrus’ approach is bespoke, cutting down on negative dynamics like decay with respect to time.
Given dislocations across single stock skew, term structure, and volatility risk premium, Ambrus will position itself in options with less time to maturity, buying protection up to six weeks out.
“The market will underestimate the distribution,” Sidial said in a conversation on Ambrus’ internal models that spot positional imbalances to determine who is off-sides and in what single asset. “We’re buying things that have happened before and we’re looking for it to carry a heavier beta when the sell-off happens.”
So, by analyzing flow, as well as using internal models to assess the probabilities of deleveraging in a risk-off event, Ambrus is able to venture into individual stocks where there may be excess fragility; “I know if stock XYZ goes down five percent, it’s going to go down 10% because this fund needs to deleverage.”
To aid the cost to carry, Ambrus utilizes defined-risk, short-volatility, absolute return strategies.
“I’m basically giving you a free put on the market – with a ton of convexity – with something that offers a payout that’s just more than a regular put,” Sidial summarized. “If the market doesn’t do anything, and we do an amazing job, we’re flat and you made money on all your long-only equity exposure.”
Capelj spoke with The Ambrus Group’s Kris Sidial about the meme stock debacle of 2021.
“You have distressed debt hedge funds that focus on shorting these types of companies. Melvin Capital is the one that is singled out due to the media, but they aren’t the only ones.”
Market participants added to the crash-up dynamics. Retail investors aggressively bought stock and short-term call options, while institutional investors further took advantage of the momentum and dislocations.
“You have this dynamic in the derivatives market where there is a gamma squeeze when people are buying way far out-of-the-money calls, and dealers reflexively have to hedge off their risk,” Sidial said.
“It causes a cascading reaction, moving the stock price up because dealers are short calls and they have to buy stock when the delta moves a specific way.”
The participation in the stock on the institutional side has not received much attention, he said.
“We’ve noticed that some of the flow is more institutional,” he said in reference to activity on the level two and three order books, which are electronic lists of buy and sell orders for a particular security.
“You have certain prop guys and other hedge funds that understand what’s going on, and they’re trying to take advantage of it, as well.”
This institutional activity disrupted traditional correlations and caused shares of distressed debt assets like GameStop, BlackBerry Ltd, and AMC Entertainment Holdings Inc to trade in-line with each other.
“This was not some WallStreetBet user, … if you look at how some of these things were moving premarket, you would see GME drop like 2%, BB’s best bid would drop and AMC’s best bid would drop. That’s an algo.”
The takeaway: although the WallStreetBets crowd is getting most of the blame, institutions are also at fault for the volatility.
Technical
As of 7:00 AM ET, Tuesday’s regular session (9:30 AM – 4:00 PM ET) in the S&P 500 will likely open in the lower part of a balanced overnight inventory, inside the prior day’s range, suggesting a limited potential for immediate directional opportunity.
The S&P 500 pivot for today is $4,003.25.
Key levels to the upside include $4,026.75, $4,038.75, and $4,049.75.
Key levels to the downside include $3,980.75, $3,955.00, and $3,937.00.
Disclaimer: Click here to load the updated key levels via the web-based TradingView platform. New links are produced daily. Quoted levels likely hold, barring an exogenous development.
Graphic: 65-minute profile chart of the Micro E-mini S&P 500 Futures.
Definitions
Overnight Rally Highs (Lows): Typically, there is a low historical probability associated with overnight rally-highs (lows) ending the upside (downside) discovery process.
Volume Areas: Markets will build on areas of high-volume (HVNodes). Should the market trend for some time, this will be identified by a low-volume area (LVNodes). The LVNodes denote directional conviction and ought to offer support on any test.
If participants auction and find acceptance in an area of a prior LVNode, then future discovery ought to be volatile and quick as participants look to the nearest HVNodes for more favorable entry or exit.
POCs: Areas where two-sided trade was most prevalent in a prior day session. Participants will respond to future value tests as they offer favorable entry and exit.
Definitions
Volume Areas: Markets will build on areas of high-volume (HVNodes). Should the market trend for some time, this will be identified by a low-volume area (LVNodes). The LVNodes denote directional conviction and ought to offer support on any test.
If participants auction and find acceptance in an area of a prior LVNode, then future discovery ought to be volatile and quick as participants look to the nearest HVNodes for more favorable entry or exit.
About
The author, Renato Leonard Capelj, spends the bulk of his time at Physik Invest, an entity through which he invests and publishes free daily analyses to thousands of subscribers. The analyses offer him and his subscribers a way to stay on the right side of the market.
You may view this letter’s content calendar at this link.
Disclaimer
Do not construe this newsletter as advice. All content is for informational purposes. Capelj and Physik Invest manage their own capital and will not solicit others for it.
Physik Invest’s Daily Brief is read free by thousands of subscribers. Join this community to learn about the fundamental and technical drivers of markets.
Graphic updated 9:10 AM ET. Sentiment Risk-On if expected /MES open is above the prior day’s range. /MES levels are derived from the profile graphic at the bottom of this letter. Click here for the latest levels. SqueezeMetrics Dark Pool Index (DIX) and Gamma (GEX) with the latter calculated based on where the prior day’s reading falls with respect to the MAX and MIN of all occurrences available. A higher DIX is bullish. The lower the GEX, the more (expected) volatility. Click to learn the implications of volatility, direction, and moneyness. Breadth reflects a reading of the prior day’s NYSE Advance/Decline indicator. The CBOE VIX Volatility Index (INDEX: VVIX) reflects the attractiveness of owning volatility. UMBS prices via MND. Click here for the economic calendar.
Administrative
Sorry for the delay. Please read through the positioning section. Have a great Monday!
As always, if there are holes or unclear language. We will fix this in the next letters.
Fundamental
On 3/22, we mentioned news of Russia wanting to adopt the yuan for settlements.
Putin: We are in favor of using the Chinese yuan for settlements between Russia and the countries of Asia, Africa, and Latin America. I am confident that these forms of settlement in yuan will develop between Russian partners and their counterparts in third countries. pic.twitter.com/Mnw1WfjW4Y
And, with that, publications covering these East alliances use some tough language. One Bloomberg article notes China and Russia “roll[ing] back US power and alliances … [to] create a multipolar world … [and] diminish the reach of democratic values, so autocratic forms of government are secure and even supreme.”
Let’s rewind a bit to understand why all the toughness and fear.
If the US dollar's global supremacy erodes, America will face a reckoning like none before.
Recall Chinese President Xi Jinping speaking with Saudi and GCC leaders. Here is our 1/4 summary takeaway:
Graphic: Retrieved from Physik Invest’s Daily Brief for January 4, 2023.
Essentially, those remarks confirm the East is hedging sanctions risk. Reliance on the West is falling, and this inevitably will present “non-linear shocks” (i.e., “inflation mess caused by geopolitics, resource nationalism, and BRICS”) monetary policymakers are not equipped to handle. So, are the markets at risk?
President Xi to President Putin:
“Change that hasn’t happened in 100 years is coming and we are driving this change together.”
This most recent meeting between China and Russia increases the risks of unwinding the “debt-fueled economy in the US,” FT’s Rana Foroohar confirms, as we wrote in the Daily Brief for 1/4. Further, this is a threat to “hidden leverage and opaqueness.” That means the markets are at risk. Let’s explain more.
With the encumbrance of commodities, among other initiatives, these nations’ weight in currency baskets may rise and keep “inflation from slowing.” If that happens, future rate expectations are off. Additionally, “the US dollar and Treasury securities will likely be dealing with issues they never had to deal with before: less demand, not more; more competition, not less,” we quoted Zoltan Pozsar (ex-Credit Suisse) saying on 1/5.
The markets most responsive to this are public, as we saw with 2022’s de-rate. In 2023 and beyond, added liquidation-type risks lie in the private markets. This will have knock-on effects.
The likes of The Ambrus Group’s Kris Sidial mentioned to your newsletter writer in a Benzinga interview that private market investors’ raising of cash to meet capital calls could prompt sales of their more liquid public market holdings. This is a major risk Sidial noted he was watching, in addition to some risks in the derivatives markets.
At the same time, Eric Basmajian believes the “banking crisis will cause a tightening of money and credit.” This will further solidify the “broader business cycle and corporate profit recession.”
Graphic: Retrieved from Bloomberg. Per John Authers, “the combination of deeply troubled banks and strong performance for the rest of the stock market cannot persist much longer.”
Positioning
Sidial’s well positioned to take advantage of the realization of these risks. In January, he explained that measures like the Cboe VIX Volatility Index (INDEX: VVIX) were low. This suggested, “we can get cheap exposure to convexity while a lot of people are worried.” In an update to Bloomberg, Sidial said The Ambrus Group’s tail-risk strategy (which Sidial has explained to us before) has performed well as the VIX index has risen, a sign of traders hedging concerns about “some contagion hitting and their portfolios being destroyed on that.”
“We have seen an increase in tail hedging,” added Chris Murphy of Susquehanna International Group. “We have continued to see call buying in the VIX since the bank turmoil began.” The caveat, though, is that realized volatility or RVOL, not just implied volatility or IVOL (i.e., that which is implied by traders’ supply and demand of options), must shift and stay higher for those options to maintain their values, which may be difficult according to Kai Volatility’s Cem Karsan.
Though Karsan thinks markets will likely see RVOL come back in a big way, he thinks policymakers’ intervention will be stimulative short-term as it reverses a lot of the quantitative tightening or QT (i.e., flow of capital out of capital markets). Stimulation will be compounded by the continued unwinding of hedging strategies in previously depressed products like the Nasdaq 100 (INDEX: NDX). What do we mean by this?
Recall that traders’ closure and/or monetization of put protection results in options counterparties buying back their short stock and/or futures hedges. Therefore, before any downside is realized, the market may trade into a far “more combustible” position.
Consequently, look for low- and zero-cost call structures (e.g., ratio spreads) to play the upside while opportunistically using higher prices and elevated volatility skew to put on bear put spreads (i.e., buy put and sell another put at a lower strike price) for cheaper prices.
Consider following and supporting us on social media:
As of 9:10 AM ET, Monday’s regular session (9:30 AM – 4:00 PM ET), in the S&P 500, is likely to open in the upper part of a positively skewed overnight inventory, outside of the prior day’s range, suggesting a potential for immediate directional opportunity.
The S&P 500 pivot for today is $4,026.75.
Key levels to the upside include $4,038.75, $4,049.75, and $4,062.25.
Key levels to the downside include $4,004.25, $3,994.25, and $3,980.75.
Disclaimer: Click here to load the updated key levels via the web-based TradingView platform. New links are produced daily. Quoted levels likely hold barring an exogenous development.
Graphic: 65-minute profile chart of the Micro E-mini S&P 500 Futures.
Definitions
Volume Areas: Markets will build on areas of high-volume (HVNodes). Should the market trend for some time, this will be identified by a low-volume area (LVNodes). The LVNodes denote directional conviction and ought to offer support on any test.
If participants auction and find acceptance in an area of a prior LVNode, then future discovery ought to be volatile and quick as participants look to the nearest HVNodes for more favorable entry or exit.
About
The author, Renato Leonard Capelj, spends the bulk of his time at Physik Invest, an entity through which he invests and publishes free daily analyses to thousands of subscribers. The analyses offer him and his subscribers a way to stay on the right side of the market.
You may view this letter’s content calendar at this link.
Disclaimer
Do not construe this newsletter as advice. All content is for informational purposes. Capelj and Physik Invest manage their own capital and will not solicit others for it.
