Tag: Options

Case Study: How A Bearish S&P 500 Trade Turned Into A Multibagger

Post author By Renato L. Capelj
Post date September 7, 2022
6 Comments on Case Study: How A Bearish S&P 500 Trade Turned Into A Multibagger

Before the 2022 equity market decline, investors foresaw weakness in response to the coming monetary tightening. They repositioned and hedged their equity downside with allocations to commodities and options, colloquially referred to as volatility.

The commodity exposure worked well, while the volatility exposure did not work well. Consequently, the 2022 equity market decline was unlike many before; the monetization and counterparty hedging of existing customer options hedges and the sale of short-dated options, particularly in some of the single names where implied volatility or IVOL was rich, lent to lackluster volatility performance. Some may have observed tameness among IVOL measures such as the Cboe Volatility Index or VIX.

“One-year variance swaps or implied volatility on an at-the-money S&P 500 put option would trade somewhere in the neighborhood of 25 to 30%,” said Michael Green of Simplify Asset Management. “That implies a level of daily price movement that is difficult to achieve.”

Eventually, entering August 2022, entities were getting squeezed out of these trades that did not work. The market advanced as participants rotated out of options and commodities; a macro-type re-leveraging ensued on improvements in inflation data, an earnings season that was better than expected, and “crazy tax receipts,” among other things. In August of 2022, the advance climaxed the week of monthly options expiry or OpEx, as shown below.

*Graphic:* *Retrieved* *from Cboe Global Markets Inc (BATS: CBOE).*

Why did the advance climax the week of OpEx? Well, heading into that particular week of OpEx, markets were rising quickly, and call options (i.e., bets on the market upside) were highly demanded.

*Graphic: Updated 8/15/2022. Retrieved from SqueezeMetrics.*

Those on the other side of the call option trades (i.e., counterparties) thus hedged in a supportive manner (i.e., counterparties sell calls to customers and buy underlying to hedge exposure).

Eventually, traders’ activity in soon-to-expire options concentrated at specific strikes – particularly $4,300.00 in the S&P 500 – while IVOL trended lower. The counterparty’s response, then, did more to support prices and reduce movement. That is because, with time passing and volatility declining, options Gamma (i.e., the sensitivity of an option to direction) became more positive; the range of spot prices across which Delta (i.e., options exposure to direction) shifts rapidly shrunk. When options Gamma exposure is more positive, market movements may positively impact the counterparty’s position (i.e., movement benefits them). However, if the counterparty is not interested in realizing that benefit, it may hedge in a manner that dulls the market’s movement. This is, in part, what happened, in the late stages of the August rally. After the S&P 500 hit $4,300.00, the near-vertical price rise sputtered. Soon, follow-on support, both from a fundamental (e.g., liquidity) and volatility perspective, would worsen following OpEx.

*Graphic: Via* *Physik Invest. Data compiled by* *@jkonopas623. Fed Balance Sheet data,* *here. Treasury General Account Data,* *here. Reverse Repo data,* *here*. ***NL = BS – TGA – RRP***.

Why the removal/weakening of support? OpEx would trigger “a big shift in market positioning,” Nomura Holdings Inc’s (NYSE: NMR) Charlie McElligott explained at the time.

In short, participants’ failure to roll forward their expiring bets on market upside coincided with a message that the Federal Reserve (Fed) would stay tough on inflation. After OpEx, those same bets prompting counterparties to stem volatility and bolster equity upside were removed (i.e., expire). We can visualize this by the drop in Gamma exposures post-OpEx, as shown below.

*Graphic: Created by Physik Invest. Data by SqueezeMetrics.*

Accordingly, August OpEx, combined with technical and fundamental contexts prompting funds to “reload[] on short sales,” shocked the market into a higher volatility, negative Gamma environment. In this negative Gamma environment, put options, through which the vast majority of participants speculate on lower prices and protect their downside, solicited far more pressure from counterparties. If markets continued trading lower, traders would likely continue rotating into those put options, further bolstering pressure from counterparties. This happened, as shown below.

*Graphic:* *Retrieved* *from SpotGamma. “There was a huge surge in large trader put buying in the equities space last week as per the OCC data.”*

Demand for put options protection was bid IVOL. To hedge against this demand for protection and rising IVOL, counterparties sold underlying. This compounded bearish fundamental flows.

*Graphic: Retrieved from SqueezeMetrics.* *Learn* *the implications of volatility, direction, and moneyness.*

In late August, new data suggested September would have “a very large options position as it is a quarterly OpEx,” SpotGamma said. With positioning “put heavy,” a slide lower, and an increase in IVOL was likely to drive continued counterparty “shorting” with little “relief until Jackson Hole.”

Based on this information, Physik Invest sought to initiate trades expecting markets to trade lower and more volatile.

Call option premiums appeared attractive in mid-August, partly due to interest rates, while IVOL metrics seemingly hit a lower bound. This was observable via a quick check of skew, a plot of IVOL for options across different strike prices. Usually, skew, on the S&P 500, shows a smirk, not a smile. This meant it was likely that short-dated, wide Put Ratio Spreads had little to lose in a sideways-to-higher market environment. Additionally, call Vertical Spreads above the market were relatively more expensive.

*Graphic:* *Retrieved* *from Cboe Global Markets Inc (BATS: CBOE). Updated August 17, 2022. Skew steepened into $3,700.00 and below $3,500.00 in the S&P 500.*

Given the above context, the following analysis unpacks how Physik Invest traded options tied to the S&P 500 leading up to and through the August 19 OpEx, into the Jackson Hole Economic Symposium.

Note: Click here to view all transactions for all accounts involved.

Sequence 1:

Through August 12, 2022, after a volatility skew smile was observed, the following positions were initiated while the S&P 500 was still trending higher for a net $7,616.68 credit.

Positions were structured in a way that would potentially net higher credits had the index moved lower.

SOLD 10 1/2 BACKRATIO SPX 100 (Weeklys) 26 AUG 22 3700/3500 PUT @ ~$0.13 Credit
SOLD 3 VERTICAL SPX 100 21 OCT 22 [AM] 4300/4350 CALL @ ~$25.10 Credit

Sequence 2:

While the S&P 500 was trading near $4,300.00 resistance, by 8/19/2022, all aforementioned Ratio Put Spread positions were rolled forward for a $452.26 credit.

The resulting position was as follows:

-17 1/2 BACKRATIO SPX 100 (Weeklys) 16 SEP 22 3700/3500 PUT
-3 VERTICAL SPX 100 21 OCT 22 [AM] 4300/4350 CALL

From thereon, the market declined and, by 9/1/2022, all positions were exited for a $6,963.84 credit.

BOT 17 1/2 BACKRATIO SPX 100 (Weeklys) 16 SEP 22 3700/3500 PUT @ ~$4.94 Credit
BOT 3 VERTICAL SPX 100 21 OCT 22 [AM] 4300/4350 CALL @ ~$4.57 Debit

Summary:

The trades netted a $15,032.78 profit after commissions and fees.

The max loss (absent some unforeseen events) sat at ~$6,790.00 if the S&P 500 closed above $4,350.00 in October. Because the Ratio Put Spreads were initiated at no cost, any loss would have resulted from the trade’s Vertical Spread component if the market went higher.

Overall, this trade netted more than a 200% return; the trade’s profit was more than two times the initial debit risk, a multi-bagger.

Reflection:

Heading into the trades, it was the case that IVOL performed poorly during much of the 2022 decline. This would likely remain the case on any subsequent drop; hence, the ultra-wide and short-dated Ratio Put Spread.

Despite the Ratio Put Spread exposing the position to negative Delta and positive Gamma (i.e., the trade makes money if the market moves lower, all else equal), if implied skew became more convex (i.e., implied volatilities grow more rapidly as strike prices decrease), the position could have been a giant loser. So, if the flatter part of the skew curve (where the position was structured) became more convex (i.e., rose), which is not something that was anticipated would happen, then the only recourse would have been to (1) close the position or (2) sell (i.e., add static negative Delta in) futures and correlated ETFs. In the second case, the trade would have allowed time to work (i.e., let Theta work) and become a potential winner.

Additionally, under Physik Invest’s risk protocol, more Short Put Ratio Spread units could have been initiated on the transition into Sequence 2. These units could have been held through Labor Day and monetized for up to an additional ~$4.00 credit per unit.

Though additional units of the Vertical Spreads could not have been added due to the strict limits to debit risks, there were still months left to that particular trade component. With lower prices expected, there was little reason the Verticals should have been removed fast.

Going forward, should the context from a fundamental and volatility perspective remain the same, only on a rally could Physik Invest potentially re-enter a similar position.

Commentary

Daily Brief For July 15, 2022

Post author By Renato L. Capelj
Post date July 15, 2022
8 Comments on Daily Brief For July 15, 2022

The daily brief is a free glimpse into the prevailing fundamental and technical drivers of U.S. equity market products. Join the 300+ that read this report daily, below!

*Graphic updated 6:35 AM ET. Sentiment* ***Neutral*** *if expected /ES open is inside of the prior day’s range. /ES levels are derived from the profile graphic at the bottom of the following section. Levels may have changed since initially quoted;* *click here* *for the latest levels. SqueezeMetrics* *Dark Pool* *Index (DIX) and* *Gamma* *(GEX) calculations are 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. At the same time, the lower the GEX, the more (expected) volatility.* *Learn* the implications of volatility, direction, and moneyness. Breadth reflects a reading of the prior day’s NYSE Advance/Decline indicator. VIX reflects a current reading of the CBOE Volatility Index (INDEX: VIX) from 0-100.

Fundamental

Note: A really interesting discussion in the below positioning section which tidies up some of the past analyses we’ve made. Read on for more!

Ahead are updates on retail sales, import prices, Empire State Manufacturing (8:30 AM ET), industrial production and capacity utilization (9:15 AM ET), as well as University of Michigan consumer sentiment and inflation expectations, and business inventories (10:00 AM ET).

This week, markets repriced after data on inflation came in hot. Participants have bet on tough action from the Federal Reserve (Fed). Now, there is a near-50% chance of a 100 basis point hike later in July.

*Graphic: Via CME Group Inc’s (NASDAQ: CME)* *FedWatch Tool*.

Per The Macro Compass, published by Alfonso Peccatiello, companies have downgraded their outlooks and job creation “is much less impressive” amid labor force shrinkage.

“[T]he number of total employed people in the US divided by its total population in the 25-54y age bracket dropped below 80%,” he explains. “Over the last 30 years, at the peak of each economic cycle, this ratio was over 80%.”

Accordingly, earnings “are nowhere near pricing the economic slowdown, … [and there still remains] way too much optimism.”

*Graphic:* *Retrieved* *from The Market Ear. Via Barclays Plc (NYCE: BCS).*

Additionally, commodities (even more so those that are industrial and “are the cleanest expression of global demand”) have endured selling pressure with a near 30% copper drawdown likely to precede positive total returns for long bonds, Peccatiello explains.

*Graphic: Retrieved from Callum Thomas. With “[r]ecessions see[ing] oil prices fall by 20% to 70%, … being bullish on oil at this point is either betting against history or [] recession.”*

Positioning

The drawdown in commodities is significant as that was, arguably, the last place that offered participants a hedge against their poorly performing bond and equity exposures.

“A lot of people allocated to commodity trend following and that did a good job in the first two quarters,” The Ambrus Group’s Kris Sidial explained.

“CTAs were performing and you had a lot of people who did not need to buy [equity] volatility because their portfolios were covered from the inflation hedges.”

*Graphic:* *Shared* *by Benn Eifert of QVR Advisors.*

That, coupled with the sale of ultra-short-dated volatility, particularly in some of the single names to capture “rich” volatility, as well as hedging of structured products issuances, continues to play into suppressed index volatility.

For context: Rising rates and a drive for yield have been a boon for exotic derivatives. 

Participants often seek exposure to products that are essentially short volatility a year or so out. The counterparty, here, is long volatility on these notes. To hedge risk – since “you can’t just be long volatility, … [otherwise] you’ll bleed money for long periods of time” – the bank will hedge risk in the listed market. 

However, on a one-year auto-callable, for which it would be appropriate to sell one-year volatility in the listed market, “some of these banks … create this synthetic calendar profile where they’re … sell[ing] a little bit of one-month vol because they can take in that theta a whole lot faster, or two- and three-month vol,” spreading exposure in buckets.

See, here, for a sample presentation on what is an Auto-Callable Yield Note.

This suppresses “vol in the front of the term structure, and … opens up the door to … that other move where if everybody is selling vol in the front of the term structure,” it may blow out on a large increase in demand.

“If you look back during COVID, there are articles about banks that lost a lot of money because of the[ir] hedges. This has happened previously and you’re seeing little blips of it start to” return.

*Graphic:* *Retrieved* *from The Ambrus Group’s Kris Sidial. “[S]ome dealers will opportunistically look to sell vol in some buckets in the front of the term structure.”*

Basically, “the macro landscape … opened up another area to hedge” which resulted in the increased movement of realized equity (RVOL) volatility, relative to that which is implied (IVOL).

*Graphic: Via S&P Global Inc (NYSE: SPGI). As* *explained* by SpotGamma, “30-day realized SPX volatility is now trading above the VIX, something that generally shows after major selloffs wherein IV “premium” needs to reset to calmer/higher equity markets.”

Now, with commodities not offering protection, one has to be concerned if “the flock move[s].”

“If commodities are not performing, they’re not going to work as a hedge for your portfolio. That opens the door … [to] markets sliding lower and [people] need[ing] to get hedges on,” which is likely to bid equity volatility where some single names “are only trading three to four vol points above where they were trading in January of 2020,” the complete dismissal of a crash.

Therefore, “if you wanted to go out and hedge, the opportunity is still there in the equity space.”

Technical

As of 6:30 AM ET, Friday’s regular session (9:30 AM – 4:00 PM ET), in the S&P 500, is likely to 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.

Any activity above the $3,807.00 VPOC puts into play the $3,830.75 MCPOC. Initiative trade beyond the MCPOC could reach as high as the $3,867.25 LVNode and $3,909.25 MCPOC, or higher.

In the worst case, the S&P 500 trades lower.

Any activity below the $3,807.00 VPOC puts into play the $3,770.75 HVNode. Initiative trade beyond the HVNode could reach as low as the $3,751.00 VPOC and $3,722.50 LVNode, 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.

*Graphic: 65-minute profile chart of the Micro E-mini S&P 500 Futures.*

Considerations: Responsiveness near key-technical areas (that are discernable visually on a chart), suggests technically-driven traders with short time horizons are very active.

Such traders often lack the wherewithal to defend retests and, additionally, the type of trade may be indicative of the other time frame participants waiting for more information to initiate trades.

Definitions

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.

MCPOCs: POCs are valuable as they denote areas where two-sided trade was most prevalent over numerous day sessions. 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, former Bridgewater Associate Andy Constan, 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.

Daily Brief For May 15, 2023 + Key Update

by Renato L. Capelj May 15, 2023

Daily Brief For May 12, 2023

by Renato L. Capelj May 12, 2023

Daily Brief For May 11, 2023

by Renato L. Capelj May 11, 2023

Commentary

Daily Brief For March 21, 2022

Post author By Renato L. Capelj
Post date March 21, 2022
No Comments on Daily Brief For March 21, 2022

Editor’s Note: 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 auctioned sideways to lower with commodities and bonds.

There are no overnight fundamental catalysts to make note of. However, it bears mentioning that implied volatility metrics – via the Cboe Volatility Index (INDEX: VIX) – are back to levels seen before Russia’s invasion of Ukraine. One may conclude that concerns are easing.

Ahead is data on the Chicago Fed national activity index (8:30 AM ET) and Fed-speak by Chair Jerome Powell (12:00 PM ET).

*Graphic updated 6:30 AM ET. Sentiment* ***Neutral*** *if expected /ES open is inside of the prior day’s range. /ES levels are derived from the profile graphic at the bottom of the following section. Levels may have changed since initially quoted;* *click here* *for the latest levels. SqueezeMetrics* *Dark Pool* *Index (DIX) and* *Gamma* *(GEX) calculations are 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. At the same time, the lower the GEX, the more (expected) volatility.* *Learn* *the implications of volatility, direction, and moneyness.* *SHIFT* data used for S&P 500 (INDEX: SPX) options activity. Note that options flow is sorted by the call premium spent; if more positive, then more was spent on call options. Breadth reflects a reading of the prior day’s NYSE Advance/Decline indicator. VIX reflects a current reading of the CBOE Volatility Index (INDEX: VIX) from 0-100.

What To Expect

Fundamental: In spite of uncertainties with respect to economic growth and the implications of tighter monetary policy to rein in inflation, as well as geopolitical conflicts abroad, the pricing of equity market risk – via the VIX – is back at levels before Russia’s invasion of Ukraine.

That leads us to question whether the de-rate (or pricing in of uncertainties) has played out?

Potentially. With greater clarity on the Federal Reserve’s commitment to raising borrowing costs (as discussed March 17 in detail), strategists like JPMorgan Chase & Co’s (NYSE: JPM) Marko Kolanovic suggest it is time to add risk in beaten-down, high-beta positions.

“While the commodity supercycle will persist,” Kolanovic said, “the correction in bubble sectors is now likely finished, and geopolitical risk will likely start abating in a few weeks’ time (while a comprehensive resolution may take a few months).”

*Graphic: Via* *Bloomberg*. “Officials on the Federal Open Market Committee voted 8-1 [] to lift the target range for their main policy rate to 0.25%-0.5% and forecast a sequence of increases that would raise it to 1.75%-2% by year-end. The projections, known as the dot plot, also showed that ***almost half of the 16 current policymakers wanted to move faster***.”

Complicating Kolanovic’s outlook is uncertainty with respect to the Fed’s decision to hike and taper asset purchases faster, as some Fed members say they are “very open to.”

At a high level, higher rates make borrowing more costly (i.e., higher rates on mortgages and business loans, as well as credit cards, among other things, disincentivize borrowing, and this funnels into less growth and inflation).

These higher rates compound the challenges of limited supply, for instance, in housing.

*Graphic: Via* *Bloomberg*. “The slide in sales reflects a market still constrained by a lack of inventory, which in February was the second-lowest on record. Buyers are bidding up prices on the few homes available. Meantime, affordability is showing signs of worsening, especially among first-time buyers … [which] accounted for 29% of sales last month, down from 31% a year earlier. [A]t current rates, monthly mortgage payments are up 28% from February last year.”

There’s also the topic of using quantitative tightening (QT) to fight inflation, too.

Recall that quantitative easing (QE) is a policy to expand the Federal Reserve’s balance sheet “to provide monetary accommodation, typically when interest rates are at a zero-lower bound (when nominal interest rates are at, or near, zero),” as JH Investment Management explains.

With QT, central banks remove assets (e.g., government bonds they bought from the private sector) from their balance sheet “either through the sale of assets they had purchased or deciding against reinvesting the principal sum of maturing securities.”

With that, we note that when bonds rise in value, their yields decline; “when the Fed embarks on bond-buying program[s] to support the U.S. economy, … [it nudges] the prices of these assets higher while pushing yields lower, which also has the effect of driving yield-hungry investors into relatively riskier asset categories that promise high returns.”

As a result, participants’ demand for risk assets prompts their divergence from fundamentals. As liquidity is removed and funding costs increase, this may prompt risk assets to converge with fundamentals.

This is as, for investors to take on additional risk for return, they must receive in excess of the risk-free rate (as provided by the Treasury). This excess is the risk premium.

At present, according to commentary by Damped Spring’s Andy Constan, “Additional risk premium expansion pressures from these levels is not likely from news emanating from” Fed meetings.

“However, if, in the unlikely event, details of QT do emerge suggesting a start of QT before June and at a greater size than expected, we would no longer be willing to hold [risk] assets as that would cause an end to any risk premium contraction possibilities.”

Positioning: According to Morgan Stanley’s (NYSE: MS) trade desk, institutions (e.g., volatility targeting funds and trend following commodity-trading advisers) dumped nearly $200 billion in global equities over the first two months of 2022.

Hedge funds’ net leverage, too, “fell 7.5 percentage points over the two weeks through March 11, the largest decrease over any comparable period since at least January 2016,” according to Goldman Sachs Group Inc (NYSE: GS).

“Institutional traders, major money managers, asset managers, and hedge funds, their moves have to do with the current market conditions — a lot of volatility, a lot of uncertainty, inflation concerns, geopolitical concerns,” says Bloomberg’s Jackson Gutenplan.

“As the market continues to downtrend, institutions selling out of positions are overwhelming any retail buying pressure.”

Given this, as mentioned in the prior fundamentals section, strategists like JPM’s Kolanovic suggest these are some of the reasons to boost risk.

“Current risk positioning is very light. This is a result of high and persistent volatility, and risk aversion caused by global geopolitical developments,” Kolanovic says. “And for this reason, risks are skewed to the upside.”

And so, alongside the buying of futures and stock to offset the decay of counterparty positive delta (post-FOMC and through OPEX), retail investor buying remained undeterred last week.

But, as Zephyr’s Ryan Nauman says, “even though retail has gained a lot of momentum over the past two years, institutional money still outweighs the retail money, and it’s still going to move markets.”

*Graphic: Via TD Ameritrade. Taken from* *Bloomberg*. “There’s a little bit of what I think is a retrenchment going on, where they weren’t just buying everything across the board,” Shawn Cruz, senior market strategist at TD Ameritrade Inc said. “As much as there is some pulling back, and there’s a lot of volatility going on, you’re seeing some selling in the more highly valued areas and the buying is very targeted.”

That is in the face of lackluster options activity. According to SpotGamma, call-buying, a feature of sustained bull markets “was at lows going back to 2020,” last week.

*Graphic: Via* *SpotGamma*. “Here’s options data from the OCC. These plots show the premium per trade aggregated each week, with calls in blue and puts in orange. This is only customer flow (i.e. retail, hedge funds). Starting with equities, call buying this past week was at LOWS going back to ’20 (top right).”

“Maybe you get to an extreme bearishness, and that’s usually where you bottom out,” adds Liz Young of SoFi Technologies Inc (NASDAQ: SOFI) in a statement on mom-and-pop investors eventually following institutional selling trends.

As this commentary has said before, a way to participate in the upside (while lowering debit risk) is through complex options structures, such as the ratio spread. Note, ratio spreads may carry margin risk, depending on the structure, resulting in undefined losses, potentially.

*Graphic: Via Banco Santander SA (NYSE: SAN)* *research, the return profile, at expiry, of a classic 1×2 (long 1, short 2 further away) ratio spread.*

Technical: As of 6:30 AM ET, Monday’s regular session (9:30 AM – 4:00 PM ET), in the S&P 500, will likely open in the middle part of a negatively skewed 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 $4,438.25 high volume area (HVNode) puts in play the $4,466.00 regular trade high (RTH High). Initiative trade beyond the RTH High could reach as high as the $4,499.00 untested point of control (VPOC) and $4,526.25 HVNode, or higher.

In the worst case, the S&P 500 trades lower; activity below the $4,438.25 HVNode puts in play the $4,409.00 VPOC. Initiative trade beyond the VPOC could reach as low as the $4,395.25 HVNode and $4,355.00 VPOC, or lower.

Considerations: Push-and-pull, as well as responsiveness near key-technical areas (that are discernable visually on a chart), suggests technically-driven traders with short time horizons are very active.

Such traders often lack the wherewithal to defend retests and, additionally, the type of trade may be indicative of the other time frame participants waiting for more information to initiate trades.

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.

Definitions

About

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.

Daily Brief For May 10, 2023

by Renato L. Capelj May 10, 2023

Daily Brief For May 9, 2023

by Renato L. Capelj May 9, 2023

Daily Brief For May 4, 2023

by Renato L. Capelj May 4, 2023

Commentary

Daily Brief For March 10, 2022

Post author By Renato L. Capelj
Post date March 10, 2022
1 Comment on Daily Brief For March 10, 2022

What Happened

Overnight, equity index futures auctioned lower practically negating the prior day’s advance. Per the news, Ukraine and Russia failed in their efforts to end the war.

Adding, similar to days prior, areas where there are key technical nuances served as supports and resistances. One may construe this as short-term traders’ dominance in the smaller time horizons while the other time frames are positioning for expansive moves (yet to happen).

To note, key metrics under the hood (SpotGamma’s HIRO, among other things) yesterday, further validated the status quo and short-covering.

Moreover, ahead is data on jobless claims and the consumer price index (8:30 AM ET). Later, participants get data on real domestic nonfinancial debt and wealth (1:00 PM ET), as well as the budget deficit (2:00 PM ET).

Graphic updated 6:40 AM ET. Sentiment Neutral if expected /ES open is inside of the prior day’s range. /ES levels are derived from the profile graphic at the bottom of the following section. Levels may have changed since initially quoted; click here for the latest levels. SqueezeMetrics Dark Pool Index (DIX) and Gamma (GEX) calculations are 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. At the same time, the lower the GEX, the more (expected) volatility. Learn the implications of volatility, direction, and moneyness. SHIFT data used for S&P 500 (INDEX: SPX) options activity. Note that options flow is sorted by the call premium spent; if more positive, then more was spent on call options. Breadth reflects a reading of the prior day’s NYSE Advance/Decline indicator. VIX reflects a current reading of the CBOE Volatility Index (INDEX: VIX) from 0-100.

What To Expect

Fundamental: The consumer price index (CPI) is to likely accelerate to 7.8% from a year ago.

This forecast varies widely, however, based on economic analysis with respect to the implications of Russia’s invasion of Ukraine and the sanction that resulted after.

“There’s going to be a lot of noise in the next six months that’s going to be extremely difficult to disentangle,” said Omair Sharif of Inflation Insights LLC.

“If you thought it was difficult to figure out what used car prices were doing and whether that was transitory, multiply that by a thousand.”

In a mention on energy market volatility, while today’s economy is less dependent on oil (i.e., less likely to kill the expansion), the action in that market (and the responses it may solicit from policymakers, later) is noteworthy.

Graphic: Via Bloomberg. “When families have to spend more money on necessities, they have less to spend on discretionary items and services. Economists at Barclays Plc expect the spike in energy prices to subtract an annualized 0.3 percentage point from consumption growth on average per quarter through the end of 2023.”

Despite a deterioration in the relationship between prices of crude and inflation, oil is “a major input in the economy – it is used in critical activities such as fueling transportation and heating homes – and if input costs rise, so should the cost of end products,” Investopedia says well.

Further, according to Reuters’ John Kemp, fuel oil inventories fell last week to the lowest seasonal level in more than 15 years.

Graphic: Via John Kemp’s “Best in Energy” note. “Distillate stocks were already looking tight and are now on track to become exceptionally tight before mid-year. Distillate inventories are on course for an expected first-half low of 103 million barrels (with a range of 92-114 million).”

“Stocks are on track to hit an even lower seasonal level than 2008 when the distillate shortages helped propel crude oil prices to a record high at the middle of the year,” Kemp says.

Graphic: Via Physik Invest. The CBOE Crude Oil Volatility Index (INDEX: OVX) reveals signs of peaking.

The highest oil prices ~$150/bbl had printed in 2008. As Alfonso Peccatiello of The Macro Compass hypothesizes, “Oil is denominated in fiat currency, and there has been A LOT of spendable money printing over the last 15 years. If you think the market gets as extreme as 2008, the equivalent oil price in today’s USD would be above $250/bbl.”

Given wage growth and the like, consumers likely start “to feel the heat way below $250.”

Graphic: Via Alfonso Peccatiello. “The red line shows the inflation-adjusted crude price: if you expect a proper tight oil environment, >$150-160 is your number. Also, anything above $120 in today’s prices and sustained for a few quarters would likely hit the demand side. 2013-2014 a good example, with the private sector turning defensive in 2015-2016 and China forced to ease big times to shore up the global economy.”

Why mention any of this? Fast moves higher in some of these commodity markets may impact end-consumer prices and behavior, quickly. In a bid to rein inflation – ”very high CPI in 2022, [and] still high in 2023 – central bankers will tighten.

“The path of least resistance is for the Fed to hike rates from 0% to at least 2% relatively quickly,” Peccatiello explains in a recent post.

However, the “Last time companies were revising their forward earnings estimates down on a net basis while Central Banks were attempting to tighten monetary policy was mid-2018,” when the markets sold nearly 20%.

Graphic: Via Yardeni Research. Taken from The Macro Compass. “The chart above shows the 3-months average of the MSCI World net earnings revisions: essentially, this metric measures the difference between the number of companies revisiting their forward earnings estimate up versus down.”

With financial conditions tightening, Peccatiello posits the Fed will be receptive to that.

Graphic: Via The Macro Compass. “Credit-default swaps on 5-year US Investment Grade Corporate Bonds are trading at 76 bps at the time of writing: Fed puts (or pivots) became more visible in the past when this measure of credit spreads approached 100 bps.”

Basically, if selling were to continue, the Fed would reassess tightening. At such level of reassessment is the Fed Put, a dynamic we’ve discussed in the past.

Graphic: Via Bank of America Corporation (NYSE: BAC). Retrieved from Callum Thomas.

Chamath Palihapitiya recently posted about this, too. He said: “In 2018, the Fed was concerned about inflation. They were wrong and within a quarter or so, the risk shifted to recession. This chart shows how the equity markets reacted… seems eerily similar.”

“Value then faded and Growth ripped.”

Graphic: Via Morgan Stanley (NYSE: MS).

Positioning: Based on a comparison of present options positioning and buying metrics, the returns distribution is skewed positive, albeit less so than before.

Graphic: Via JPMorgan, from Bloomberg.

Obviously, the fundamental picture and the market’s responsiveness to news events – given the negative gamma environment – has us discounting these metrics. It’s noteworthy, nonetheless.

For instance, in the face of some positive developments abroad, fundamentally, markets diverged from what participants in the options complex were doing.

Graphic: SpotGamma’s Hedging Impact of Real-Time Options (HIRO) indicator reveals strong put buying and call selling (a bearish negative delta trade) in the context of Wednesday’s rise.

This divergence resolved itself, some, overnight in the broader market (even in the face of a ~7% price rise of Amazon Inc (NASDAQ: AMZN) large index constituent).

I’d be remiss if I did not point out growing bets on drops in the equity market’s pricing of risk (via the CBOE Volatility Index [INDEX: VIXI]). That would occur if indexes likely rebounded.

Graphic: Via SHIFT. There was heavy buying of the 26 VIX put.

Taken together, it’s difficult to get a grasp of where the market wants to head, in the near term.

What is for certain: the compression of volatility (via passage of FOMC) or removal of counterparty negative exposure (via OPEX) may serve to alleviate some of this pressure.

Until then, participants can expect the options landscape to add to market volatility.

Graphic: @pat_hennessy breaks down returns for the S&P 500, categorized by the week relative to OPEX.

In case of lower prices, according to SpotGamma, the rate at which options counterparties increasingly add pressure on underlying SPX, so to speak, tapers off in the $4,100.00 to $4,000.00 area. Caution.

Graphic: Gamma profile flattens out near the $4,100-4,000 range suggesting less pressure and more counterparty support.

A way to take advantage of this volatility, while lowering the cost of bets, is options spreads. For instance, the Call Ratio (buy 1 call, sell 2 or more further out) can lower the cost of bets on the upside while providing exposure to asymmetric payouts.

Time and volatility are two factors, however, to be mindful of when initiating such spreads. Risk is undefined and if the time to expiry is too long (e.g., in excess of 1-2 weeks), fast moves and increases in volatility may result in large losses.

For that reason, also, one must be extremely careful with Put Ratio spreads. Consider adding protection far away from your short strikes to cap risk and turn the spreads into Butterflies.

Graphic: Via Banco Santander SA (NYSE: SAN) research, the return profile, at expiry, of a classic 1×2 (long 1, short 2 further away) ratio spread.

Technical: As of 6:30 AM ET, Thursday’s regular session (9:30 AM – 4:00 PM ET), in the S&P 500, will likely open in the lower part of a negatively skewed overnight inventory, inside of prior-range and -value, suggesting a limited potential for immediate directional opportunity.

Gap Scenarios Potentially In Play: Gaps ought to fill quickly. Should they not, that’s a signal of strength; do not fade. Leaving value behind on a gap-fill or failing to fill a gap (i.e., remaining outside of the prior session’s range) is a go-with indicator.

Auctioning and spending at least 1-hour of trade back in the prior range suggests a lack of conviction; in such a case, do not follow the direction of the most recent initiative activity.

In the best case, the S&P 500 trades higher; activity above the $4,231.00 regular trade low (RTH Low) puts in play the $4,249.25 low volume area (LVNode). Initiative trade beyond the LVNode could reach as high as the $4,285.75 high volume area (HVNode) and $4,319.00 untested point of control (VPOC), or higher.

In the worst case, the S&P 500 trades lower; activity below the $4,231.00 RTH Low puts in play the $4,177.25 HVNode. Initiative trade beyond the HVNode could reach as low as the $4,138.75 and $4,101.25 overnight low (ONL), or lower.

Such traders often lack the wherewithal to defend retests and, additionally, the type of trade may be indicative of the other time frame participants waiting for more information to initiate trades.

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.

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.

About

Capelj is also a Benzinga finance and technology reporter interviewing the likes of Shark Tank’s Kevin O’Leary, JC2 Ventures’ John Chambers, FTX’s Sam Bankman-Fried, and ARK Invest’s Catherine Wood, as well as a SpotGamma contributor developing insights around impactful options market dynamics.

Disclaimer

Physik Invest does not carry the right to provide advice.

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.

Daily Brief For May 3, 2023

by Renato L. Capelj May 3, 2023

Daily Brief For May 2, 2023

by Renato L. Capelj May 2, 2023

Daily Brief For April 26, 2023

by Renato L. Capelj April 26, 2023

Tags /CL - NYMEX WTI Crude Oil Futures, Alfonso Peccatiello, AMZN - Amazon Inc, BAC - Bank of America Corp, BAL - Balance Area Low, Balance, CDS – Credit Default Swaps, Chamath Palihapitiya, CPI - Consumer Price Index, Divergent HIRO, Fed Put, FOMC - Federal Open Market Committee Event, Gamma, Gap, HVN - High Volume Node, John Kemp, JPM - JPMorgan Chase & Co, LVN - Low Volume Node, ONL - Overnight Low, OPEX, Options, OVX - CBOE Crude Oil Volatility Index, P-Shape Profile (Potential Short Covering), Pat Hennessy, Ratio Spread, RTH Low - Regular Trade Low, SAN - Banco Santander SA, Short Gamma - Sell Dip & Buy Rip, SpotGamma, SPX - Cash S&P 500 Index, SPY - SPDR S&P 500 Trust ETF, The Macro Compass, Trade Ideas, VIX - CBOE Volatility Index, Volume-Weighted Average Price (VWAP), VPOC - Virgin Point Of Control

Methodology

LIVE: How To Navigate Market Volatility

Post author By Renato L. Capelj
Post date March 8, 2022
No Comments on LIVE: How To Navigate Market Volatility

Today, Physik Invest’s Renato Leonard Capelj joined Benzinga’s Spencer Israel and Aaron Bry live.

Topics discussed include Capelj’s thoughts on the current market environment, as well as how he goes about structuring trades around his opinion.

Tune in, below!

Tags IV - Implied Volatility, Options, Ratio Spread, Trade Ideas, Volatility Skew

Commentary

Daily Brief For March 3, 2022

Post author By Renato L. Capelj
Post date March 3, 2022
No Comments on Daily Brief For March 3, 2022

Editor Note: In light of travel commitments, there will be no Daily Brief published tomorrow, March 4, 2022. Thank you for the support and see you next week!

What Happened

Overnight, equity index futures were sideways to lower while commodity and bond products remained bid. Cross-asset volatility measures remain heightened in the face of uncertainties with respect to geopolitical tensions and monetary policy action.

To note, in light of the economic war waged on Russia, participants received positive news from Federal Reserve Chair Jerome Powell who ruled out a 50 basis-point hike.

Moreover, ahead is data on jobless claims, productivity, labor costs (8:30 AM ET), ISM services, factory orders, core capital equipment orders, and Fed-speak by Jerome Powell (10:00 AM ET), as well as John Williams (6:00 PM ET).

What To Expect

Positioning: Skipping the fundamentals section and will follow up on (and add to) some notes established in Wednesday’s commentary.

Mainly, cross-asset volatility is spiking as investors are seeking protection against the uncertainties posed by geopolitical tensions and monetary policy action.

*Graphic: Via* *@EffMktHype. “Rate vol through the roof, FX picking up steam while equity vol arguably still cheap in comparison despite being at the high end of its 1-year end.”*

As explained, however, the equity market’s pricing of risk (which we can take as being reflected by the CBOE Volatility Index [INDEX: VIX]) is not moving lock-step with that of measures in FX and rate markets.

“The fear in one market tends to feed into the fear of another; regardless of the cause, it seems that equity and bond market participants are not (quite) on the same page,” is the direct quote.

In the subsequent text, I did little to mention the implications of liquidity supply at the index level. This realization came to me while writing some commentary for SpotGamma (who just launched its Hedging-Impact of Real-Time Options indicator or HIRO).

Moreover, the evolving monetary frameworks and intention to take from the max liquidity – which pushed participants out of the risk curve and promoted a divergence from fundamentals – has the effect of removing market excesses that have found their way into volatility markets.

*Graphic: Taken from The Ambrus Group’s Kris Sidial. Annual listed option volumes.*

Taking a look at the U.S. high yield OAS (option-adjusted spread), participants see a “risk-off” bottom; deteriorating credit conditions are a bearish leading indicator and that’s likely been reflected by the bond market’s pricing of risk (but not equity markets, as noted above).

*Graphic: Via* *St. Louis Fed. ICE BoA High YIeld OAS.*

Tempering equity market volatility is likely supply, particularly at the index level, whereas elsewhere, at the single-stock level, underlying components are volatile.

As explained in the SpotGamma note: “We’re using the VIX as a proxy for equity market volatility while underlying components are actually very volatile.”

“There is a decline in correlation, and this is due to suppressive counterparty hedging of the most dominant customer positioning.”

The dominant positioning at the index level is best explained as follows:

Customers have positive directional (delta) exposure to the equity markets.
The indexes (in which there are tax advantages, cash-settlement, among other things) provide participants exposure to a diversified and liquid hedge, easy to get in and out of.
To hedge positive delta exposure against drops, customers will purchase downside put protection. Puts carry a negative delta and their gains are multiplied to the downside (positive gamma).
To reduce the cost of this hedge, they sell upside call protection (also a negative delta trade). This “offset” so to speak can be initiated as a ratio to the protection carried on the downside (e.g., 2 calls for 1 put, and so on), and this feeds into skewness, also.

Options counterparties, who are on the other side of this customer activity, have positive exposure to direction.

In selling a put, the dealer has positive exposure to the direction (meaning the position makes money, all else equal, with trade higher), but their losses are multiplied with movement to the downside (negative gamma).

To hedge this put exposure, all else equal, they must sell into weakness and buy strength.

On the call side, however, the counterparty has positive exposure to delta and gamma (meaning gains are multiplied to the upside).

To hedge this call exposure, all else equal, they must buy into weakness and sell strength.

When, in the normal course of action, protection decays (given that time and volatility trend to zero), counterparty positive delta exposure decreases.

Graphic: Via SpotGamma. “SPX prices X-axis. Option delta Y-axis. When the factors of implied volatility and time change, hedging ratios change. For instance, if SPX is at $4,700.00 and IV jumps 15% (all else equal), the dealer may sell an additional 0.2 deltas to hedge their exposure to the addition of a positive 0.2 delta. The graphic is for illustrational purposes, only.”

This solicits the buy-back of short futures hedges (static negative delta against dynamic positive delta options exposure) that can support the market.

As we’ve seen, a feature of falling markets is the demand for protection. When this protection is monetized (or decay ensues), options counterparties add to the market liquidity (i.e., buying back short futures hedges).

A feature of rising markets is the supply of protection (and more active hedging of call options).

Further, as markets rise, volatility falls. Participants’ demand for yield drives participants further out the risk curve (i.e., they sell more volatility) and this can solicit even more supply.

*Pictured: SqueezeMetrics* *highlights* *implications of volatility, direction, and moneyness.*

As explained in the SpotGamma note: “The counterparty is left carrying more positive exposure to delta and gamma (meaning gains are multiplied to the upside). As time and volatility trend to zero, the sensitivity of these options to underlying price (gamma) increases.”

“When gamma increases, counterparties add more liquidity (i.e., sell [buy] more into strength [weakness] against increasing [decreasing] positive delta exposure).”

Amidst this most recent leg higher, volatility has fallen (some) and the heavily-demanded put protection amidst earlier trade lower has solicited decreased hedging. The buyback of hedges has bolstered sideways to higher trade.

Pursuant to that remark, however, participants are still adding to their negative delta options exposure. They’re doing this via call sales (downward sloping HIRO line, below).

*Graphic: SpotGamma’s Hedging Impact of Real-Time Options (HIRO) indicator.*

Moreover, given the build in open interest in options at higher strike prices – through naive assumptions and data collected from HIRO, among other measures – we surmise options counterparties are tending to add to the market liquidity and this is stabilizing.

*Graphic: Updated 3/2/2022. There is rising interest in options at higher strike prices.*

“As the highly-demanded put protection decays, dealers have less exposure to positive delta. To re-hedge this, dealers buy back (cover) existing short (negative-delta) futures hedges,” SpotGamma further explains. “At the same time, as markets trend higher, … the additional interest in options participants supplied on the call side solicits increased hedging.”

From above, we surmise counterparties are long and therefore tend to sell (buy) into strength amid increasing (decreasing) positive delta exposure.

As short-dated activity clusters in the area just north of the most recent week-long consolidation area, and this protection decays, dealer exposure to positive delta (gamma) falls (rises).

0DTE
Incites volatility

In the final 20 minutes of trading the S&P rallied >1%.

Here we've plotted the 2/28 SPY options contract volume.
You can see the massive spike in today's expiration volume as 0DTE vampires get pushed offsides. pic.twitter.com/Mlc2MmlKKC
— SpotGamma (@spotgamma) February 28, 2022

“Taken together, dealers add to the market liquidity. When there is rising liquidity, volatility (a measure of how ample liquidity is) falls.”

It is options market activity and associated hedging – the supply of liquidity – that’s tempering equity market volatility relative to that of rates and FX.

We have not seen moves in European bond markets like these since the the Euro-crisis (2011-2012), and there are few episodes like this in general (ERM crisis 1992, GFC 2008)

Bonds fully understand the gravity of the situation pic.twitter.com/QHsnqWPNKf
— Jens Nordvig 🇩🇰🇺🇸🇺🇦 (@jnordvig) March 1, 2022

*Graphic: Via* *SpotGamma. “There’s been a big pop in put volumes for the higher yield bond ETFs: JNK, HYG, and LQD. This syncs with the idea this sell-off is based mainly on rates with a side of geopolitics.”*

Hope that better explains index-level volatility and the decline in correlation by constituents.

Still be careful out there.

The Nasdaq, S&P 500 and DJIA are all still below their respective 200d ma.

Nearly 80% of Nasdaq stocks are below their 200d ma.

More than 50% of stocks on the S&P 500 are below their 200d ma.$COMPQ $SPX $DJIA pic.twitter.com/kFDxLBfVId
— Chris Perruna (@cperruna) March 1, 2022

As an aside, these forces are, too, amplified by the general trend toward “passive” investing. This is a topic for another time, though.

*Graphic: Per* *Nasdaq*, “we’ve seen patches of retail selling of stocks that have mostly lasted for less than a week (blue bars in Chart 2). Interestingly, ETFs (yellow bars) remained net buy every single day, albeit at lower levels than usual in the last week of January.”

Technical: As of 6:30 AM ET, Thursday’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.

Balance (Two-Timeframe Or Bracket): Rotational trade that denotes current prices offer favorable entry and exit. Balance-areas make it easy to spot a change in the market (i.e., the transition from two-time frame trade, or balance, to one-time frame trade, or trend). 

Modus operandi is responsive trade (i.e., fade the edges), rather than initiative trade (i.e., play the break).

In the best case, the S&P 500 trades higher; activity above the $4,395.25 high volume area (HVNode) puts in play the $4,415.00 untested point of control (VPOC). Initiative trade beyond the VPOC could reach as high as the $4,438.00 key response area and $4,464.75 low volume area (LVNode), or higher.

In the worst case, the S&P 500 trades lower; activity below the $4,395.25 HVNode puts in play the $4,346.75 HVNode. Initiative trade beyond the $4,346.75 could reach as low as the $4,285.50 HVNode and $4,227.75 overnight low (ONL), 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.

Definitions

Overnight Rally Highs (Lows): Typically, there is a low historical probability associated with overnight rally-highs (lows) ending the upside (downside) discovery process.

About

Disclaimer

Physik Invest does not carry the right to provide advice.

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.

Commentary

Daily Brief For January 10, 2022

Post author By Renato L. Capelj
Post date January 10, 2022
No Comments on Daily Brief For January 10, 2022

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 auctioned lower alongside bonds and most commodities.

Ahead is data on wholesale inventories (10:00 AM ET) and Fed-speak (12:00 PM ET).

What To Expect

Fundamental: Improvements in the U.S. labor market and increased hawkishness from the Federal Reserve are some of the factors playing into a recent rotation.

With yields climbing and the 10-year benchmark breaking out toward 2.00%, there’s been a clear move out of growth- and innovation-names to value- and cyclical-type stocks.

*Graphic: Via* *Bloomberg, “Markets face increasing volatility as investors grapple with how to reprice assets as the pandemic liquidity that helped drive equities to record highs is withdrawn.”*

This is just as Goldman Sachs Group Inc (NYSE: GS) announced that it expects four interest rate hikes this year (in MAR, JUN, SEP, and DEC) and a balance sheet runoff to begin in July.

“Valuations are at historical highs, companies are raising billions based on fairy dust, and the Fed is signaling a tightening cycle,” said Jason Goepfert of Sundial Capital Research. “All of these are scaring investors that we’re on the cusp of a repeat of 1999-2000.”

Why are higher rates scary?

Though higher rates are to fend off inflation, they have the potential to decrease the present value of future earnings making stocks (especially high growth) less attractive.

For context, at no other point since the dot-com bubble has so many constituents have fallen while the index was so close to its peak.

*Graphic: From Sundial Capital Research. Posted by* *Bloomberg*.

Despite participation continuing to narrow, equities should be able to withstand rate hikes and balance sheet runoff amidst above-trend growth and a looming rebound in some international markets, JPMorgan Chase & Co (NYSE: JPM) adds.

“As long as yields are rising for the right reasons, including better growth, we believe that equities should be able to tolerate the move,” a JPMorgan note said.

“The rise in real rates should not be hurting equity markets, or economic activity, at least until they move into positive territory, or even as long as real rates are below the real potential growth.”

Positioning: As discussed in Friday’s detailed write-up, bonds and equities are down.

That’s due in part to the bond-stock relationship being upended as a result of monetary tightening to combat inflation.

“At stake are trillions of dollars that are managed at risk parity funds, balanced mutual funds, and pension funds that follow the framework of 60/40 asset allocation.”

As explained Friday, we mention this (broken) relationship as it forces us (participants, in general) to look elsewhere for protection.

The growing asset class of volatility, so to speak, is that protection. Investors are aware of both the protective and speculative efficiency afforded to them by options and that is the primary reason option volumes are so comparable to stock volumes, now.

If interested, read this primer on “Trading Volatility, Correlation, Term Structure, and Skew.”

With option volumes higher, related hedging flows can represent an increased share of volume in underlying stocks; the correlation of stock moves, versus options activity, is pronounced.

All that means is that we can look to the options market for context on where to next.

According to options modeling and data service SpotGamma (learn more here), the S&P 500, in particular, based on an earlier demand for protection is set up for higher volatility.

“End-of-week compression in volatility, in spite of a high-volatility, negative-gamma regime characterized by dealer hedging that exacerbates movement, sets markets up for instability in case of even lower prices and demand for protection.”

Why?

Knowing that demand for downside protection coincides with customers indirectly taking liquidity and destabilizing the market as the participant short the put will sell underlying to neutralize risk, participants ought to keep their eye out on whether implied volatility expands or contracts.

All else equal, higher implied volatility marks up options delta (exposure to direction) and this leads to more selling as hedging pressures exacerbate weakness.

*Graphic: SqueezeMetrics* *details* *the implications of customer activity in the options market, on the underlying’s order book.*

*Graphic: Per* *Interactive Brokers Group Inc* (NASDAQ: IBKR), VIX futures show little concern; “An inverted curve, or even a flattish one, indicates a shortage of available volatility protection. We saw that as recently as a month ago, but not now.”

Taking into account options positioning, versus buying pressure (measured via short sales or liquidity provision on the market-making side), positioning metrics remain positively skewed.

*Graphic: Data SqueezeMetrics. Graph via Physik Invest.*

In ending this section, Friday’s put-heavy expiration removed some negative gamma that was adding to instability, at least at the index level.

Though markets will tend toward instability so long as volatility is heightened and products (especially some constituents) remain in negative gamma, the dip lower and demand for protection may serve to prime the market for upside (when volatility starts to compress again and counterparties unwind hedges thus supporting any attempt higher).

“Failure to expand the range, lower, on the index level, at least, likely invokes supportive dealer hedging flows with respect to time (‘charm’) and volatility (‘vanna’),” SpotGamma adds.

At present, there’s a push-and-pull; “no-touch” garbage stocks in the S&P and Nasdaq 100 are gaining strength. If this dynamic persists, in light of what was discussed above, what happens?

While everyone gets all beared up over the weekend consider that the pile of the most garbage stocks in the SPX and QQQ that I refer to as "no touch" is now outperforming pic.twitter.com/wVVLyg3ZNx
— Andy Constan (@dampedspring) January 7, 2022

Technical: As of 6:30 AM ET, Monday’s regular session (9:30 AM – 4:00 PM ET), in the S&P 500, will likely open in the lower part of a negatively skewed overnight inventory, just inside of prior-range and -value, suggesting a limited potential for immediate directional opportunity.

Spike Scenario Still In Play: Spike’s mark the beginning of a break from value. Spikes higher (lower) are validated by trade at or above (below) the spike base (i.e., the origin of the spike).

Spike base is at $4,761.25. Above, bullish. Below, bearish.

In the best case, the S&P 500 trades higher; activity above the $4,647.25 high volume area (HVNode) puts in play the $4,674.25 HVNode. Initiative trade beyond the latter could reach as high as the $4,691.25 micro composite point of control (MCPOC) and $4,717.25 low volume area (LVNode).

In the worst case, the S&P 500 trades lower; activity below the $4,647.25 HVNode puts in play the $4,629.25 HVNode. Initiative trade beyond the latter could reach as low as the $4,585.00 and $4,549.00 untested point of control (VPOC), 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.

What People Are Saying

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Definitions

DIX: For every buyer is a seller (usually a market maker). Using DIX — which is derived from short sales (i.e., liquidity provision on the market-making side) — we can measure buying pressure.

Gamma: Gamma is the sensitivity of an option to changes in the underlying price. Dealers that take the other side of options trades hedge their exposure to risk by buying and selling the underlying. When dealers are short-gamma, they hedge by buying into strength and selling into weakness. When dealers are long-gamma, they hedge by selling into strength and buying into weakness. The former exacerbates volatility. The latter calms volatility.

Vanna: The rate at which the delta of an option changes with respect to volatility.

Charm: The rate at which the delta of an option changes with respect to time.

Options: If an option buyer was short (long) stock, he or she would buy a call (put) to hedge upside (downside) exposure. Option buyers can also use options as an efficient way to gain directional exposure.

About

Disclaimer

Physik Invest does not carry the right to provide advice.

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.

Commentary

Daily Brief For January 5, 2022

Post author By Renato L. Capelj
Post date January 5, 2022
No Comments on Daily Brief For January 5, 2022

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 indices auctioned sideways to lower after a failed balance-area breakout resulted in a rotation back toward the most accepted (or traded at) price levels over two weeks.

Ahead is data on ADP National Employment Report (8:15 AM ET), Markit Services PMI (9:45 AM ET), and FOMC minutes (2:00 PM ET).

What To Expect

Fundamental: Today, participants ought to get further clarity around the timing of the Federal Reserve’s first interest-rate hike and its taper to the pace of asset buying.

The central bank doubled the pace of tapering in mid-December, setting the stage for rate hikes, later in 2022.

According to Bloomberg, expected are three quarter-percentage-point increases in the key federal funds rate target in 2022.

*Graphic: The “annual rate of change in the Fed Funds rate” via topdowncharts.com.*

This expectation has coincided with a move higher in Treasury yields and weakness in the growth- and innovation-heavy Nasdaq 100.

Recall that inflation and rates move inverse to each other. In defending against the pressures of inflation, higher rates have the potential to decrease the present value of future earnings making stocks, especially those that are high growth, less attractive.

*Graphic: Via* *Bloomberg*, “Fed Chair Jerome Powell at his press conference after last month’s meeting said that policy makers eventually ‘expect a gradual pace of policy firming.’ They don’t anticipate raising rates before ending the taper process, but could hike before reaching full employment, he added.”

Moreover, a concern is that “[t]he minutes could hint at a quicker start to shrinking the balance sheet than after the prior tapering.”

With the equity market rallying on the back of easy monetary frameworks and max liquidity, markets diverged from fundamentals.

So all the rally in SPX last year was 'fake', driven by negative real rates and 'liquidity' (QE + ZIRP) – which led to a huge jump in multiples (valuation) – as investors and companies borrowed cheap money to buy (or buyback) stocks in the face of TINA, right?

Right? 🤦 pic.twitter.com/7VFgI4kEnJ
— Rishi Mishra (@aRishisays) January 4, 2022

Reductions in the balance sheet (i.e., removal of liquidity) may help prick the bubble.

Additionally, with the use of leveraged products trending higher than in the past, cross-asset correlations increase with volatility and stress. This may result in “hedging and de-leveraging cascades that affect the stability of all markets,” as well put in one article I recently wrote.

In other words, the response by customers, as well as the dynamics of dealers’ risk exposure to direction and volatility, can cause violent crash dynamics to transpire, further cutting into liquidity, and aiding an unraveling.

“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,” Kai Volatility’s Cem Karsan once told me. “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.”

See the graphic below for implications of customers’ demands for downside protection.

*Graphic: SqueezeMetrics* *details* the implications of customer activity in the options market, on the underlying’s order book. For instance, in selling a put, customers add liquidity and stabilize the market. How? The market maker long the put will buy (sell) the underlying to neutralize directional risk as price falls (rises).

Positioning: Pursuant to some of the comments made in yesterday’s commentary, expected is a continued compression in volatility.

Monday saw the selling of upside (call) and downside (put) protection. Tuesday saw more of the former, and that promoted some of the reversion, for lack of better phrasing, seen yesterday.

Recall that the participant on the other side of this dominant trade is taking on more exposure to positive delta.

Why? Well, with any price rise, gamma (or how an option’s delta is expected to change given a change in the underlying) is added to the delta. Counterparties are to offset gamma by adding liquidity (as can be approximated with thickening of book depth, below) to the market (i.e., buy dips, sell rips).

*Graphic: Analysis of book depth for the E-mini S&P 500 futures contract, via CME Group Inc’s (NASDAQ: CME)* *Liquidity Tool. For more on the implications of participants’ options positioning and dealer hedging,* *read here*.

The continued compression of volatility will only serve to bolster any price rise as “hedging vanna and charm flows, and whatnot will push the markets higher.”

Were participants to reach for downside protection, markets will tend toward instability. Not seeing this yet.

*Graphic: The “Biggest tail* *risk* *to SPX isn’t any macro data/virus/war but its own options market.”*

Technical: As of 6:40 AM ET, Wednesday’s regular session (9:30 AM – 4:00 PM ET), in the S&P 500, will likely open in the middle part of a negatively skewed overnight inventory, inside of prior-range and -value, suggesting a limited potential for immediate directional opportunity.

Balance (Two-Timeframe Or Bracket) Scenarios: Rotational trade that denotes current prices offer favorable entry and exit. Balance-areas make it easy to spot a change in the market (i.e., the transition from two-time frame trade, or balance, to one-time frame trade, or trend). 

Modus operandi is responsive trade (i.e., fade the edges), rather than initiative trade (i.e., play the break).

In the best case, the S&P 500 trades higher; activity above the $4,783.75 micro composite point of control (MCPOC) puts in play the $4,808.25 minimal excess high. Initiative trade beyond the $4,808.25 figure could reach as high as the $4,814.00 and $4,832.25 extension, or higher.

In the worst case, the S&P 500 trades lower; activity below the $4,783.75 MCPOC puts in play the $4,756.00 low volume area (LVNode). Initiative trade beyond the LVNode could reach as low as the $4,732.50 high volume area (HVNode) and $4,717.25 LVNode, or lower.

Considerations: The aforementioned trade in the S&P 500 marks a potential willingness to continue balance, and it is built on poor structure, a dynamic that adds to technical instability.

On a liquidation that finds acceptance (i.e., more than 30-minutes of trade at a particular price level) below $4,756.00, there is increased potential for a fast move lower to $4,732.50 or lower.

This is as there has been a persistence of responses to technical levels; weaker-handed participants (which seldom defend retests) are carrying a heavier hand in recent discovery.

With that, any penetration of low-volume pockets – voids like gaps that can be seen on a chart – there ought to be follow-through as the participants that were most active at those levels run for the exits.

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.

What People Are Saying

Successful traders understand they need to study themselves as much they study markets. Don’t neglect journaling & studying the person who’s clicking the buttons.
— Anthony Crudele (@AnthonyCrudele) January 5, 2022

Definitions

Vanna: The rate at which the delta of an option changes with respect to volatility.

Charm: The rate at which the delta of an option changes with respect to time.

Excess: A proper end to price discovery; the market travels too far while advertising prices. Responsive, other-timeframe (OTF) participants aggressively enter the market, leaving tails or gaps which denote unfair prices.

About

Capelj is also a Be n zinga finance and technology reporter interviewing the likes of Shark Tank’s Kevin O’Leary, JC2 Ventures’ John Chambers, FTX’s Sam Bankman-Fried, and ARK Invest’s Catherine Wood, as well as a SpotGamma contributor developing insights around impactful options market dynamics.

Disclaimer

Physik Invest does not carry the right to provide advice.

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.