First Republic Bank (NYSE: FRC) is in the news for its failure. FRC was known for handing out mortgages at rock-bottom rates. When interest rates rose, the bank’s book of mortgages was hurt and left it with not enough to suffice withdrawals.
“FRC believed its business model of extraordinary customer service and product pricing would result in superior customer loyalty through all cycles,” wrote Timothy Coffey of Janney Montgomery Scott. “Instead, too many FRC customers showed their true loyalties were to their own fears.”
This “marks the second-biggest bank failure in U.S. history, behind the 2008 collapse of Washington Mutual Inc.,” reports WSJ; after the instability in March, the bank finally succumbed to the Federal Reserve’s (Fed) rate increases and depositor worry.
JPMorgan Chase & Co (NYSE: JPM) acquired the bulk of FRC’s operations.
Graphic: Retrieved from JPM. See a nice summary by @brandonjcarl.
Further, research shows money is getting tighter, a headwind for the economy, while inflation is sticky and the Fed’s bond holdings are preventing tightening from being effective; WSJ reports the Fed’s balance sheet loaded with bonds may be insulating stocks from interest rate policies.
“Quantitative easing locked the Fed into a position that is difficult to unwind,” said Stephen Miran of Amberwave Partners. Quantitative easing, or QE, made stocks less sensitive to interest rates. “It’s made tightening both slower and less effective than it should have been.”
Graphic: Retrieved from Bloomberg. The Fed’s favorite measure of inflation, the core PCE index, has been consistently stuck around 4-5% since 2022. The employment cost index, which shows wage growth at around 4-5%, is inconsistent with a 2% inflation target.
Not “adjusting balance-sheet policy,” but raising rates to 5.00-5.25% as expected, ‘is akin to “hitting the same nail with a hammer over and over again.’” Therefore, stocks, which are higher alongside surprising economic and earnings data, though risky, can do “ok” for longer, comments Andy Constan of Damped Spring Advisors.
Graphic: Retrieved from CME Group Inc’s (NASDAQ: CME) FedWatch Tool.
The sale of volatility bolsters the stability and emboldens upside bettors, adds JPM’s Marko Kolanovic, who finds “selling of options forces intraday reversion, leaving the market price virtually unchanged many days.”
Graphic: Retrieved from Goldman Sachs Group Inc (NYSE: GS).
“This, in turn, drives buying of stocks by funds that mechanically increase exposure when volatility declines (e.g., volatility targeting and risk parity funds),” he elaborates. “This market dynamic artificially suppresses perceptions of fundamental macro risks. The low hurdle rate and robust fundamentals bode well for 1Q earnings results, but we advise using any market strength on reporting to reduce exposure.”
At this juncture, yes, stocks can move sideways or higher for a bit longer as a function of “momentum, not value,” Simplify Asset Management’s Michael Green concludes. Traders can position for this and various levels of potential upset later with structures included in a report we published last week.
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.
Physik Invest’s Daily Brief is read by thousands of subscribers. You, too, can join this community to learn about the fundamental and technical drivers of markets.
Graphic updated 7:00 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 this letter. Levels may have changed since initially quoted; 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. At the same time, 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. VIX reflects a current reading of the CBOE Volatility Index (INDEX: VIX) from 0-100.
Administrative
We will issue a content calendar, soon, revealing the dates letters are likely to be published and the content that may be covered. That said, due to the writer’s travel commitments, from 12/6 to 12/9 and 12/12 to 12/16 there will be no commentaries. If any queries, or if you are local to New York City or Paris, ping renato@physikinvest.com or Renato Capelj#8625 on Discord.
Reflections
Fundamentally, our Wednesday letter pointed to some macro-type forces creating an uncertain context for traders.
Key crosswinds are numbered (1-4).
Alongside (1) easing financial conditions, the markets roared higher with boosts coming from (2) a “vol crunch” and “systemic exposure reallocation,” Nomura Holdings Inc’s (NYSE: NMR) Charlie McElligott November 28, 2022, said.
Our November 30, 2022 letter noted Morgan Stanley (NYSE: MS) strategists were seeing a (3) “contraction … [or] squeezing of liquidity that, alone, implies an 8% drop for the S&P 500.”
Strategists JPMorgan Chase & Co (NYSE: JPM) agreed:
On “a significant decline in corporate earnings, at a time of higher interest rates (implying lower P/Es and lower prices relative to the 2022 lows), … [a] market decline could happen between now and the end of the first quarter of 2023.”
With (4) “the financial system … evolved around an environment of near-zero interest rates, … [built up] market interdependencies … can cause selloffs” that feed on themselves (i.e., large market drops statistically add to the likelihood of further large drops).
In light of the above (1-4) crosswinds, we took a step back and asked:
How do we get bullish – particularly if policymakers ease the pace of rate increases – and not lose much money if the market falls, or position ourselves for the drop many expect?
Graphic: Retrieved from Bloomberg.
To quote our November 30, 2022 letter, the Nasdaq 100’s (INDEX: NDX) “volatility skew … was smile-shaped, … making for some great trades to the upside,” we said, adding: “we can use the richness of further away calls to reduce the cost of our bets on the market upside.”
Graphic: Updated 11/28/2022. Retrieved from Interactive Brokers (NASDAQ: IBKR). Nasdaq 100 (INDEX: NDX) volatility skew resembles the so-called smile.
The sample trade provided: 500-1000 points wide call ratio spreads (buy the closer leg, sell two of the farther legs) expiring in fifteen days may work well (e.g., SELL -1 1/2 BACKRATIO NDX 100 16 DEC 22 [AM] 13425/13925 CALL @.20 CR LMT).
The trade’s key greeks (+Delta and +Gamma) suggested upside would result in profit. The NDX did rise, and the sample trade priced as high as +2,000%. Adding, as sized by the letter writer, if NDX -10.00%, the loss was limited to $60.00. If the NDX +10.00%, with other conditions the same, profit ~$12,000.00.
Graphic: Retrieved from the Charles Schwab Corporation-owned (NYSE: SCHW) thinkorswim platform. Nasdaq 100 options prices.
Back to the present. What now?
With news that China is loosening its grip on Covid, and the Federal Reserve seeing inflation fall in some parts of the economy (despite markets showing the terminal rate at ~5.20% next spring) ahead of PCE inflation updates this morning, there is a chance for follow-on bullishness.
Graphic: Via Charles Schwab Corporation’s (NYSE: SCHW) TD Ameritrade thinkorswim. Observed is the Eurodollar, the interest offered on U.S. dollar-denominated deposits held at banks outside of the U.S. (i.e., participants’ outlook on interest rates).
So, what is the takeaway?
The purpose of this letter, though it seems we venture beyond it at times, is to ponder theory as well as generate actionable trade ideas based on the application of theory to recent happenings.
Though there are factors that may skew the expected distribution of returns one way or another, a trade is a coinflip; your bet either works or it does not. Using the factors of volatility and time to our advantage may lower the risk and cost of bets, in case they do not pan out.
In short, we don’t know if up or down, but we can use market context to lower our costs and live to fight another day! See you later.
Technical
As of 7:00 AM ET, Thursday’s regular session (9:30 AM – 4:00 PM ET), in the S&P 500, is likely to 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.
Our S&P 500 pivot for today is $4,069.25.
Key levels to the upside include $4,093.00, $4,122.75, and $4,136.75.
Key levels to the downside include $4,049.25, $4,024.00, and $4,000.25.
Click here to load today’s key levels into the web-based TradingView platform. 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
Volume Areas: Markets will build on areas of high-volume (HVNodes). Should the market trend for long periods of time, it will be identified by low-volume areas (LVNodes). 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 HVNodes for favorable entry or exit.
POCs: 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: Denote areas where two-sided trade was most prevalent over numerous 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
In short, an economics graduate working in finance and journalism.
Capelj spends most of his time as the founder of Physik Invest through which he invests and publishes daily analyses to subscribers, some of whom represent well-known institutions.
Separately, Capelj is an equity options analyst at SpotGamma and an accredited journalist interviewing global leaders in business, government, and finance.
Physik Invest’s Daily Brief is read by over 1,200 people. To join this community and learn about the fundamental and technical drivers of markets, subscribe below.
Graphic updated 6:50 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 this letter. Levels may have changed since initially quoted; 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. At the same time, 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. VIX reflects a current reading of the CBOE Volatility Index (INDEX: VIX) from 0-100.
Positioning
Aksel Kibar of Tech Charts said it well: There are two types of trades.
“1) Trades that you take moving from low volatility to high volatility [and] 2) trades that you take in high volatility while moving to low volatility.”
Like Kibar, we aim to be well-positioned for a move from low to high volatility. In short, that is where we are today. After an expansion of range to the upside, markets are trading sideways, in a tight range, and traders’ recent activities are likely to keep the status quo intact a bit longer.
Notwithstanding, we are likely nearing an expansion of realized volatility (RVOL), per the implied volatility (IVOL) bid; on Monday, some IVOL measures, such as the Cboe Volatility Index (INDEX: VIX), shifted up, as did term structure. Markets sold a bit, too.
Quick aside:
Changes in IVOL are a byproduct of supply and demand (i.e., demand rushes in → IVOL rises → option prices adjust higher).
When protection is demanded by investors, counterparties may pressure markets (a naive take, if we will, for the purpose of breaking things down).
To explain further, say the market is in balance and trading sideways, and traders seek to protect against potential downside movement by purchasing put options.
This new demand will bid put options prices, causing counterparties to hedge in a manner that pressures the market (i.e., a trader buys put and bids IVOL → the counterparty sells that put and futures to hedge that put), as we’re seeing (i.e., IVOL higher and market lower ahead of updates to measures like the Personal Consumption Expenditures [INDEX: PCE], the Fed’s go-to inflation reading).
Back to the letter:
Upon some new information, participants will enter and reprice the market.
Counterparties’ re-hedging could add to the movement up or down (e.g., traders sell their put hedges → IVOL compresses → counterparties buy back futures hedges and support the market).
If you’re betting on lower prices, recommended is a quick reference of Physik Invest’s Daily Brief for November 28, 2022. In short, according to SpotGamma, “there’s less to be lost owning protection down below,” given the performance of skew, relative to topline measures such as the Cboe Volatility Index (INDEX: VIX).
“On the contrary, if you buy [protection] and nothing happens, that [protection] may very well hold its value better than in the past.”
Graphic: Retrieved from TradingView. Top, S&P 500 (INDEX: SPX). Middle Nations SkewDex (INDEX: SDEX). Bottom Cboe Volatility Index (INDEX: VIX). According to one paper from Nations Indexes, “SkewDex tells market participants how expensive out-of-the-money options are in relation to at-the-money options and thus, how risk-averse investors are.”
On the call side, the story is similar; selling volatility blindly is not a good trade.
To explain, incentive schemes drove “people to be much more willing to pay and chase upside,” and this is, in part, evidenced by historically low skew. There is also stock replacement, among other things, due to the opportunity cost of buying stock being higher in the current interest rate environment (i.e., “higher call options premium when interest rates are high is the ‘opportunity cost’ of forgone interest”).
Graphic: Retrieved from Charles Schwab Corporation (NYSE: SCHW).
In the interest of brevity, this environment has resulted in a smile-shaped volatility skew pattern, rather than the typical smirk-shaped reverse volatility skew pattern.
Graphic: Retrieved from Interactive Brokers (NASDAQ: IBKR). Nasdaq 100 (INDEX: NDX) volatility skew resembles the so-called smile.
Skew has steepened on the call side – a result of traders positioning for an upside move – and we can use the richness of out-of-the-money calls to reduce the cost of our bets on the market upside.
Graphic: Retrieved from the Charles Schwab Corporation-owned (NYSE: SCHW) thinkorswim platform. Nasdaq 100 options prices.
For instance, low-cost 500-1000 points wide call ratio spreads (buy the closer leg, sell two of the farther legs) expiring in fifteen days may work well.
Graphic: Via Banco Santander SA (NYSE: SAN) research. The return profile, at expiry, of a 1×2 (long 1, short 2 further away) ratio spread.
A 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 upside market movement hurts the position and losses are amplified.
Technical
As of 6:45 AM ET, Tuesday’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 positively skewed overnight inventory, inside of prior-range and -value, suggesting a limited potential for immediate directional opportunity.
Our S&P 500 pivot for today is $4,997.00.
Key levels to the upside include $4,024.00, $4,051.00, and $4,069.25.
Key levels to the downside include $3,965.25, $3,923.00, and $3,909.25.
Click here to load today’s key levels into the web-based TradingView platform. 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.
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 writes options market analyses at SpotGamma and is a Benzinga journalist.
The daily brief is a free glimpse into the prevailing fundamental and technical drivers of U.S. equity market products. Join the 900+ that read this report daily, below!
Graphic updated 6:50 AM ET. Sentiment Risk-Off if expected /ES open is below 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.
Administrative
A longer note so stick with me!
Updates are pending for the above dashboard. Exciting! Beyond this, the newsletter is getting a revamp in other parts. If you have any feedback on what should be changed, please comment!
Also, I am going to refer everyone to a conversation between Joseph Wang and Andy Constan, as well as some updates Cem Karsan of Kai Volatility made (HERE and HERE). That is, in part, a primer for what we will be talking more about, soon.
Fundamental
Talked about yesterday was the prospects of contractionary monetary policy reducing inflation and growth. BlackRock Inc (NYSE: BLK) strategists, even, put forth that a “deep recession” is needed to stem inflation. In short, “there is no way around this,” they claim.
Graphic: Retrieved from The Market Ear. FedEx Corporation (NYSE: FDX) sold 20% on warning about the global economy.
From thereon, we talked about how rates rising would “bring private sector credit growth down,” as well as “private sector spending and, hence, the economy.”
Based on where rates are at, the market may still be too expensive.
Graphic: Retrieved from Bloomberg via Michael J. Kramer. “What is amazing is how expensive this market is relative to rates. The spread between the S&P 500 Earnings yield and the 10-Yr nominal rate is at multi-year lows.”
On the other hand, some argue inflation peaks are in. ARK Invest’s Cathie Wood suggests “deflation [is] in the pipeline, heading for the PPI, CPI, PCE Deflator.”
Tesla Inc’s (NASDAQ: TSLA) Elon Musk added that he thinks the Federal Reserve (Fed) may make a mistake noting “a major Fed rate hike risks deflation.” Musk suggested the Fed should drop 0.25%, basing his decision on non-lagging indicators, unlike the Fed.
That’s not in line with what CME Group Inc’s (NASDAQ: CME) FedWatch tool shows. Through this tool we see traders pricing an 80% chance of a 0.50-0.75% hike, all the while quantitative tightening (reducing Fed Treasuries and mortgage-backed securities holdings) accelerated on September 15.
UST and MBS will roll off (which could turn into “outright sales”) at a pace of $95 billion per month, now, increasing competition for funding among commercial banks, and bolstering borrowing costs, as explained, below.
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.
According to Bank of America Corporation (NYSE: BAC), since 2010, nearly 50% of the moves in market price-to-earnings multiples were explained by quantitative easing (QE), the inverse of QT, through which the Fed (or central banks, in general) creates credit used to buy securities in open markets, MarketWatch explains.
Graphic: Retrieved from the Federal Reserve Bank of Richmond. “The Fed Is Shrinking Its Balance Sheet. What Does That Mean?”
The “purchases of long-dated bonds are intended to drive down yields, which is seen enhancing appetite for risk assets as investors look elsewhere for higher returns. QE creates new reserves on bank balance sheets. The added cushion gives banks, which must hold reserves in line with regulations, more room to lend or to finance trading activity by hedge funds and other financial market participants, further enhancing market liquidity.”
Graphic: Retrieved from Bank of America Corporation (NYSE: BAC) via MarketWatch.
The liability side of the Fed’s balance sheet is what “matters to financial markets.”
Thus far, “reductions in Fed liabilities have been concentrated in the Treasury General Account, or TGA, which effectively serves as the government’s checking account” to run the day-to-day business.
Given that we’re talking about balance sheets, here, Fed liabilities must match assets. Thus, a rise in the TGA must be accompanied by a decline in bank reserves (which are liabilities to the Fed). This, as a result, decreases the room banks have to “lend or to finance trading activity by hedge funds and other financial market participants, [which] further [cuts into] market liquidity.”
With the Treasury set to increase debt issuance, boosting TGA, it will effectively take “money out of the economy and put[] it into the government’s checking account.” The linked reduction in bank deposits and reserves bolsters “repurchase agreement rates and borrowing benchmarks linked to them, like the Secured Overnight Financing Rate,” per Bloomberg.
Graphic: Retrieved from the Federal Reserve Bank of New York. “The Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.”
Adding, this may play into “an additional tightening of overall financial conditions, in addition to the increase in the main fed funds rate target that the central bank intends to continue boosting.”
This will “put more pressure on the private sector to absorb those Treasurys, which means less money to put into other assets” that may be riskier, like equities, said Aidan Garrib, the head of global macro strategy and research at Montreal-based PGM Global.
Positioning
As of 6:50 AM ET, Friday’s expected volatility, via the Cboe Volatility Index (INDEX: VIX), sits at ~1.44%. Net gamma exposures decreasing may promote generally more expansive ranges.
Graphic: Via Physik Invest. Data retrieved from SqueezeMetrics.
Given where realized (RVOL) and implied (IVOL) volatility measures are, as well as skew, it is beneficial to be a buyer of options structures.
This is as there’s been a lot of speculation, particularly on the downside (put options), setting the stage for a more volatile and fragile market environment, says Kai Volatility’s Cem Karsan.
“On the index level, people are not well hedged,” a departure from what the case was heading into and through much of 2022. It’s the case that heading into 2022, traders were well hedged. Into and through the decline, traders’ monetization of existing hedges, as well as counterparty reactions, “compressed volatility” realized across US equities, as explained on July 15, 2022.
This made for some attractive trade opportunities seen here.
Graphic: Retrieved from The Market Ear. “VIX has decoupled from cross-asset volatilities.”
Now, given that the go-to trade is to sell stock and puts, short interest has grown, as have other risks, associated with this activity; essentially people are “los[ing] faith in convexity and risk premia’s ability to work,” as a result of “poor performance of vol,” and, the reaction to their “pain and financial loss,” is setting the stage for tail risks heading into the Q1 and Q2 2023.
The sale (purchase) of the front (back) expirations will bolster market pinning; as SpotGamma puts forth, “the positive impact of put closers and rolls, as well as decay,” is easing the market drop. However, this “positioning likely compounds drops and adds to volatility,” in the future.
To quote: “Though the removal of put-heavy exposures can boost markets higher, too add, the positive impacts are dulled via the demand for put exposures at much lower prices.”
Graphic: Retrieved from SpotGamma.
These particular options, which are at much lower prices, “are far more sensitive to changes in direction and IVOL,” as I explained in a SpotGamma note. These options can go “from having very little Delta (exposure to direction) to a lot more Delta on the move lower,” quickly.
Graphic: Via Mohamed Bouzoubaa et al’s Exotic Options and Hybrids.
“If we maintain that liquidity providers are short those puts, a positive Delta trade, then those liquidity providers [will sell] futures and stock, a negative Delta trade to stay hedged.”
Graphic: Via Banco Santander SA (NYSE: SAN) research.
Technical
As of 6:50 AM ET, Friday’s regular session (9:30 AM – 4:00 PM ET), in the S&P 500, is likely to open in the lower part of a negatively skewed overnight inventory, outside of prior-range and -value, suggesting a potential for immediate directional opportunity.
In the best case, the S&P 500 trades higher.
Any activity above the $3,909.25 MCPOC puts into play the $3,935.00 VPOC. Initiative trade beyond the latter could reach as high as the $3,964.75 HVNode and $4,001.00 VPOC, or higher.
In the worst case, the S&P 500 trades lower.
Any activity below the $3,909.25 MCPOC puts into play the $3,857.25 HVNode. Initiative trade beyond the latter could reach as low as the $3,826.25 and $3,770.75 HVNodes, 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: A feature of this 2022 down market was responsiveness near key-technical areas (that are discernable visually on a chart). This suggested to us that technically-driven traders with shorter time horizons were 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.
That’s changing. The key levels, quoted above, are snapping far easier and are not as well respected. That means other time frame participants with wherewithal are initiating trades.
Those are the participants you should not fade.
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.
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.
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.
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.
The daily brief is a free glimpse into the prevailing fundamental and technical drivers of U.S. equity market products. Join the 600+ that read this report daily, below!
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. 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.
Updates: Hey, team! I’m offering some updates on the letter and gauging your thoughts, if any.Been incredibly busy juggling what is, basically, 3 jobs. Here’s a bit about me, if interested. That said, my attention has been elsewhere, to put it simply, so the letters have taken a bit of a hit.Sorry!The few options I’ve been faced with include (1) lowering the frequency of letters to improve quality and/or (2) continuing pace but increasing simplicity for some time.I’m aware that many rely on the key levels I provide, daily, as well as some of the narratives and trade ideas often included in the positioning section. Therefore, I’m soliciting feedback and will follow through with the consensus, if any. Have a great weekend!
Fundamental
The Fed’s preferred inflation measure – the personal consumption expenditure deflator (PCE) – is set to update. Per Bloomberg, this measure grew an annualized 7.1% for the second quarter.
This is on the heels of the Federal Reserve’s (Fed) interest rate hike aimed at reining inflation, as well as data that suggests the “drumbeat of recession” growing louder.
Graphic: Retrieved from Bloomberg. “GDP fell at a 0.9% annualized rate after a 1.6% decline in the first three months of the year []. Personal consumption, the biggest part of the economy, rose at a 1% pace, a deceleration from the prior period.”
Yelena Shulyatyeva and Eliza Winger, economists cited by Bloomberg, comment that the fall in GDP growth “raises the risk that the economy will fall into recession by year-end.”
However, based on the research and expert commentary set forth in past letters, the case is the economy may already be in recession.
Notwithstanding, what’s the impact on equity markets (i.e., now earnings compression)?
It’s the consensus that equity markets endured one of the sharpest de-rates in three decades as participants priced the compression in multiples on the rise in interest rates and flow of capital to capital markets – the quantitative tightening (QT) – component.
For context, beyond raising costs to borrow and innovate, higher interest rates may mean future discounted valuations are lower. Additionally, yield-hungry investors may seek less risky assets, now, given that their yields are more attractive.Recall that in engaging in practices such as quantitative easing (QE), central banking authorities purchase assets from private sector entities through the creation of central bank reserves. The unwind of this through the QT exercise removes reserves from balance sheets either through asset sales or non-reinvestment of the principal sum of maturing securities.In less complex terms, the Fed’s purchase of assets depressed their yields forcing investors into risk. Liquidity withdrawal ought to have the opposite effect, amplifying the impact of rate hikes.Adding, per Joseph Wang, who we’ve quoted in the past, with bank deposits expected to drain ~1T by year-end, the competition for cash forces investors to continue “lower[ing] their selling prices to compete for the cash they want.”
Accordingly, the “Fed will continue to hike interest rates until something breaks,” as explained by Andreas Steno Larsen. In ending forward guidance, “the Fed will rely even more on lagging indicators such as the unemployment rate and the monthly CPI report.”
Graphic: Retrieved from Andreas Steno Larsen. “Most leading indicators for inflation point (seriously) down, while early unemployment indicators are ticking up, but the Fed will not admit to it until risk assets have taken another beating.”
“Once unemployment starts increasing alongside weakening momentum in the inflation reports, it will likely be at least 3-6 months too late to pivot.”
The Eurodollar – which reflects the interest offered on U.S. dollar-denominated deposits at banks outside of the U.S. (i.e., participants’ outlook on interest rates) – curve is inverted and implies rate cuts ahead, “6-7 months from now.”
Given the above, portfolios can “stay away from highly speculative assets, own USD cash, and start allocating towards 5-10y+ government bonds,” as Alfonso Peccatiello explained well.
Context: A stronger dollar, on the tightening of liquidity and credit, as well as increased demand and competition for money, does more to pressure risk and, is an equity headwind. Additionally, per Morgan Stanley (NYSE: MS) research, "The simple math on S&P 500 earnings from currency is that for every percentage point increase on a year-on-year basis it’s [] a 0.5 hit to EPS growth.”
Positioning
For the past few sessions, we did much to unpack and understand some of the implications of participants’ market positioning.
In summation, own volatility where the market is likely to not expire. Sell it where the market is likely to expire. Just because implied (IVOL) volatility is at a high starting point does not mean it should be sold, blindly, particularly on the put side, below the market.
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 $4,111.00 RTH High puts into play the $4,149.00 VPOC. Initiative trade beyond the $4,149.00 VPOC could reach as high as the $4,164.25 RTH High and $4,189.25 LVNode, or higher.
In the worst case, the S&P 500 trades lower.
Any activity below the $4,111.00 RTH High puts into play the $4,073.00 VPOC. Initiative trade beyond the VPOC could reach as low as the $4,041.25 and $4,015.75 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.
Graphic: 65-minute profile chart of the Micro E-mini S&P 500 Futures.
Considerations: This week’s advance was strong, based on market internals. Given this information, the rally is to not be sold, blindly.
Graphic: Market Internals (Advance/Decline, Up-Volume/Down-Volume, Tick) as Peter Reznicek at ShadowTrader teaches. Though positive, readings were weak and supportive of responsive trade, similar to what market liquidity (via Bookmap) was showing.
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.
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.
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!
Overnight, equity index and commodity futures auctioned lower while bonds, the dollar, and implied volatility metrics were bid at the tail-end of the quarterly rebalancing period.
Pursuant to this letter’s remarks in the days prior, trades biased long volatility are performing well, particularly those structured a standard deviation and beyond prior prices. We’ll unpack why that is, today.
Ahead is data on PCE inflation, disposable income, and consumer spending, as well as jobless claims (8:30 AM ET) and Chicago PMI (9:45 AM ET).
Graphic updated 6:30 AM ET. Sentiment Risk-Off if expected /ES open is below 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: Discussed in recent letters were the prospects of whether a recession would be necessary for stemming inflation.
Graphic: Via Bloomberg. “[W]hat’s happened to mortgage-backed bonds this year is a radical departure. Bloomberg’s index dates back to 1988 when the asset class was still in its infancy. This is the first time it has ever withstood a decline that stretches into double figures.”
“That’s the message the market took,” Bloomberg’s John Authers explained. “[T]he most painful surprise over the second half of this year would be for inflation to stay sticky.”
“That would quash the belief in a swift easing campaign in 2023.”
Graphic: CME Group Inc’s (NASDAQ: CME) FedWatch Tool.
Some, like the Federal Reserve’s (Fed) Loretta Mester, suggest that gone are the days to err on the side of being too accommodative.
“It also calls into question the conventional view that monetary policy should always look through supply shocks,” Mester said. “In some circumstances, such shocks could threaten the stability of inflation expectations and would require policy action.”
Graphic: Via Bloomberg. “The Richmond Fed’s survey of manufacturing isn’t generally one of the most closely monitored releases, but as this one was the worst since the Great Recession (barring only one month during the Covid shutdown), it garnered more attention than usual.”
Moreover, the Fed’s preferred inflation measure – the personal consumption expenditure deflator (PCE) – is set to update. The expectation is that core PCE drops, “thanks to base effects from last year,” bolstering the “narrative that inflation will soon be licked.”
Positioning: Discussed, earlier this week, was whether it made sense to lean toward owning volatility, rather than selling it outright.
A “higher starting point” in implied volatility (IVOL), and a still-present right-tail (from the positioning for a bear market rally), made it so we could position, for less cost, in short-dated structures with asymmetric payouts, on both sides of the market.
For instance, S&P 500 (INDEX: SPX) spreads +1 (near-the-money) x -2 (out-of-the-money), in excess of 200 points or so in width and up to 15 days to expiration, are performing well, today, pricing in excess of a 600% gain, only after pricing for little to no cost to enter in the days prior.
Disclaimer: Have delta in the direction you want the market to move, as well as positive gamma. In our case, we wanted negative delta (short bias) and positive gamma (profits amplified).
Graphic: Via Glyn Holton. “Positive gamma corresponds to curvature that opens upward. Negative gamma corresponds to curvature that opens downward.”
Recent market weaknesses will allow us to monetize and rotate those proceeds into speculative directional bets on the call-side, potentially. After all, the money is made in not losing it. Stay nimble. These are not trade recommendations. Be open-minded.
Graphic: Via Pat Hennessy. “[T]he performance of short-dated 1×2 put ratios in SPX this year. Despite being short the tail, the grind lower has been well captured by this trade structure.”
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, outside of prior-range and -value, suggesting a potential for immediate directional opportunity.
In the best case, the S&P 500 trades higher; activity above the $3,770.75 HVNode puts in play the $3,793.25 Ledge. Initiative trade beyond the Ledge could reach as high as the $3,821.50 LVNode and $3,840.75 ONH, or higher.
In the worst case, the S&P 500 trades lower; activity below the $3,770.75 HVNode puts in play the $3,735.75 HVNode. Initiative trade beyond the HVNode could reach as low as the $3,722.50 LVNode and $3,696.00 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
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.
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.
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.
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!
Overnight, equity index futures resolved a multi-day consolidation and auctioned higher, far beyond the prior day’s range. Commodities were mixed while bonds were lower.
The break from consolidation is one of the most bullish happenings in weeks. We’re monitoring whether participants add to their recent short volatility bets against direction, or whether there is repositioning and this bolsters the initiative probe.
Ahead is data on University of Michigan consumer sentiment, inflation expectations, and new home sales (10:00 AM ET), as well as some Fed speak (7:30 AM and 4:00 PM ET).
Graphic updated 6:40 AM ET. Sentiment Risk-On if expected /ES open is above 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: To start, I want to apologize for any confusion, yesterday, with respect to the /GE Eurodollar quote. This newsletter said the peak of the Fed-rate-hike cycle – terminal rate – sat near December 2023.
That’s wrong. It’s December 2022.
Graphic: Via Charles Schwab Corporation-owned (NYSE: SCHW) TD Ameritrade’s Thinkorswim. The Eurodollar (FUTURE: /GE) futures curve is a reflection of participants’ outlook on interest rates. The peak of the Fed-rate-hike cycle – terminal rate – is around DEC 20[22].
Okay, moving on, now!
New data is pointing to a “remarkable” drop in demand for goods and services during June, compared to months prior.
“US economic growth has slowed sharply in June, with deteriorating forward-looking indicators setting the scene for an economic contraction in the third quarter,” S&P Global (NYSE: SPGI) Market Intelligence’s Chris Williamson explained.
“The survey data are consistent with the economy expanding at an annualized rate of less than 1% in June, with the goods-producing sector already in decline and the vast service sector slowing sharply.”
Graphic: Via S&P Global Inc. “This is a sizeable miss and evidence of a quick slowdown in demand, though it’s still in positive territory (above 50). This report is consistent with a shifting narrative away from inflation worries and towards growth worries.”
Businesses (particularly in retail) are way “more concerned about the outlook” of costs and demand, as well as the path in monetary policies and deterioration in financial conditions.
Graphic: Via Bloomberg. “Supply constraints, exacerbated by Russia’s war in Ukraine this year, account for about half of the surge in US inflation, with demand currently making up a third of the increase, according to new research from the Federal Reserve Bank of San Francisco.”
That’s validated by Tesla Inc’s (NASDAQ: TSLA) CEO Elon Musk speaking about the carmaker’s losses from new plants, supply chain problems, and the like.
Graphic: Via Bloomberg. “Long-term ocean freight rates between China and the US West Coast are higher than spot prices for the first time since April 2020.”
“The past two years have been an absolute nightmare of supply chain interruptions, one thing after another,” Musk said.
“We’re not out of it yet. That’s overwhelmingly our concern is how do we keep the factories operating so we can pay people and not go bankrupt.”
Graphic: Via Bloomberg. “Supply chains in Asia look to be on the mend,” though it will “ take a while for supply and demand to rebalance.”
It’s a global move into recession all at once, as Jeffrey Snider of Alhambra Investments says.
“Combine the potential for break in repo collateral with economy heading toward recession, no wonder the Euro[dollar] curve inversion is spreading as rapidly as it has. Possibility of something big going wrong, therefore ending rate hikes, is huge now.”
“Euro[dollar] squeeze, collateral shortage, deflationary potential in money, and now demand destruction in global real economy.”
Graphic: Via Alhambra Investments.
Over the last four decades, monetary policy was a go-to for supporting the economy. Money was sent to capital and that promoted innovation and, by that token, deflation, ultimately creating “unimportance to cash flows,” as well put by Kai Volatility’s Cem Karsan.
Now, there’s a strong commitment to reducing liquidity and credit, all the while there are chokepoints monetary policymakers have little control over.
This has consequences on the real economy and asset prices, accordingly, which rose and kept deflationary pressures at bay. A stock market drop is both a recession and a direct reflection of the unwind of carry. It is the manifestation of a deflationary shock, and today’s poor sentiments and economic data reflects this.
At the same time, “bonds are not acting as a hedge and appear to be becoming less ‘money’ like due persistent declines in price and elevated rate vol,” as Joseph Wang puts it.
Bank deposits are to drain about $1 trillion or so by year-end, prompting investors to “continue to lower their selling prices to compete for the cash they want.”
Retail buyers, who, according to Michael Wang of Prometheus Alternative Investments, “were a significant driver of the inflated valuations we saw in tech and crypto,” are capitulating in stocks, all the while froth in housing markets is soon to abate, likewise.
Notwithstanding, Mark Zandi of Moody’s Corporation (NYSE: MCO) does not see “the kind of mortgage defaults and distressed sales that would be necessary for big declines in housing values,” just as prices of raw materials are retreating as inventories are bloating.
As put forth, partially, earlier this week, one has to wonder about the likelihood that inflation is near its high and whether the de-rates have played their course.
Let’s keep an open mind and follow up on this, in detail, next week.
Graphic: Via Bloomberg. “The hot commodities rally is cooling off fast as recession fears again ground and cloud the outlook for demand.”
Positioning: Keeping this section short.
As stated yesterday, a feature of the equity sell-off is the suppression of implied volatility (IVOL) versus that which the market realizes (RVOL) given that participants are hedged and volatility remains in strong supply.
Options data and insights platform SqueezeMetrics explained that this is due in part to lower leverage, too.
“Leveraged long S&P lost favor (understandable), and marginal demand for puts went with it. Creeping into net selling territory is ‘smart’ bear market positioning. Short delta, short skew.”
As I said in SpotGamma’s note, last night, given “the high starting point in IVOL, as well as its place in relation to [RVOL], it makes sense to own structures that benefit either from sharp changes in underlying price or an abrupt repricing in volatility.”
Cutting into the realization of a sharp change in underlying price or a far-reaching rally, however, are short-volatility bets across shorter maturity periods (and the associated hedging), as well as big (and popularized) positions set to roll off at the quarter-end.
Liquidity providers, per SpotGamma, all else equal, will have to sell to re-hedge, and we will talk about this further, next week.
Graphic: Taken 6/22/2022. SpotGamma’s Hedging Impact of Real-Time Options (HIRO) indicator points to selling of put and call options in the S&P 500 (INDEX: SPX) and S&P 500 ETF (SPY). Those liquidity providers, who are on the other side, are more exposed to long volatility, which they hedge by buying (selling) into weakness (strength) underlying.
Technical: As of 6:40 AM ET, Friday’s regular session (9:30 AM – 4:00 PM ET), in the S&P 500, will likely open in the upper part of a positively skewed overnight inventory, outside of prior-range and -value, suggesting a potential for immediate directional opportunity.
In the best case, the S&P 500 trades higher; activity above the $3,821.50 LVNode puts in play the $3,843.00 RTH High. Initiative trade beyond the RTH High could reach as high as the $3,911.00 VPOC and $3,943.25 HVNode, or higher.
In the worst case, the S&P 500 trades lower; activity below the $3,821.50 LVNode puts in play the $3,793.25 ledge. Initiative trade beyond the ledge could reach as low as the $3,770.75 HVNode and $3,735.75 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.
Graphic: 65-minute profile chart of the Micro E-mini S&P 500 Futures.
Considerations: Recent trade has been lackluster and the overnight break is the most bullish happening in weeks. The go-to trade this week was short volatility. Participants responded to tests of key visual areas, and sold options, particularly in shorter maturities.
In the coming session(s), some of those participants will respond to the break in a manner that bolsters the initiative drive. Notwithstanding, the key to watch for is whether participants will use the bump as an opportunity to add to their most recent short volatility bets against the direction.
Ultimately, the more time that is spent outside of the prior consolidation area, the likelihood that the breakout is a signal to look for dips to buy and play rotations to key areas up above.
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.
Balance-Break + Gap Scenarios: A change in the market (i.e., the transition from two-time frame trade, or balance, to one-time frame trade, or trend) is occurring.
Monitor for acceptance (i.e., more than 1-hour of trade) outside of the balance area.
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.
Rejection (i.e., return inside of balance) portends a move to the opposite end of the balance.
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.
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.
Overnight, U.S. equity index futures came off of their Thursday peaks before, late in the morning, trading to a new rally high, at which is a confluence of technical nuances.
Thursday’s cash session was characterized by a near-vertical advance into mid-day. Then, trade became two-sided, a feature of short-covering and not new buying. More on this, later.
In the news was Citigroup Inc’s (NYSE: C) downgrading of U.S. stocks on recession risks and the “elements of a deflating bubble,” while leaning optimistic on China assets due to marginal policy support, there. This is on the heels of similar conclusions put forward by BlackRock Inc (NYSE: BLK) and Morgan Stanley (NYSE: MS).
Mortgage rates staged their biggest drop since April of 2020 as “the housing market has clearly slowed, and the deceleration is spreading to other segments of the economy,” the Federal Home Loan Mortgage Corporation’s (OTC: FMCC) Sam Khater explained.
In other news, Secretary of State Antony Blinken took aim at China, commenting on the U.S.’s intention to “shape the strategic environment around Beijing to advance [its] vision for an open, inclusive international system.” This is as the U.S. also plans economic talks with Taiwan.
Pippa Malmgren, who is a former White House adviser and economist we wrote on earlier this week, discussed more of this decoupling and coordination among Eastern and Western powers.
In a two-part series, she explains the challenging of U.S. island bases by China and Russia, as well as their maritime strategies, “island hopping [and] shopping.” Check them out.
Today we received data on PCE inflation, real disposable and personal income, along with consumer spending and trade in goods (8:30 AM ET). University of Michigan Sentiment and five-year inflation expectations come later (10:00 AM ET).
Graphic updated 6:45 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: At its core, there’s a commitment to cutting liquidity and credit after the spending of COVID-era “benefits and lockdown savings … created a lot of demand,” and inflation.
Graphic: Via the Federal Reserve. Taken from Nasdaq Inc (NASDAQ: NDAQ). “Rates have risen dramatically this year, impacting valuations of stocks and bonds.”
This has consequences on the real economy and asset prices, accordingly, which rose and kept the deflationary pressures of prevailing monetary policies at bay.
Graphic: Taken from Nasdaq Inc. “At a very simple level, rising rates increase interest expenses, reducing profits. But they also cause investors, who can earn more interest on safe cash deposits, to demand stronger returns from all other investments too.”
As unpacked, in detail, on May 18, 2022, there is an argument that stock market drops are both a recession and a reflection of the unwind of carry (or investment in long-duration bets with cheap debt) – a deflationary shock.
Graphic: Via Bloomberg. “Tighter financial conditions themselves are a clear success story for the Fed — it is the only way they can reduce inflationary pressures,” said Seema Shah, chief strategist at Principal Global Investors.
“The Fed has a mandate … to control price stability,” Kai Volatility’s Cem Karsan had explained.
“With supply-side economics, the only way that they can control this ultimately is to pull back. And slow capital markets decrease via the wealth effect. Ultimately, there’s a significant lag, so they are not in a position to ultimately control inflation without bringing down markets.”
Graphic: Via Bloomberg. “Of course, economic growth is a good thing. But too much of that good thing will just continue to stoke inflation. With that perspective in mind, the slowdown in surprises is positive.”
Accordingly, in our May 25, 2022 commentary, in which we discussed what to search for in the minutes of the last Federal Open Market Committee (FOMC) meeting. Knowing that there’s a lag in policy impact, we accurately floated the potential for the Federal Reserve (Fed) to “shift gears” late this summer if further cooling of inflation and “evidence of a growth slowdown.”
Graphic: Via Bloomberg. “After hitting a record above 3% last month, 10-year breakevens are on track for their biggest monthly drop since March 2020. The so-called five-year, five-year forward — the Fed’s favored measure — is set to post its biggest drop in May since August 2019.”
“Policy works with a lag,” as Diane Swonk of Grant Thorton explained. The Fed may pause as it seeks to “catch up but not outrun the market in its effort to tighten credit market conditions.”
“There is still more progress to be made in bringing inflation expectations down to resonate with the Committee’s target, but current valuations are at least in the realm of acceptable,” Ian Lyngen, who is head of U.S. rates strategy at the Bank of Montreal (NYSE: BMO), said.
“The market is showing some faith in Powell’s inflation-fighting creditability.”
Graphic: Taken from Nasdaq Inc. “Although inflation is high right now, it’s because of Covid and the Ukraine war. Both, hopefully, will pass, and 3%-4% inflation a year from now seems possible if the economy slows to a more normal level. In turn, that means the interest rate that keeps the U.S. economy growing slowly is likely much lower than we might currently be thinking. It might, in fact, be right around where bond rates are now.”
Concluding the fundamental section with remarks from a March 2022 Substack newsletter published by Andreas Steno Larsen of the Stenos Signals Substack.
“I simply don’t find >3.5% territory for the Fed Funds feasible as the hiking cycle peaked at 2.25-2.50% in 2018/2019 and fundamentals have worsened since. Debt loads are much higher, demographics have weakened, and the labour force is smaller, which suggests that the neutral rate is lower, not higher, than in 2018/2019.”
Graphic: Via Bloomberg. “The swaps market and consensus forecasts to Bloomberg Economics both imply considerably faster rate hikes, while Bloomberg’s own forecast is more hawkish still.”
Positioning: Per Bank of America Corporation (NYSE: BAC) notes, investors poured nearly $20 billion into global stocks (in the week to May 25, 2022).
As I wrote in a SpotGamma note, notable was the reversal in beaten-down areas of the market, as well as the implosion at the front-end of the volatility term structure, affecting protection most sensitive to changes in direction and volatility.
The Cboe VVIX Index (INDEX: VVIX), the expected volatility of the 30-day forward price of the VIX or the volatility of volatility (a naive but useful measure of skew), dropped off markedly, too, in comparison to the VIX, itself.
Graphic: Via Physik Invest. Taken from TradingView. VVIX, top. VIX, bottom.
Further, as stated in SpotGamma’s note, a “falling VVIX (and VIX term structure drop off) may be the product of a collapse in the value of customers’ long put exposures concentrated in very short-dated timeframes (potentially exposures hedging tail risks with respect to the release of FOMC minutes, among other things).”
“It is then as the skew, here, decays, and term structure compresses, that liquidity providers buy back their hedges to the puts they are short (i.e., the vanna dynamic pointed to, earlier).”
This market-generated information helps us give context to this most recent equity market rally that is characterized by a little change in demand for bets on upside further in price and time
All else equal, this is not a feature of sustainable market rallies.
Why you ask?
Those names that have been most depressed, and are now reversing, were recipients of heavy demand for protection in the months prior.
For this reason – participants being well hedged – selling was orderly, rather than violent as in past episodes of market shock when the reach for protection solicited a cascading reaction that exacerbated underlying price movements due to liquidity providers’ hedging.
Graphic: Via Banco Santander SA (NYSE: SAN) research.
The large drop off in term structure, as well as the VVIX versus the VIX, is affecting protection most sensitive to changes in direction and volatility and the unwind of liquidity providers’ short futures and stock hedges to this protection is, in part, playing into this internally weak rally.
So, what? How do you play this? Good question.
It still may make sense to have exposure to underlying markets, synthetically (i.e., own options), as detailed, well, May 25, 2022. Read that letter for detail on how to think about trade structure.
Technical: As of 6:45 AM ET, Friday’s regular session (9:30 AM – 4:00 PM ET), in the S&P 500, will likely open in the upper part of a positively 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 $4,069.25 HVNode puts in play the $4,095.00 ONH. Initiative trade beyond the ONH could reach as high as the $4,119.00 VPOC and $4,148.25 HVNode, or higher.
In the worst case, the S&P 500 trades lower; activity below the $4,069.25 HVNode puts in play the $3,997.75 RTH High. Initiative trade beyond the RTH High could reach as low as the $3,982.75 LVNode and $3,951.00 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.
Graphic: 65-minute profile chart of the Micro E-mini S&P 500 Futures.
Definitions
Overnight Highs And Lows (ONH and ONL): 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.
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.
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.
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.
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What Happened
Overnight, equity index futures were divergent, albeit nearly flat, after Wednesday’s release of minutes to the last Federal Open Market Committee (FOMC) meeting were less hawkish than expected, bolstering a small expansion of the range to the upside.
Though higher prices were held at the index level, some products like Apple Inc (NASDAQ: AAPL) were lower after issuing updates on its production. Yesterday, it was social media and advertising businesses like Snap Inc (NYSE: SNAP) that fell on forecasts for meager growth.
In other news, Sequoia Capital warned that the current environment for founders is a “crucible moment,” and there is no indication good times will return soon.
Pursuant to that belief, we have firms like Klarna and Bolt, who just began laying off employees, preparing for slower growth and focusing on “short-term profitability.”
A chief concern, among participants at the World Economic Forum, beyond a global recession and inflation, is the potential for ongoing conflicts to cause “mass starvation” and “political instability around the world.”
Today we get updates on jobless claims, real gross domestic product, and income, as well as final sales to domestic purchasers (8:30 AM ET). Later, pending home sales (10:00 AM 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: As was suggested could happen in Wednesday’s pre-market letter, the Federal Reserve (Fed) indicated potential policy flexibility, later this year.
Per the most recent FOMC minutes, officials are determined to achieve price stability with “50 basis-point increases in the target range … at the next couple of meetings.”
“Many participants judged that expediting the removal of policy accommodation would leave the committee well-positioned later this year to assess the effects of policy firming and the extent to which economic developments warranted policy adjustments.”
Graphic: Via Bloomberg. “The swaps market and consensus forecasts to Bloomberg Economics both imply considerably faster rate hikes, while Bloomberg’s own forecast is more hawkish still.”
Accordingly, finalized were balance sheet reduction plans. Starting June 1, 2022, Treasury holdings will decline by $30 billion per month, rising to $60 billion per month in September.
Mortgage-backed securities (MBS) holdings will shrink by $17.5 billion per month, ultimately rising to $35 billion, in accordance with our post-FOMC letter published May 5, 2022.
As stated, previously, with QT, central banks remove assets from their balance sheet either through outright sales or the non-reinvestment of the principal sum of maturing securities.
“QT is a direct flow of capital to capital markets” and the prospects of withdrawing this liquidity, when revealed in December’s FOMC meeting minutes, was what fed into a retreat from risk.
Overall, the minutes left the tone unchanged and reaffirmed the Fed’s commitment to stable prices.
Bloomberg’s John Authers concludes, well: “If inflation should look as though it might fail to get down even to the revised forecast of 4.3% by the end of the year, there’s still a possibility that the Fed will have to be more hawkish than it currently intends, not less.”
“But at least the path until the end of summer looks clear.”
Positioning: We’re carrying forward remarks from notes earlier this week as there has been a limited change in tone.
Based on current positioning, most products we monitor continue to trade in an environment that solicits more volatile hedging of put open interest and realized volatility (RVOL). This is because, naively, we look at participants as mainly owning protection to the downside.
So, they have asymmetric (positive gamma) exposure to the downside (negative delta). On the other side, liquidity providers have a negative gamma and positive delta that they must sell into weakness and buy into strength underlying to hedge.
It is at a certain juncture, far above current prices (i.e., Zero Gamma), that the volatile effects of hedging this put open interest begin to cool. It is above these levels that participants’ exposure to calls solicits increased hedging activities which promote stability and less volatility.
Graphic: Via Tier1Alpha. “Spot SPX is currently over -8.55% below the gamma flipping point, a distance similar to the drawdown at the end of 2018. We’ll have to see quite a reverse in trend before a substantial regime shift can take place.”
It’s because, naively, we look at participants as financing their bets on the downside with call exposure. On the other side, liquidity providers, then, have a positive gamma and delta trade they hedge by buying into weakness and selling into strength.
We’re definitely not there yet but, based on remarks in past letters (e.g., stretched market and investors bidding “skew on the call side” amid their “fear of missing on the upside”), this letter’s author continues leaning toward strategies that have little to lose in case of further implied volatility (IVOL) compression or weakness into the June FOMC and OPEX.
Graphic: Via SpotGamma. “[C]all positions were added [above] $4,000.00, with $4,100.00 [and] $4,200.00 adding 10k + 15k [in open interest] respectively. That’s not huge, but it was enough to kink the gamma curve in an interesting way.”
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 upper part of a positively skewed overnight inventory, nearly outside of prior-range and -value, suggesting a potential for immediate directional opportunity.
In the best case, the S&P 500 trades higher; activity above the $3,951.00 VPOC puts in play the $3,997.75 RTH High. Initiative trade beyond the RTH High could reach as high as the $4,061.00 VPOC and $4,095.00 ONH, or higher.
In the worst case, the S&P 500 trades lower; activity below the $3,951.00 VPOC puts in play the $3,909.25 MCPOC. Initiative trade beyond the MCPOC could reach as low as the $3,863.25 LVNode and $3,831.00 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.
Graphic: 65-minute profile chart of the Micro E-mini S&P 500 Futures.
Definitions
Overnight Highs And Lows (ONH and ONL): 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 value tests as they offer favorable entry and exit.
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.
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.
