Last week, we discussed the recent response to the bank issues cutting risks for the S&P 500 (INDEX: SPX). Volatility and correlations fell as time passed, and this helped contain the market. Though last week’s options expiration (OpEx) may free markets up, we maintain that the SPX may stay contained longer before it weakens.
Graphic: Retrieved from SqueezeMetrics. “Monthly OpEx just shaved off nearly $300mm per point in SPX dealer gamma exposure. That means index liquidity has lost quite a bit of depth going into next week.”
Catalysts for weakness include falling earnings growth and a debt-ceiling crisis that’s driven T-bill yields lower from surging demand; a failure by Congress to raise the limit on how much the government can borrow may disrupt funding markets, WSJ reports.
Let’s limit our expectations and focus on low- or zero-cost call structures (e.g., bull call ratio) monetized to finance longer-dated put structures (e.g., bear put vertical) while allocating a chunk of our portfolio to near-risk-free yield-harvesting structures (e.g., box spread), mainly if you are a portfolio margin trader.
As I explained to a subscriber over the weekend, for boxes, the greatest possible loss across a range of prices is negligible. Hence, buying power is unaffected in trading a box. Consequently, using portfolio margin and trading boxes, you have more buying power to allocate to other trades that are margin (and not debit) intensive, such as synthetic long stock (i.e., purchase ATM call and sell ATM put). Using options, among other derivatives, enables us to stack returns on each other.
Here’s one example.
We can trade box spreads expiring at the end of June. We buy the $4,000/$5,000 call spread for $22,365.00 and simultaneously buy the $5,000/$4,000 put spread for $76,620. This trade costs $98,985.00, and by lending this amount (on April 21, 2023), you will receive $1,015.00 upon maturity. Yes, you will have $99,000.00 cash tied up, but you should be able to use $99,000.00 in buying power in other trades if you have that portfolio margin component which is so important.
If this action-oriented letter is valuable to you, consider sharing it with others.
See you later!
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.
Bank of America Corporation (NYSE: BAC) sees allocations to equities versus bonds falling. That’s amid recession fears. Per EPB, “the cyclical economy has just started to shed jobs today, and leading indicators signal the recession is likely underway.”
“To get advanced warning of recessions, you must look at the construction and manufacturing sectors, even though these two sectors are only 13% of the labor market,” EPB adds, noting traditional indicators’ weakening predictability is not so great to ignore the insight. “It’s clear that the composition of traditional leading indicators remains appropriate, and thus, the current resounding recessionary signal should not be ignored.”
BAC strategist Michael Hartnett said, though, that this “consensus lust for recession” must soon be satisfied. Otherwise, the “pain trade” would be even higher yields and stocks; the S&P 500 (INDEX: SPX) is enjoying an accelerated rally which Jefferies Financial Group (NYSE: JEF) strategists think portends a period of flatness, now, over the coming weeks …
Graphic: Retrieved from Jefferies Financial Group (NYSE: JEF) via The Market Ear.
… and through options expiration (OpEx), typically a poor performance period for the SPX.
Beyond the uninspiring fundamentals, the positioning contexts are supportive. Recall our letters published earlier this year. If the market consolidated and failed to break substantially, then falling implied volatility (IVOL) and time passing would bolster markets and, potentially, help build a platform for a rally into mid-year. A check of fixed-strike and top-line measures of IVOL like the Cboe Volatility Index or VIX confirms options activities are keeping markets intact.
Graphic: Retrieved from Danny Kirsch of Piper Sandler (NYSE: PIPR). “SPX May $4,150.00 call volatility, the lack of realized volatility weighing on the market. Volatility low, not cheap.”
Beyond the rotation into shorter-dated options, just one of the factors exacerbating the decimation of longer-dated volatility, traders’ consensus is that markets won’t move a lot and/or they don’t need to hedge over longer time horizons; traders want punchier exposure to realized volatility (RVOL), and that they can get through shorter-dated options that have more gamma (i.e., exposure to changes in movement), not vega (i.e., exposure to changes in implied volatility).
Graphic: Retrieved from Goldman Sachs Group Inc (NYSE: GS) via Bloomberg.
Consequently, counterparties may be less dangerous to accelerating movement in either direction; hence, the growing likelihood of a period of flatness.
“Despite the collapse in the 1-month realized volatility, we suspect most vol control funds have scaled into using their longer-term realized vols, which by design, lead to less aggressive rebalancing flows,” Tier1Alpha says. “For example, the 3-month rVol, which is currently driving our model, was essentially unchanged yesterday, which means volatility targets were maintained, and very little additional rebalancing had to occur. So even with the decline in the 1-month vol, overall risk exposure remained the same.”
With IVOL at a lower bound, the bullish impacts yielded by its compressing have largely played out. There may be more to be gained by movements higher in IVOL, in addition to the expiry of many call options this OpEx. By owning protection, particularly far from current prices, you are positioned to monetize on the market downside and non-linear repricings of volatility, as this letter has discussed in recent history. The caveat is that volatility can cluster and revert for longer; hence, your structure matters.
“I am concerned that VIX is underpricing the series of events that we know to expect over the coming weeks,” says Interactive Brokers Group Inc’s (NASDAQ: IBKR) Steve Sosnick. “While there is now an 88% implied likelihood of a 25 basis point hike, the likely path of any potential future hikes and assumed cuts should be more clarified at the meeting and in its aftermath. And oh, has anyone ever heard the expression “sell in May and go away?”
Graphic: Retrieved from Interactive Brokers Group Inc (NASDAQ: IBKR).
With call skews far up meaningfully steep in some products, still-present low- and zero-cost call structures this letter has talked about in the past remain attractive. If the market falls apart, your costs are low, and losses are minimal. If markets move higher into a “more combustible” position, wherein “volatility is sticky into a rally,” you may monetize your call structures and roll some of those profits into bear put spreads (i.e., buy put and sell another at a lower strike). An alternative option is neutral. Own something such as a T-bill or box spread (i.e., buy call and sell put at one strike and sell call and buy put at another higher strike). Some boxes are yielding upwards of 5.4% as of yesterday’s close.
To end, though the short-dated options activity may prompt cascading events in market downturns, the main issue is the reduced use of longer-dated options; a supply and demand imbalance likely resolves itself with an implied volatility repricing of a great size where longer-dated options outperform those that are shorter-dated.
Our locking in of rates or using the profits of call structures to position for a potential IVOL repricing, particularly in the back half of the year when dealer positioning is less clear, buybacks are to fall off of a cliff, rates may fall, and the boost from short-covering has played its course, is an attractive proposition given the context.
Graphic: Retrieved from Bloomberg. “The S&P 500 (white line) is well above its levels from early March, while the yield on the 3m-2y spread remains in a deep inversion, signifying meaningful expectations of cuts in the months ahead.”
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 free by thousands of subscribers. Join this community to learn about the fundamental and technical drivers of markets.
Graphic updated 7:00 AM ET. Sentiment Neutral if expected /MES open is inside of the prior day’s range. /MES levels are derived from the profile graphic at the bottom of this letter. Click here for the latest levels. SqueezeMetrics Dark Pool Index (DIX) and Gamma (GEX) with the latter calculated based on where the prior day’s reading falls with respect to the MAX and MIN of all occurrences available. A higher DIX is bullish. The lower the GEX, the more (expected) volatility. Click to learn the implications of volatility, direction, and moneyness. Breadth reflects a reading of the prior day’s NYSE Advance/Decline indicator. The CBOE VIX Volatility Index (INDEX: VVIX) reflects the attractiveness of owning volatility. UMBS prices via MND. Click here for the economic calendar.
Administrative
Time for something inspiring! Separate from his work at Physik Invest, founder Renato Leonard Capelj is a journalist interviewing global leaders in business, government, and finance. In his desire to learn and apply the methods of those others who are far more experienced, Capelj has a long list of interviews you may find helpful in strengthening your understanding of markets. Check out some recent ones!
Capelj spoke with Simplify Asset Management’s Michael Green about cutting investors’ portfolio volatility while amplifying profit potential.
In response to uncertainty, Green says investors can park cash in short-term near-risk-free bonds yielding 5% or more, as well as allocate some capital to volatility “to introduce a degree of convexity,” risking only the premium paid. Alternatively, investors can take a more optimistic long view and position in innovations like artificial intelligence or next-generation energy production.
Capelj spoke with The Ambrus Group’s Kris Sidial about his market perspectives.
Naive measures like the VVIX, which is the volatility of the VIX or the volatility of the S&P 500’s volatility, are printing at levels last seen in 2017, Sidial explains, noting this would suggest “we can get cheap exposure to convexity while a lot of people are worried.”
“Even if inflation continues, the rate at which it rises won’t be the same. Due to this, CTA exposures likely will not perform as well as they did in 2022, and that’s why you may see more opportunities in the volatility space.”
Capelj spoke with Damped Spring Advisors’ Andy Constan about what investors should focus on and how he creates trades that lose him less money.
Constan’s trades are constructed around two- to four-month time horizons and are structured long and short using defined-risk options trades like debit or credit spreads, depending on whether volatility is cheap or expensive.
“I want deltas and leverage. My macro indicators give me an edge on price and in the worst case, the loss is limited to 10%, if everything has to go against me all at once. I can be 100% invested and only risk 10%.”
Capelj spoke with 42 Macro’s Darius Dale about his Wall Street story and perspectives on life and markets.
“We’re tracking at an above-potential level of output in terms of the growth rate of output. We’re also slowing and the pace of that deceleration is likely to pick up steam in the coming quarters.”
By 2023, that process is likely to “catalyze pressure on asset markets through the lens of corporate earnings and valuations you assign to a lower level of growth.”
Floor traders, according to Reznicek, had low capital requirements. As a result, they could put on strategies like the 1×2 ratio — a debit spread with an extra short option — for a low cost.
(See parts 1, 2, and 3 of ShadowTrader’s how-to series on ratio spreads.)
“On the floor, it is either go big or go home,” he chuckled, remarking that ratio spreads were the way of the casino. “You either get rich or they take your house. So, why would you put on any other spread?”
The next big turning point was Jim Dalton, who’s been a member of the Chicago Board of Trade, as well as a member of the Chicago Board Options Exchange (CBOE) and senior executive vice president of the CBOE during its formative years.
“I’m still in touch with him on a regular basis and I consider him a friend,” Reznicek said in a discussion on Dalton’s works like Mind Over Markets and Markets in Profile, as well as his use of WindoTrader Market Profile software. “I went to Chicago twice to see him teach live … and I came home from those seminars with five, six, 10 pages of notes. The nuances of profile continue to mold me.”
Capelj spoke with Kai Volatility Advisors’ Cem Karsan about the implications of record valuations and the growth of derivatives markets on policy, the economy, and financial markets.
“It’s not a coincidence that the mid-February to mid-March 2020 downturn literally started the day after February expiration and ended the day of March quarterly expiration. These derivatives are incredibly embedded in how the tail reacts and there’s not enough liquidity, given the leverage, if the Fed were to taper.”
Capelj spoke with The Ambrus Group’s Kris Sidial to understand how to capitalize on volatility dislocations.
Unlike standard tail-risk funds which systematically buy equity puts, Ambrus’ approach is bespoke, cutting down on negative dynamics like decay with respect to time.
Given dislocations across single stock skew, term structure, and volatility risk premium, Ambrus will position itself in options with less time to maturity, buying protection up to six weeks out.
“The market will underestimate the distribution,” Sidial said in a conversation on Ambrus’ internal models that spot positional imbalances to determine who is off-sides and in what single asset. “We’re buying things that have happened before and we’re looking for it to carry a heavier beta when the sell-off happens.”
So, by analyzing flow, as well as using internal models to assess the probabilities of deleveraging in a risk-off event, Ambrus is able to venture into individual stocks where there may be excess fragility; “I know if stock XYZ goes down five percent, it’s going to go down 10% because this fund needs to deleverage.”
To aid the cost to carry, Ambrus utilizes defined-risk, short-volatility, absolute return strategies.
“I’m basically giving you a free put on the market – with a ton of convexity – with something that offers a payout that’s just more than a regular put,” Sidial summarized. “If the market doesn’t do anything, and we do an amazing job, we’re flat and you made money on all your long-only equity exposure.”
Capelj spoke with The Ambrus Group’s Kris Sidial about the meme stock debacle of 2021.
“You have distressed debt hedge funds that focus on shorting these types of companies. Melvin Capital is the one that is singled out due to the media, but they aren’t the only ones.”
Market participants added to the crash-up dynamics. Retail investors aggressively bought stock and short-term call options, while institutional investors further took advantage of the momentum and dislocations.
“You have this dynamic in the derivatives market where there is a gamma squeeze when people are buying way far out-of-the-money calls, and dealers reflexively have to hedge off their risk,” Sidial said.
“It causes a cascading reaction, moving the stock price up because dealers are short calls and they have to buy stock when the delta moves a specific way.”
The participation in the stock on the institutional side has not received much attention, he said.
“We’ve noticed that some of the flow is more institutional,” he said in reference to activity on the level two and three order books, which are electronic lists of buy and sell orders for a particular security.
“You have certain prop guys and other hedge funds that understand what’s going on, and they’re trying to take advantage of it, as well.”
This institutional activity disrupted traditional correlations and caused shares of distressed debt assets like GameStop, BlackBerry Ltd, and AMC Entertainment Holdings Inc to trade in-line with each other.
“This was not some WallStreetBet user, … if you look at how some of these things were moving premarket, you would see GME drop like 2%, BB’s best bid would drop and AMC’s best bid would drop. That’s an algo.”
The takeaway: although the WallStreetBets crowd is getting most of the blame, institutions are also at fault for the volatility.
Technical
As of 7:00 AM ET, Tuesday’s regular session (9:30 AM – 4:00 PM ET) in the S&P 500 will likely open in the lower part of a balanced overnight inventory, inside the prior day’s range, suggesting a limited potential for immediate directional opportunity.
The S&P 500 pivot for today is $4,003.25.
Key levels to the upside include $4,026.75, $4,038.75, and $4,049.75.
Key levels to the downside include $3,980.75, $3,955.00, and $3,937.00.
Disclaimer: Click here to load the updated key levels via the web-based TradingView platform. New links are produced daily. Quoted levels likely hold, barring an exogenous development.
Graphic: 65-minute profile chart of the Micro E-mini S&P 500 Futures.
Definitions
Overnight Rally Highs (Lows): Typically, there is a low historical probability associated with overnight rally-highs (lows) ending the upside (downside) discovery process.
Volume Areas: Markets will build on areas of high-volume (HVNodes). Should the market trend for some time, this will be identified by a low-volume area (LVNodes). The LVNodes denote directional conviction and ought to offer support on any test.
If participants auction and find acceptance in an area of a prior LVNode, then future discovery ought to be volatile and quick as participants look to the nearest HVNodes for more favorable entry or exit.
POCs: Areas where two-sided trade was most prevalent in a prior day session. Participants will respond to future value tests as they offer favorable entry and exit.
Definitions
Volume Areas: Markets will build on areas of high-volume (HVNodes). Should the market trend for some time, this will be identified by a low-volume area (LVNodes). The LVNodes denote directional conviction and ought to offer support on any test.
If participants auction and find acceptance in an area of a prior LVNode, then future discovery ought to be volatile and quick as participants look to the nearest HVNodes for more favorable entry or exit.
About
The author, Renato Leonard Capelj, spends the bulk of his time at Physik Invest, an entity through which he invests and publishes free daily analyses to thousands of subscribers. The analyses offer him and his subscribers a way to stay on the right side of the market.
You may view this letter’s content calendar at this link.
Disclaimer
Do not construe this newsletter as advice. All content is for informational purposes. Capelj and Physik Invest manage their own capital and will not solicit others for it.
Physik Invest’s Daily Brief is read free by thousands of subscribers. Join this community to learn about the fundamental and technical drivers of markets.
Graphic updated 9:10 AM ET. Sentiment Risk-On if expected /MES open is above the prior day’s range. /MES levels are derived from the profile graphic at the bottom of this letter. Click here for the latest levels. SqueezeMetrics Dark Pool Index (DIX) and Gamma (GEX) with the latter calculated based on where the prior day’s reading falls with respect to the MAX and MIN of all occurrences available. A higher DIX is bullish. The lower the GEX, the more (expected) volatility. Click to learn the implications of volatility, direction, and moneyness. Breadth reflects a reading of the prior day’s NYSE Advance/Decline indicator. The CBOE VIX Volatility Index (INDEX: VVIX) reflects the attractiveness of owning volatility. UMBS prices via MND. Click here for the economic calendar.
Administrative
Sorry for the delay. Please read through the positioning section. Have a great Monday!
As always, if there are holes or unclear language. We will fix this in the next letters.
Fundamental
On 3/22, we mentioned news of Russia wanting to adopt the yuan for settlements.
Putin: We are in favor of using the Chinese yuan for settlements between Russia and the countries of Asia, Africa, and Latin America. I am confident that these forms of settlement in yuan will develop between Russian partners and their counterparts in third countries. pic.twitter.com/Mnw1WfjW4Y
And, with that, publications covering these East alliances use some tough language. One Bloomberg article notes China and Russia “roll[ing] back US power and alliances … [to] create a multipolar world … [and] diminish the reach of democratic values, so autocratic forms of government are secure and even supreme.”
Let’s rewind a bit to understand why all the toughness and fear.
If the US dollar's global supremacy erodes, America will face a reckoning like none before.
Recall Chinese President Xi Jinping speaking with Saudi and GCC leaders. Here is our 1/4 summary takeaway:
Graphic: Retrieved from Physik Invest’s Daily Brief for January 4, 2023.
Essentially, those remarks confirm the East is hedging sanctions risk. Reliance on the West is falling, and this inevitably will present “non-linear shocks” (i.e., “inflation mess caused by geopolitics, resource nationalism, and BRICS”) monetary policymakers are not equipped to handle. So, are the markets at risk?
President Xi to President Putin:
“Change that hasn’t happened in 100 years is coming and we are driving this change together.”
This most recent meeting between China and Russia increases the risks of unwinding the “debt-fueled economy in the US,” FT’s Rana Foroohar confirms, as we wrote in the Daily Brief for 1/4. Further, this is a threat to “hidden leverage and opaqueness.” That means the markets are at risk. Let’s explain more.
With the encumbrance of commodities, among other initiatives, these nations’ weight in currency baskets may rise and keep “inflation from slowing.” If that happens, future rate expectations are off. Additionally, “the US dollar and Treasury securities will likely be dealing with issues they never had to deal with before: less demand, not more; more competition, not less,” we quoted Zoltan Pozsar (ex-Credit Suisse) saying on 1/5.
The markets most responsive to this are public, as we saw with 2022’s de-rate. In 2023 and beyond, added liquidation-type risks lie in the private markets. This will have knock-on effects.
The likes of The Ambrus Group’s Kris Sidial mentioned to your newsletter writer in a Benzinga interview that private market investors’ raising of cash to meet capital calls could prompt sales of their more liquid public market holdings. This is a major risk Sidial noted he was watching, in addition to some risks in the derivatives markets.
At the same time, Eric Basmajian believes the “banking crisis will cause a tightening of money and credit.” This will further solidify the “broader business cycle and corporate profit recession.”
Graphic: Retrieved from Bloomberg. Per John Authers, “the combination of deeply troubled banks and strong performance for the rest of the stock market cannot persist much longer.”
Positioning
Sidial’s well positioned to take advantage of the realization of these risks. In January, he explained that measures like the Cboe VIX Volatility Index (INDEX: VVIX) were low. This suggested, “we can get cheap exposure to convexity while a lot of people are worried.” In an update to Bloomberg, Sidial said The Ambrus Group’s tail-risk strategy (which Sidial has explained to us before) has performed well as the VIX index has risen, a sign of traders hedging concerns about “some contagion hitting and their portfolios being destroyed on that.”
“We have seen an increase in tail hedging,” added Chris Murphy of Susquehanna International Group. “We have continued to see call buying in the VIX since the bank turmoil began.” The caveat, though, is that realized volatility or RVOL, not just implied volatility or IVOL (i.e., that which is implied by traders’ supply and demand of options), must shift and stay higher for those options to maintain their values, which may be difficult according to Kai Volatility’s Cem Karsan.
Though Karsan thinks markets will likely see RVOL come back in a big way, he thinks policymakers’ intervention will be stimulative short-term as it reverses a lot of the quantitative tightening or QT (i.e., flow of capital out of capital markets). Stimulation will be compounded by the continued unwinding of hedging strategies in previously depressed products like the Nasdaq 100 (INDEX: NDX). What do we mean by this?
Recall that traders’ closure and/or monetization of put protection results in options counterparties buying back their short stock and/or futures hedges. Therefore, before any downside is realized, the market may trade into a far “more combustible” position.
Consequently, look for low- and zero-cost call structures (e.g., ratio spreads) to play the upside while opportunistically using higher prices and elevated volatility skew to put on bear put spreads (i.e., buy put and sell another put at a lower strike price) for cheaper prices.
Consider following and supporting us on social media:
As of 9:10 AM ET, Monday’s regular session (9:30 AM – 4:00 PM ET), in the S&P 500, is likely to open in the upper part of a positively skewed overnight inventory, outside of the prior day’s range, suggesting a potential for immediate directional opportunity.
The S&P 500 pivot for today is $4,026.75.
Key levels to the upside include $4,038.75, $4,049.75, and $4,062.25.
Key levels to the downside include $4,004.25, $3,994.25, and $3,980.75.
Disclaimer: Click here to load the updated key levels via the web-based TradingView platform. New links are produced daily. Quoted levels likely hold barring an exogenous development.
Graphic: 65-minute profile chart of the Micro E-mini S&P 500 Futures.
Definitions
Volume Areas: Markets will build on areas of high-volume (HVNodes). Should the market trend for some time, this will be identified by a low-volume area (LVNodes). The LVNodes denote directional conviction and ought to offer support on any test.
If participants auction and find acceptance in an area of a prior LVNode, then future discovery ought to be volatile and quick as participants look to the nearest HVNodes for more favorable entry or exit.
About
The author, Renato Leonard Capelj, spends the bulk of his time at Physik Invest, an entity through which he invests and publishes free daily analyses to thousands of subscribers. The analyses offer him and his subscribers a way to stay on the right side of the market.
You may view this letter’s content calendar at this link.
Disclaimer
Do not construe this newsletter as advice. All content is for informational purposes. Capelj and Physik Invest manage their own capital and will not solicit others for it.
Separate from his work at Physik Invest, founder Renato Leonard Capelj is an accredited journalist interviewing prestigious global leaders in business, government, and finance.
In his desire to learn and apply the methods of those others who are far more experienced, Capelj has a long list of interviews you may find helpful in strengthening your understanding of markets.
Capelj spoke with Simplify Asset Management’s Michael Green about cutting investors’ portfolio volatility while amplifying profit potential.
In response to uncertainty, Green says investors can park cash in short-term near-risk-free bonds yielding 5% or more, as well as allocate some capital to volatility “to introduce a degree of convexity,” risking only the premium paid. Alternatively, investors can take a more optimistic long view and position in innovations like artificial intelligence or next-generation energy production.
Capelj spoke with The Ambrus Group’s Kris Sidial about his market perspectives.
Naive measures like the VVIX, which is the volatility of the VIX or the volatility of the S&P 500’s volatility, are printing at levels last seen in 2017, Sidial explains, noting this would suggest “we can get cheap exposure to convexity while a lot of people are worried.”
“Even if inflation continues, the rate at which it rises won’t be the same. Due to this, CTA exposures likely will not perform as well as they did in 2022, and that’s why you may see more opportunities in the volatility space.”
Capelj spoke with Damped Spring Advisors’ Andy Constan about what investors should focus on and how he creates trades that lose him less money.
Constan’s trades are constructed around two- to four-month time horizons and are structured long and short using defined-risk options trades like debit or credit spreads, depending on whether volatility is cheap or expensive.
“I want deltas and leverage. My macro indicators give me an edge on price and in the worst case, the loss is limited to 10%, if everything has to go against me all at once. I can be 100% invested and only risk 10%.”
Capelj spoke with 42 Macro’s Darius Dale about his Wall Street story and perspectives on life and markets.
“We’re tracking at an above-potential level of output in terms of the growth rate of output. We’re also slowing and the pace of that deceleration is likely to pick up steam in the coming quarters.”
By 2023, that process is likely to “catalyze pressure on asset markets through the lens of corporate earnings and valuations you assign to a lower level of growth.”
Floor traders, according to Reznicek, had low capital requirements. As a result, they could put on strategies like the 1×2 ratio — a debit spread with an extra short option — for a low cost.
(See parts 1, 2, and 3 of ShadowTrader’s how-to series on ratio spreads.)
“On the floor, it is either go big or go home,” he chuckled, remarking that ratio spreads were the way of the casino. “You either get rich or they take your house. So, why would you put on any other spread?”
The next big turning point was Jim Dalton, who’s been a member of the Chicago Board of Trade, as well as a member of the Chicago Board Options Exchange (CBOE) and senior executive vice president of the CBOE during its formative years.
“I’m still in touch with him on a regular basis and I consider him a friend,” Reznicek said in a discussion on Dalton’s works like Mind Over Markets and Markets in Profile, as well as his use of WindoTrader Market Profile software. “I went to Chicago twice to see him teach live … and I came home from those seminars with five, six, 10 pages of notes. The nuances of profile continue to mold me.”
Capelj spoke with Kai Volatility Advisors’ Cem Karsan about the implications of record valuations and the growth of derivatives markets on policy, the economy, and financial markets.
“It’s not a coincidence that the mid-February to mid-March 2020 downturn literally started the day after February expiration and ended the day of March quarterly expiration. These derivatives are incredibly embedded in how the tail reacts and there’s not enough liquidity, given the leverage, if the Fed were to taper.”
Capelj spoke with The Ambrus Group’s Kris Sidial to understand how to capitalize on volatility dislocations.
Unlike standard tail-risk funds which systematically buy equity puts, Ambrus’ approach is bespoke, cutting down on negative dynamics like decay with respect to time.
Given dislocations across single stock skew, term structure, and volatility risk premium, Ambrus will position itself in options with less time to maturity, buying protection up to six weeks out.
“The market will underestimate the distribution,” Sidial said in a conversation on Ambrus’ internal models that spot positional imbalances to determine who is off-sides and in what single asset. “We’re buying things that have happened before and we’re looking for it to carry a heavier beta when the sell-off happens.”
So, by analyzing flow, as well as using internal models to assess the probabilities of deleveraging in a risk-off event, Ambrus is able to venture into individual stocks where there may be excess fragility; “I know if stock XYZ goes down five percent, it’s going to go down 10% because this fund needs to deleverage.”
To aid the cost to carry, Ambrus utilizes defined-risk, short-volatility, absolute return strategies.
“I’m basically giving you a free put on the market – with a ton of convexity – with something that offers a payout that’s just more than a regular put,” Sidial summarized. “If the market doesn’t do anything, and we do an amazing job, we’re flat and you made money on all your long-only equity exposure.”
Capelj spoke with The Ambrus Group’s Kris Sidial about the meme stock debacle of 2021.
“You have distressed debt hedge funds that focus on shorting these types of companies. Melvin Capital is the one that is singled out due to the media, but they aren’t the only ones.”
Market participants added to the crash-up dynamics. Retail investors aggressively bought stock and short-term call options, while institutional investors further took advantage of the momentum and dislocations.
“You have this dynamic in the derivatives market where there is a gamma squeeze when people are buying way far out-of-the-money calls, and dealers reflexively have to hedge off their risk,” Sidial said.
“It causes a cascading reaction, moving the stock price up because dealers are short calls and they have to buy stock when the delta moves a specific way.”
The participation in the stock on the institutional side has not received much attention, he said.
“We’ve noticed that some of the flow is more institutional,” he said in reference to activity on the level two and three order books, which are electronic lists of buy and sell orders for a particular security.
“You have certain prop guys and other hedge funds that understand what’s going on, and they’re trying to take advantage of it, as well.”
This institutional activity disrupted traditional correlations and caused shares of distressed debt assets like GameStop, BlackBerry Ltd, and AMC Entertainment Holdings Inc to trade in-line with each other.
“This was not some WallStreetBet user, … if you look at how some of these things were moving premarket, you would see GME drop like 2%, BB’s best bid would drop and AMC’s best bid would drop. That’s an algo.”
The takeaway: although the WallStreetBets crowd is getting most of the blame, institutions are also at fault for the volatility.
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Graphic updated 6:30 AM ET. Sentiment Neutral if expected /MES open is inside of the prior day’s range. /MES levels are derived from the profile graphic at the bottom of this letter. Click here for the latest levels. SqueezeMetrics Dark Pool Index (DIX) and Gamma (GEX) with the latter calculated based on where the prior day’s reading falls with respect to the MAX and MIN of all occurrences available. A higher DIX is bullish. The lower the GEX, the more (expected) volatility. Click to learn the implications of volatility, direction, and moneyness. Breadth reflects a reading of the prior day’s NYSE Advance/Decline indicator. The CBOE VIX Volatility Index (INDEX: VVIX) reflects the attractiveness of owning volatility. UMBS prices via MND. Click here for the economic calendar.
Administrative
A long(er) letter, today. Through the end-of-this week, newsletters may be shorter due to the letter writer’s commitments. Take care!
Fundamental
Yesterday’s letter focused on the SVB Financial Group (NASDAQ: SIVB) failure, albeit with an optimistic tone. In short, the bank could not make good on fast accelerating withdrawals. Read more here.
According to one TechCrunch article, the likes of Founders Fund “reportedly advised their portfolio companies … to withdraw their money, … [and], if everybody is telling each other that SVB is in trouble, that will be a challenge,” as it was.
Graphic: Retrieved from @Citrini7. In the worst-case scenario, it was likely that uninsured depositors at SIVB would have received $0.80 on each dollar barring a bailout.
Authorities later put forth emergency measures guaranteeing all deposits. The effort shored up confidence in the banking system and markets strengthened, though some regional names such as First Republic Bank (NYSE: FRC) continued trading weak. In FRC’s case, the Federal Reserve’s (Fed) new bailout facility does not help. As former Fed trader Joseph Wang explains, “you need Treasuries and Agency MBS to tap the facility, and [FRC] barely owns any.”
Anyways, as yesterday’s letter briefly mentioned, expectations on the path of Fed Funds shifted. Traders put the terminal/peak rate at 5.00-5.25%, down from 5.50-5.75%, while pricing cuts after spring. Previously, no cuts were expected in 2023.
Graphic: Retrieved from CME Group Inc’s (NASDAQ: CME) FedWatch Tool.
Measures of US Treasury yield volatility implied by options (i.e., bets or hedges on or against market movement) adjusted higher, accordingly. This is often a harbinger of equity market volatility.
Graphic: Merrill Lynch Option Volatility Estimate retrieved from TradingView
Call options on the three-month Secured Overnight Financing Rate (FUTURE: SOFR) future (i.e., bets on interest rates falling in the future) paid handsomely.
For instance, bull call spreads that expire in December 2023 (e.g., BUY +1 VERTICAL /SR3Z23:XCME 1/2500 DEC 23 /SR3Z23:XCME 96/97 CALL @.0375) increased in value by about 650.00% to $0.33 (i.e., $750.00 per contract).
Graphic: Retrieved via TradingView. Three-month SOFR Future (December 2023). When SOFR is at a lower (higher) number, the market is pricing an increase (decrease) in interest rates. Participants put the December 2023 SOFR rate at 100-96.145 = 3.855%.
In the equity space, some readers may have caught some commentary on spot-vol beta in the VIX complex strengthening like we have not seen in a while, a nod to the harbinger of equity market volatility remark a few paragraphs higher.
Recommended Readings:
Read: The Ambrus Group’s Kris Sidial on two major risks investors should watch out for in 2023. In short, volatility’s sensitivity to underlying prices (spot-vol beta) was low, and Sidial cast blame, in part, on commodity trading advisors and strong volatility supply.
Read: Simplify Asset Management’s Michael Green on using option and bond overlays to hedge big uncertainties facing markets. Following 2022, investors swapped poor-performing long-dated volatility exposures for ones with bounded risk and less time to expiry, hence the increase in 0 DTE trading.
Graphic: Retrieved from Piper Sandler’s (NYSE: PIPR) Danny Kirsch.
This spot-vol beta remark suggests that (at least some of) the volatility in rates, as well as certain small pockets of the equity and crypto market, manifested demand for crash protection in the S&P 500, “which feeds back into VIX,” one explanation put well.
Graphic: Retrieved from Piper Sandler’s (NYSE: PIPR) Danny Kirsch. “[Last] week finally got a bit of explosiveness in VIX as fixed strike volatility got bid. This is VIX generic front month future and move in SPX. Last time it really “paid” to have VIX upside was Jan of 2022 (point in upper left corner).”
Notwithstanding, for these options to keep their value and continue to perform well, realized volatility (RVOL) must pick up substantially, which is not likely.
Unlimited’s Bob Elliott comments: “the bond market is pricing a broad-based credit crunch, … [and though] it’s not crazy for the Fed to slow down here given the current uncertainty,” odds are financial problems are contained and the Fed moves forward with its mission to get (and keep) inflation down.
Graphic: Retrieved from Fabian Wintersberger. Just as the “monetary expansion supported the rise in equity and bond prices in January.”
Consequently, “the pricing of Dec23s and 5yr BEIs makes no sense,” Elliott adds. This means the example SOFR trade above is/was ripe for some monetization, and equity volatility must be dealt with carefully (i.e., price movements must be higher than they are now which would be difficult given that authorities/Fed do not want liquidations).
In support of siding with the less extreme take, we paraphrase Kai Volatility’s Cem Karsan who says that for years prior to the 2007-2008 turmoil, macro tourists were calling for a crash.
For markets to crumble, there would have to be an exogenous event far greater in implications than what just transpired with SIVB over the weekend. With odds that such turmoil doesn’t happen soon, coupled with participants easing up on their long-equity exposure (i.e., selling stock and not needing to hedge, hence the statement that owning equity volatility must be dealt with carefully), RVOL is likely to stay contained. That’s not to say that this volatility observed in the rates market can’t persist. It’s also not to say that markets can’t continue to trade lower (in fact, with interest rates rising and processes like quantitative tightening challenging bank liquidity, there is less incentive for investors to reside in lower-yielding equities). It just means that, barring some exogenous event, the market remains intact.
Graphic: Retrieved from Jack Farley. “Silicon Valley Bank owns >$80 Billion of Mortgage-Backed Securities (MBS), a market that is ‘more prone to bouts of volatility’ because ‘small investors & leveraged funds have become the main buyers’ as the Fed & banks step away from market, according to Dec 2022 BIS report.”
Positioning
Following important events like the release of the Consumer Price Index (CPI) today, the compression of implied volatility or IVOL, coupled with the nearing of big options expirations (OpEx), sets the market up for potential short bursts of strength heading into the end of the month and next month.
Graphic: Retrieved from Bloomberg. Inflation has been well within forecasts.
A quick comparison of the Russell 2000 (INDEX: RUT) and Nasdaq 100 (INDEX: NDX) suggests this options-induced strength may help keep the recent re-grossing theme intact. The compression of wound IVOL and passage of OpEx, coupled with the still-live re-grossing theme, may put a floor under equities.
Graphic: Retrieved from TradingView. Orange = RUT. Candles = NDX. Note the weakness in RUT. Note the strength of the Nasdaq relative to the Russell.
To play, one could place a portion of their cash in money market funds or T-bill ETFs or box spreads, for instance, while allocating another portion to leverage potential by way of some call options structures that use one or more short options to help bring down the cost of a long option that is closer to current market prices (e.g., a bull call spread or short ratio call spread). To note, based on options prices as of this writing, it may be too early to enter call structures (i.e., too expensive given the context).
DEFINED OUTCOME INVESTING
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As of 6:30 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 balanced overnight inventory, inside of the prior day’s range, suggesting a limited potential for immediate directional opportunity.
The S&P 500 pivot for today is $3,904.25.
Key levels to the upside include $3,921.75, $3,945.00, and $3,970.75.
Key levels to the downside include $3,884.75, $3,868.25, and $3,847.25.
Disclaimer: Click here to load the updated key levels via the web-based TradingView platform. New links are produced daily. Quoted levels likely hold barring an exogenous development.
Graphic: 65-minute profile chart of the Micro E-mini S&P 500 Futures.
Definitions
Volume Areas: Markets will build on areas of high-volume (HVNodes). Should the market trend for a period of time, this will be identified by a low-volume area (LVNodes). The LVNodes denote directional conviction and ought to offer support on any test.
If participants auction and find acceptance in an area of a prior LVNode, then future discovery ought to be volatile and quick as participants look to the nearest HVNodes for more favorable entry or exit.
POCs: Areas where two-sided trade was most prevalent in a prior day session. Participants will respond to future 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
The author, Renato Leonard Capelj, spends the bulk of his time at Physik Invest, an entity through which he invests and publishes free daily analyses to thousands of subscribers. The analyses offer him and his subscribers a way to stay on the right side of the market.
You may view this letter’s content calendar at this link.
Disclaimer
Do not construe this newsletter as advice. All content is for informational purposes. Capelj and Physik Invest manage their own capital and will not solicit others for it.
Physik Invest’s Daily Brief is read by thousands of subscribers. You, too, can join this community to learn about the fundamental and technical drivers of markets.
Graphic updated 8:20 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. 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. The CBOE VIX Volatility Index (INDEX: VVIX) reflects the attractiveness of owning volatility.
Positioning
The Federal Reserve’s (Fed) decision to increase its benchmark interest rate by 25 basis points kicked off a bout of strength, boosted by the compression of wound implied volatility (IVOL). This volatility compression we observed with a shift lower in the IV term structure in the S&P 500 (INDEX: SPX). Follow-on strength surfaced on Thursday and, based on an analysis of top-line IVOL measures such as the Cboe Volatility Index (INDEX: VIX) trending higher with the SPX, it was, in part, from traders’ demands for call options, hence high call option volumes.
Graphic: Retrieved from Bloomberg via Danny Kirsch on 2/2/2023.
Recall our detailed letter published prior to February 2, 2023 (e.g., February 1, 2023, January 26, 2023, and beyond). The context was set for the SPX and VIX to trend higher; traders bidding up call options due to their fear of missing out, in the context of less liquidity to absorb those demands, would be beneficial to owners of structures like call option butterflies and ratio spreads. Additionally, owning such structures would help dampen the impact of potential SPX downside on portfolios.
For instance, on January 25, 2023, this letter said trades structured in the indexes such as the Nasdaq 100 (INDEX: NDX), where there was a steeper skew that would enable us to collect more credit in the options we are short, thereby lowering the cost of the spread we own, looked attractive, given the likelihood that the index would stay strong after the earnings reports of some big movers like Tesla Inc (NASDAQ: TSLA).
In yesterday’s letter update, we said that such trades were working spectacularly. In fact, your letter writer’s trading partner, who “initiated some +1 x -2 (17 FEB 23 13500/14000) [NDX] call ratio spreads for free (i.e., $0.00 debit or better to enter),” saw his spreads price in excess of a $40.00 credit to close, yesterday. That structure went from a $0 debit to open to a $4,000.00 credit to close. Again, nice job Justin. I’m expecting that case study, soon!
The NDX was probably the best place to be, yesterday, looking at the magnitude of movement in some of the heavyweights in the SPX, yesterday.
Noteworthy is that many of the strongest performers (e.g., Google, Amazon, Apple) weakened considerably in the after-market when their earnings, and the speeches associated, pointed to some challenges ahead.
Breadth was, generally, not that strong, to add. This validates your letter writer’s belief the market is in a precarious position. Notwithstanding the market’s potential to stay strong into the mid-February timeframe as some strategists believe, the data seems to suggest that “whenever there are two million or more call contracts that exchange hands on the Cboe, future 5- and 10-day returns tend toward being negative (about -1.37% and -2.12% respectively),” SpotGamma said.
SpotGamma added: “This is, in part, because the bullish hedging impact of short-dated call options activity is not long-lasting. Also, IV compressing from a relatively low starting point also does little to bolster long-lasting rallies.”
As further validation for the precariousness the market is in, “[t]he most prominent feature of the 0DTE landscape is actually customer-bought calls way out at $4,200.00 (which would ramp up buying from dealer long-gamma if SPX were to rise to ~$4,170.00.” Per SpotGamma, should “traders’ interest build at or slightly above current SPX prices, then dealers’ hedging may actually result in range suppression or pressure” as time passes and volatility falls. That’s because if a long call option’s probability of finishing in the money at expiration falls, the dealer’s risk falls as well and, so, the dealer can sell some of their hedges. This is market pressure.
As this letter stated, yesterday, knowing that longer-dated SPX IVOL “is cheap, now attractive trades include selling rich call verticals to finance put verticals.”
Per Joseph Wang, the “increasing probability of a second bout of inflation, an issue in the 1970s that the Fed is keen to avoid … [by] retighten[ing] financial conditions … through its balance sheet,” the flow of capital out of capital markets presents more pressure on the financial economy (not necessarily the real economy). Cheap put protection may help hedge the realization of further macro-type market pressure.
As of 8:15 AM ET, Friday’s regular session (9:30 AM – 4:00 PM ET), in the S&P 500, is likely to open in the upper part of a negatively skewed overnight inventory, inside of the prior range, suggesting a limited potential for immediate directional opportunity.
The S&P 500 pivot for today is $4,165.75.
Key levels to the upside include $4,189.00, $4,202.75, and $4,214.25.
Key levels to the downside include $4,153.25, $4,136.75, and $4,122.50.
Disclaimer: Click here to load the updated key levels via the web-based TradingView platform. New links are produced daily. Quoted levels hold weight barring an exogenous development.
Graphic: 65-minute profile chart of the Micro E-mini S&P 500 Futures.
Definitions
Volume Areas: Markets will build on areas of high-volume (HVNodes). Should the market trend for a period of time, this will be identified by a low-volume area (LVNodes). The LVNodes denote directional conviction and ought to offer support on any test.
If participants auction and find acceptance in an area of a prior LVNode, then future discovery ought to be volatile and quick as participants look to the nearest HVNodes for more favorable entry or exit.
POCs: Areas where two-sided trade was most prevalent in a prior day session. Participants will respond to future tests of value as they offer favorable entry and exit.
About
In short, Renato Leonard Capelj is 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 thousands of subscribers. You, too, can join this community to learn about the fundamental and technical drivers of markets.
Graphic updated 7:30 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 this letter. Click here for the latest levels. SqueezeMetrics Dark Pool Index (DIX) and Gamma (GEX) with the latter calculated based on where the prior day’s reading falls with respect to the MAX and MIN of all occurrences available. A higher DIX is bullish. 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. The CBOE VIX Volatility Index (INDEX: VVIX) reflects the attractiveness of owning volatility.
Positioning
The Federal Reserve (Fed) upped its benchmark interest rate by 25 basis points. This puts the target rate range between 4.5% and 4.75%.
The Fed’s Jerome Powell signaled that toughness on inflation will last; though the “disinflation process has started,” and markets are pricing about 50 basis points of cuts by year-end, Powell said rates will continue to increase at least a couple more times. He said rates may reach as high as 5.25% to cut “inflation to 2% over time.”
Markets rallied sharply when Powell began talking. Some suggest his not “overly combative” responses were a reason. Looking back to the Daily Brief for February 1, 2023, we said that in spite of “toughness from the Fed,” markets would likely trend sideways to higher as traders would “not be able to justify the pricing of the ultra-short-dated options they demanded heading into Wednesday.”
Consequently, the supply and expiry of short-dated options coincided with dealers, who were short-stock against the puts they supplied, buying back their hedges. Kai Volatility’s Cem Karsan put this well in a media appearance pre-Fed.
He said that “vol structurally affects how markets move” and that put options, which traders own and dealers are short (and hedging with short stock, as well), would likely go down in value as the “event vol” falls; “those vanna and charm effects will naturally lead to a buyback.”
Graphic: Retrieved from SqueezeMetrics. Click to learn the implications of volatility, direction, and moneyness.
For context, vanna is the change in an options delta with respect to changes in IVOL. Charm is the change in an options delta with respect to changes in time. These are second-order derivatives of an option’s value, once to time or IVOL, and once to delta.
The positive market response, however, should not overly excite. Rather, the market is in a precarious position, and the compression of volatility, given its low starting point, probably does little to encourage a long-lasting rally.
Graphic: Small spread between realized (RVOL) and implied (IVOL) volatility. Retrieved from Bloomberg via CME Group Inc (NASDAQ: CME) analysis.
Trades this letter put forth (e.g., call butterflies and ratio spreads) that would benefit from a sharp move higher while limiting the downside, in products like the Nasdaq 100 (INDEX: NDX), are working spectacularly. In fact, while your letter writer was traveling, his trading partner initiated some +1 x -2 (17 FEB 23 13500/14000) call ratio spreads for free (i.e., $0.00 debit or better to enter), and those spreads are now pricing over $6.00 credit to close. That’s $600.00. Nice job, Justin!
Anyways, though markets could continue trending higher, the risks for a move lower, particularly after mid-February, are increasing some say. Additionally, though we keep our technical analysis usually limited to volume and market profiles, there are a few anchored volume-weighted average price levels sticking out just above current prices.
For context, VWAPs are metrics highly regarded by chief investment officers, among other participants, for the quality of trade. Additionally, liquidity algorithms are benchmarked and programmed to buy and sell around VWAPs.
Knowing that longer-dated S&P 500 (INDEX: SPX) implied volatility (IVOL) is cheap, now attractive trades include selling rich call verticals to finance put verticals.
As an aside, there are a number of reasons for calls pricing the way they do. Some of them include the opportunity cost of forgone interest (i.e., buy a call and invest the outlay difference in an interest-bearing account), as well as a fear of missing out in the context of a lower liquidity environment and less supply to absorb demand for hedging (hence higher lows in the VIX).
Graphic: Retrieved from Morgan Stanley (NYSE: MS).
Technical
As of 7:30 AM ET, Thursday’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 the prior range, suggesting a limited potential for immediate directional opportunity.
The S&P 500 pivot for today is $4,153.25.
Key levels to the upside include $4,165.75, $4,189.25, and $4,202.75.
Key levels to the downside include $4,136.75, $4,122.50, and $4,100.25.
Disclaimer: Click here to load the updated key levels via the web-based TradingView platform. New links are produced daily. Quoted levels hold weight barring an exogenous development.
Graphic: 65-minute profile chart of the Micro E-mini S&P 500 Futures.
Definitions
Volume Areas: Markets will build on areas of high-volume (HVNodes). Should the market trend for a period of time, this will be identified by a low-volume area (LVNodes). The LVNodes denote directional conviction and ought to offer support on any test.
If participants auction and find acceptance in an area of a prior LVNode, then future discovery ought to be volatile and quick as participants look to the nearest HVNodes for more favorable entry or exit.
About
In short, Renato Leonard Capelj is 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 thousands of subscribers. You, too, can join this community to learn about the fundamental and technical drivers of markets.
Graphic updated 8:00 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. 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. The CBOE VIX Volatility Index (INDEX: VVIX) reflects the attractiveness of owning volatility.
Positioning
Markets think the Federal Reserve (Fed) raises its benchmark rate by 25 basis points. Notwithstanding the less aggressive hike, strategists believe the Fed will stay tougher on inflation for far longer and, accordingly, crush traders’ optimism.
“I suspect the Fed messaging tomorrow will push back against the pivot narrative and thereby current bond market pricing,” DoubleLine Capital CIO Jeffrey Gundlach said. Former investment banker and trader, as well as the president of the Minneapolis Fed, Neel Kashkari warned the Fed is set on finishing the job and cutting inflation, even if it costs millions of Americans their jobs. “I’ve spent enough time around Wall Street to know that they are culturally, institutionally, optimistic,” he said.
Further, relief in markets (e.g., stocks, housing) is a boon for asset owners and may enable companies to raise cash, bid up equipment prices, and demand new hires.
Graphic: Retrieved from Mortgage News Daily. “A trend of [increasing] purchase applications implies home buyer demand is [increasing].” The prevailing narrative is that the Fed wants less inflation and less demand. This narrative’s been disrupted, in part. Recall our Monday letter talking about investors’ desire to put their cash to work and the demand for treasuries (i.e., bond bid and yield pressured) which forced investors into previously depressed assets.
With inflation still a problem, regardless of whether there are better solutions as we put forth in the January 31 letter, the Fed is looking to keep rates above 5% for the rest of 2023, though markets are pricing a pivot far earlier and at a lower rate.
Despite the expectation of toughness from the Fed, markets have not broken down. Rather, if we zoom out, they are trending sideways to higher and may continue to do so. That’s according to Kai Volatility’s Cem Karsan who says that implied volatility (IVOL) is heightened across options with very little time to expiry (1- to 3-days).
“Event vol, which is the pricing of one-, two-, and three-day options, is significantly higher than everything else behind it right now,” he said, noting that customers’ or traders’ demands for downside put protection is the culprit. That said, despite the committee’s recent hawkishness, “the market responded relatively well at those levels, and you’re seeing vol come back down.”
Graphic: Retrieved from TradingView. First included in SpotGamma’s PM Note for 1/31/2023. During Tuesday’s strength, measures of IVOL, such as the Cboe Volatility Index (INDEX: VIX) fell, though the VIX did not move lower in as sharp of a fashion that the S&P 500 (INDEX: SPX) traded higher. In fact, the VIX trended up into the close, after a mid-day bottom, suggesting some left-over hedging demands ahead of some important macroeconomic drivers this week.
“I think that’s kind of likely what you’re going to see, regardless of what the Fed does,” Karsan added. That’s because, barring some unexpected development, traders will not be able to justify the pricing of ultra-short-dated options post-Fed; the supply and expiry of short-dated options will coincide with the dealers or market makers who are short-stock against the puts they supplied buying back their hedges.
“Vol structurally affects how markets move. Puts are the way people hedge in the market and dealers are short the puts. If you have an event vol that comes down, those vanna and charm effects will naturally lead to a buyback,” post-Fed.
For context, vanna is the change in an options delta with respect to changes in IVOL. Charm is the change in an options delta with respect to changes in time. These are second-order derivatives of an option’s value, once to time or IVOL, and once to delta.
You might have heard the old #trading adage "never short a dull market", Cem Karsan @jam_croissant explains how some second order Greeks, vanna & charm, play a role in proving out that phrase. #Vol411pic.twitter.com/AMnd7kQQdA
As your letter writer explained in a SpotGamma analysis yesterday, we saw an interest to hedge heading into this week’s Fed announcement. This coincided with a slight rebound in measures like the Cboe VIX Volatility (INDEX: VVIX) (which, in general, reads low and suggests convexity is a good place to be), and put a damper on the rally, hence its climax on Friday.
Moreover, if “macroeconomic events do not disappoint, IVOL compression may provide markets a boost,” SpotGamma explained. “Notwithstanding, the marginal compression of heightened IVOL, because of its lower starting point, probably does less to encourage a longer-lasting rally,” hence the thought that, if there was to be relief post-Fed, it would likely last up until the mid-February monthly options expiration (OpEx). OpEx’s removal of traders’ options protection (as well as dealers’ supportive buyback to those options that were demanded), may leave the market at risk of bearish macro-type flows.
Compounding the risk is traders’ expected reaction in case of weakness. The desire to hedge during a drop would coincide with a re-pricing in IVOL dangerous to anyone who is short volatility, hence this letter’s recent focus on owning the S&P 500 (INDEX: SPX) via call butterflies and call ratio spreads, the sorts of trades that would benefit from an SPX and VIX up environment (the result of traders bidding up call options due to their fear of missing out, in the context of less liquidity to absorb those demands).
To summarize everything, we have the Fed rate decision coming up. After, markets will be volatile but more likely to trend higher into mid-February, bolstered by traders’ fears of missing out in the context of a lower liquidity environment, as well as stimulus (e.g., falling Treasury General Account played into an easing of financial conditions by making it easier for banks to lend and finance trading activities). After mid-February, the window for markets to weaken and accelerate to the downside may open, based on the information we have today.
As an aside, the last time the Nasdaq 100 (INDEX: NDX) was up more than 10% in January was in 2001, The Market Ear informed subscribers yesterday.
Graphic: Retrieved from BNP Paribas ADR (OTC: BNPQY) via The Market Ear.
Should you wish to hedge, longer-dated SPX IVOL is cheap, relative to recent history.
Graphic: Retrieved from Bank of America Corporation (NYSE: BAC) via The Market Ear.
Finally, if you’re interested in following further along the fundamental conversation in Tuesday’s letter, check out Dr. Pippa Malmgren’s post on “ancient empires springing back to life.”
Technical
As of 8:00 AM ET, Wednesday’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 negatively skewed overnight inventory, inside of the prior range, suggesting a limited potential for immediate directional opportunity.
The S&P 500 pivot for today is $4,087.00.
Key levels to the upside include $4,100.25, $4,122.50, and $4,136.75.
Key levels to the downside include $4,071.50, $4,055.00, and $4,028.75.
Disclaimer: Click here to load the updated key levels via the web-based TradingView platform. New links are produced daily. Quoted levels hold weight barring an exogenous development.
Graphic: 65-minute profile chart of the Micro E-mini S&P 500 Futures.
Definitions
Volume Areas: Markets will build on areas of high-volume (HVNodes). Should the market trend for a period of time, this will be identified by a low-volume area (LVNodes). The LVNodes denote directional conviction and ought to offer support on any test.
If participants auction and find acceptance in an area of a prior LVNode, then future discovery ought to be volatile and quick as participants look to the nearest HVNodes for more favorable entry or exit.
POCs: Areas where two-sided trade was most prevalent in a prior day session. Participants will respond to future tests of value as they offer favorable entry and exit.
About
In short, Renato Leonard Capelj is 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.
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Graphic updated 8:00 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 this letter. Click here for the latest levels. SqueezeMetrics Dark Pool Index (DIX) and Gamma (GEX) with the latter calculated based on where the prior day’s reading falls with respect to the MAX and MIN of all occurrences available. A higher DIX is bullish. 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. The CBOE VIX Volatility Index (INDEX: VVIX) reflects the attractiveness of owning volatility.
Positioning
It’s a dynamic this letter has discussed before. Levels quoted in the bottom section of this letter have proved useful in recent trade, marking the bottom and top of rallies precisely. A factor to blame is short-term participation. Let’s explain this further.
Graphic: 65-minute profile chart of the Micro E-mini S&P 500 Futures.
For instance, as SpotGamma said this morning, volumes at options strikes, very close to levels this letter quotes, are very large relative to the open interest changes. These volumes are large enough to add to the movement and result in responses to certain areas, but their impact is not long-lasting. In fact, some suggest the activity is part of “trading for risk positioning” and the impact “can net out” over a longer time horizon.
It is this letter writer’s opinion that the noise is easy to get swept into. Rather, we are interested in participating in the bigger strides, hence the trades we’ve quoted prior.
As your letter writer elaborated in a recent note for SpotGamma, following weakness heading into the January monthly options expiration (OpEx), the window was open for relief. A cross above big inflections like the 200-day simple moving average, a trigger for some to buy stocks, coupled with measures like the Cboe Volatility Index (INDEX: VIX) trending higher, partly the result of the fear of missing out and hedging in a lower liquidity environment, had us leaning optimistic.
Notwithstanding, with measures like the Cboe VIX Volatility (INDEX: VVIX) “at low levels and rebounding” implying “(1) traders are looking to hedge for cheap and (2) convexity remains a good place to be”, we had the interest to limit downside via call structures with long and short options. The short options help us harvest a bit of call skew and lower the cost of the spread, helping it retain “value better through time.”
In short, though “the marginal positivity of further IV compression likely does little to keep stocks on an upward trajectory”, SpotGamma explained, structures we explained recently may enable you to get on the right side of an SPX and VIX up environment (explained by SpotGamma), all the while limiting downside on the eventual turn.
If you’re averse to directional risk, consider trades like the Box Spreads we talked about many letters back, which are now gaining popularity.
Technical
As of 8:00 AM ET, Thursday’s regular session (9:30 AM – 4:00 PM ET), in the S&P 500, is likely to open in the upper part of a positively skewed overnight inventory, outside of prior-range and -value, suggesting a potential for immediate directional opportunity.
Our S&P 500 pivot for today is $4,050.25.
Key levels to the upside include $4,061.75, $4,071.50, and $4,083.75.
Key levels to the downside include $4,028.75, $4,011.75, and $3,998.25.
Click here to load updated 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.
About
In short, Renato Leonard Capelj is 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.
