The Daily Brief is a free glimpse into the prevailing fundamental and technical drivers of U.S. equity market products. Join the 200+ that read this report daily, below!
What Happened
Overnight, equity index futures were sideways, inside of the prior range, after exploring much lower, Monday. Measures of implied volatility, bonds, and most commodities were bid.
This is alongside news that Russia is dodging default, the necessity for the Fed to drop inflation down to 4% by year-end per Citadel’s Ken Griffin, the U.S. Treasury’s intent to scale back sales of longer-term debt, falling earnings estimates, Taiwan preparing to fend-off a potential invasion as Beijing ordered officials to find ways to fight against western sanctions, similar to those used against Russia, among other things including Fitch trimming China’s 2022 growth forecast.
Also, near risk-free, inflation-protected I bonds will pay 9.62% through October, the Treasury said, and here’s more on the Citigroup Inc (NYSE: C) trader that’s behind a European crash.
Ahead is data on job openings and quits, as well as factory and core capital goods orders (10:00 AM ET).
Read on for coverage on the fundamental and technical position of the market, as well as ways to position for future trade.
What To Expect
Fundamental: The Federal Reserve (Fed) is expected to raise its target overnight rate by about 50 basis points and provide updates on quantitative tightening (QT).
The expectations of the aforementioned have played into a tightening of financial conditions which, as Columbia Threadneedle’s Gene Tannuzzo explains, “reduces demand and ultimately slows inflation.”
The key is the update on QT. As Bloomberg’s John Authers puts it well, “what the Fed does with its balance sheet at the margin [] matters for asset prices, and there is little or no lag.”
The Fed’s liquidity reductions, thus far, have played into the market’s troubles since the start of the year. This is as QT has an impact on the “ability to roll over or refinance investments.”
Perspective: JPMorgan Chase & Co (NYSE: JPM) strategists note that investors’ fears are unwarranted. The U.S.’s economic expansion has not been derailed.
“Worries about China’s growth outlook, a negative take on the Q1 earnings reporting season, concerns about higher bond yields and further tightening of financial conditions from a strong dollar, all appear to have soured equity and credit investors’ sentiment,” the strategists said.
“We find these fears overblown.”
Positioning: Comments from yesterday’s morning letter remain valid, today.
Participants’ bets on the direction are concentrated in negative delta (long puts, short calls). The exposure is short-dated and extremely sensitive to changes in implied volatility and direction.
Those options carry a lot of gamma and are exposed to the potential for asymmetric or convex payouts. This is not good for those who are on the other side.
In hedging a short put, for instance, a positive delta and negative gamma trade, counterparties sell underlying if there is weakness or jumps in implied volatility. If the underlying trades higher, or dips in volatility, the counterparty will buy the underlying, all else equal.
Taken together, in such an environment, the counterparty leans toward taking liquidity and this exacerbates underlying movement if there’s a thinning liquidity environment, SpotGamma says.
In other words, hedging matters more in such an environment. This was clear during Monday’s trade when a bout of put selling and light call buying appeared in both the SPDR S&P 500 ETF Trust (NYSE: SPY) and Invesco QQQ Trust Series 1 (NASDAQ: QQQ).
This, ultimately, too, fed into the compression of volatility at the short-end of the term structure, yesterday. To re-hedge, counterparts likely bought into the market’s weakness and bolstered the near-vertical reversal, and close higher.
The odds of follow-through, to the upside, come back to the fundamental situation and Fed announcements this week. Should fears with respect to monetary policy be assuaged, then volatility can compress and that, alone, will spur a buy-back of those underlying short hedges.
If participants start to concentrate their bets at higher prices, further out in time, that confirms the odds of sustained follow-through. If not, it’s likely that prices, after a short-term relief, will succumb to fundamental weaknesses.
Technical: As of 6:45 AM ET, Tuesday’s regular session (9:30 AM – 4:00 PM ET), in the S&P 500, will likely open in the middle part of a balanced overnight inventory, inside of prior-range and -value, suggesting a limited potential for immediate directional opportunity.
In the best case, the S&P 500 trades higher; activity above the $4,123.00 untested point of control (VPOC) puts in play the $4,176.00 overnight high (ONH). Initiative trade beyond the ONH could reach as high as the $4,247.00 VPOC and $4,279.75 ONH, or higher.
In the worst case, the S&P 500 trades lower; activity below the $4,123.00 VPOC puts in play the $4,055.75 low volume area (LVNode). Initiative trade beyond the LVNode could reach as low as the $3,978.50 LVNode and $3,943.25 high volume area (HVNode), or lower.
Click here to load today’s key levels into the web-based TradingView charting platform. Note that all levels are derived using the 65-minute timeframe. New links are produced, daily.
Considerations: Most interesting was Monday’s response at a key technical level ($4,055.75) outlined in the morning letter.
Specifically, the E-mini S&P 500 probed $4,056.00 before staging a sharp reversal and closing higher. This is noteworthy as it tells us a lot about who has (or is gaining) the upper hand.
Push-and-pull, as well as responsiveness near key-technical areas (discernable visually on a chart), suggests technically-driven traders with shorter time horizons are (becoming) active.
Such traders often lack the wherewithal to defend retests and, additionally, this type of trade may suggest other time frame participants are waiting for more information to initiate trades.
Adding, the Federal Reserve’s meeting this week concludes with statements to be shared on Wednesday. For weeks heading into this event, (larger) participants (that move by committee) have de-grossed and hedged. For that reason, the reliability of our technical levels took a hit.
In the very near term, until more fundamental information is revealed, these technical-driven traders may play a larger role in the volatility. These traders, given capital constraints and tolerances, often trigger sharp moves in their entry and exit on news. Caution on whipsaw.
How I’m Playing: Presently, the market is stretched to the downside and participants are leaning, heavily, one way.
Pursuant to that remark, as SpotGamma says, “traders are underpricing right-tail risk,” and that opens the window for unique ways to play a returns distribution that is skewed positive (albeit with large negative outliers).
Consider zero- or low-cost bets that deliver asymmetric payouts in case of reversals.
This letter’s writer presently is structured positive delta and gamma in the Nasdaq 100 (INDEX: NDX) via ratios spread (1×2) and butterfly (1x2x1) structures.
The concern with these strategies is the width and time to expiry. Should either of those be wrong, then spreads initially positive gamma turn negative, meaning losses are amplified.
For instance, in the Nasdaq 100, to put in short, 500-1000 points wide ratio spreads (buy the closer leg, sell two of the farther legs) expiring in ten to fifteen days work well.
For those spreads that are not zero cost, debits can be offset with credit sales (on the put side) in products that have shown relative strength like the S&P 500 (INDEX: SPX). This, inherently, carries more risk. Read more about these strategies, here.
Please note that the above is NOT a trade recommendation or advice.
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: A structurally sound market will build on areas of high volume (HVNodes). Should the market trend for long periods of time, it will lack sound structure, identified as low volume areas (LVNodes). LVNodes denote directional conviction and ought to offer support on any test.
If participants were to auction and find acceptance into areas of prior low volume (LVNodes), then future discovery ought to be volatile and quick as participants look to HVNodes for favorable entry or exit.
POCs: POCs are valuable as they denote areas where two-sided trade was most prevalent in a prior day session. Participants will respond to future tests of value as they offer favorable entry and exit.
Volume-Weighted Average Prices (VWAPs): A metric highly regarded by chief investment officers, among other participants, for quality of trade. Additionally, liquidity algorithms are benchmarked and programmed to buy and sell around VWAPs.
About
After years of self-education, strategy development, mentorship, and trial-and-error, Renato Leonard Capelj began trading full-time and founded Physik Invest to detail his methods, research, and performance in the markets.
Capelj also develops insights around impactful options market dynamics at SpotGamma and is a Benzinga reporter.
Some of his works include conversations with ARK Invest’s Catherine Wood, investors Kevin O’Leary and John Chambers, FTX’s Sam Bankman-Fried, Kai Volatility’s Cem Karsan, The Ambrus Group’s Kris Sidial, among many others.
Disclaimer
In no way should the materials herein be construed as advice. Derivatives carry a substantial risk of loss. All content is for informational purposes only.
Physik Invest 