Posted by: Michael Williams on Wednesday, July 20, 2016

The Dow Jones and S&P 500 indices broke their resistance levels over a week ago and continue to rocket higher. There hasn’t been any news or economic data to support such a move, actually the last 3-6 months have seen rather stagnant data. The only major jolt to the market recently was the run-up, sell-off, and bounce from the BREXIT hysteria – which was really more optics, driven by mainstream media supporting the statist view. Suffice to say, so far it is a nonevent in the short-term and when BREXIT does occur, it will take months if not years before the real economic trends are seen. Additionally, the UK needs to decide how it wants to position itself – unfortunately that will be driven by more ideological concerns than economic or monetary.

VIX Warning

Touching base with a few colleagues in the financial markets, there is a general opinion that the market is getting a little ahead of itself. Looking at the contraction of short-interest during the rally, it would stand to reason that the rally has been fueled (in some cases significantly), by short covering. Recently I have been working on a model to determine the approximate percentage of a move based on margin calls (both up and down). I am of the camp, like a few of my colleagues, that at this point – after the extend break-out rally, it is better to lock in some gains and flatten out any hard delta exposure. In essence, be thankful what was handed to you (regardless of reason) and reassess the situation. The concerning factor has been the VIX which has plummeted on the recent rally, reflecting complacency and a seemingly lack of concern. The 13-14 range has been recent support in the VIX and I would argue, with the potential volatility in the market (BREXIT, terrorist activity, elections, earnings, etc.) that below 14 is getting rather complacent. My judgement the volatility should be fairly priced in the 15-16 range. However, the recent crack below 13 as the market broke through resistance is sending off alarm bells in my head. We dropped below 12 yesterday and if this market gets squeezed higher, we could see it hit 11 or 10. Single digit VIX is akin to DEFCON 1. No doubt there is a math component that drives volatility, irrespective of market conditions. That is simply if “true range” remains a constant, as the underlying increases price, volatility decreases. The reverse is also true. Of course this impacts statistical or historical volatility, not implied. However, implied attempts to (in some cases) – move towards statistical volatility, rightly or wrongly I might add. It is important to note WHY statistical volatility is changing, whether it is a factor of true range contracting or expanding vs. the price changes in the underlying, before ever comparing it to implied. VIX at these levels and if the theme translates to implied volatilities of individual issues, then now is certainly the time to lock in gains by hedging positions on a 1:1 basis. Those that want to take advantage of any pull back can increase their hedge beyond 1:1. Premium is just getting very cheap, relative to my forecast potential volatility. The VIX is always wrong at extremes, whether too high or too low. We have pierced the realistic barrier of low volatility this week, breaking below 13. The leitmotif is to buy cheap insurance and the VIX below 13 is telling you insurance is getting very cheap.
Strategies I am a lover of any type of FLY strategy, probably one of the best risk/reward strategies in all of finance. The problem is allocating the sweet spot and determining the width of that sweet spot. I have frequently heard that low implied volatility conditions is no place for shorting premium (or gamma), while certainly true - it doesn't necessarily apply to FLYS. There is more than one way to brew coffee (note: I prefer espresso). With implied so low, it is possible to just get net long OTM contracts. Then on any move down in the market, you have both Delta and Vega working for you (implied will increase for sure), you can sell a 2:1 ratio and complete a FLY – perhaps even for a credit. I was never one to believe in just sending condors and flies down to the exchanges to be filled at one price. Not only are you showing your hand, but the trade is done and there remains no more opportunity. In any event, now is a very low cost time to “leg into” positions. Of course one needs to pay attention to time-to-expiration, as it will directly impact your VEGA. While I wouldn’t consider monitoring VANNA using spreads to leg into positions, it is worth monitoring if you are going to use a naked long position, followed by a 2:1 ratio. As VANNA will help determine the Delta/Vega rate of change based on your expectations of implied volatility increase. Skew will also work in your favor if you are correct. Of course you don’t have to leg into the fly on a pull back and rise in implied volatility, you can do numerous things based on ones assessment. Here are few examples of what to do with that long OTM put on the pull back. 1. Convert to synthetic call (if bullish) – if there are dividends, this would be a huge advantage. 2. Convert into synthetic straddle – this can be ratioed to lean more bullish or bearish. 3. Convert into 2 flies – sell half the 2:1 ratios below the strike and the other half above the strike. 4. Convert into condor 5. Convert into butterfly Actually the possibilities are endless. The most important thing is to be able to build out the strategy based on your resulting sentiment.

Support & Resistance

INDU 18,500 We are seeing a little stall in here. I think a pull back to 18,400 and if we get a rout we could see as low as 18,000 before support kicks in. The upside is an unknown and it will depend on any more short-squeezes vs. market appetite. SPX 2160 Much like the Dow Jones, the S&P 500 is stalling a little in here and a short-term pull back could be in the cards. However, there is certainly upside room – based on what – perhaps earnings, beyond that, who knows. NDX 4600 The tech heavy index rocketed from 4200 to 4600 and there was some huge short-covering for a couple of days. The short-covering has subsided, which we are seeing in a slowdown in momentum. However, there is still room to run. RUT 1200 Unlike the Dow Jones and the S&P500 this index never made it to its previous 1295 high. It is also seeing more struggle after the run and starting to flatten. The Russell is a great index to watch, because it doesn’t have a smattering of over-weights that can drive precipitous rallies or cliff dropping sell-offs. Suffice to say, it is far harder to generate a gaping broad market rally or sell-off, even with margin calls. I think it is pointing to a small short-term pull back. VIX 12 We broke down below 13 and are in the 12 range. This morning we could see 11 and on a strong rally even 10. The VIX might as well say that insurance is over-rated, because no one is interested in buying it during this rally.
Conclusion Earnings have been general good, but the top-line sales/revenue on year-over-year has been weak. It’s one thing to beat expectations, but I would always rather see beating year-over-year actual numbers. The buy-backs (reducing floats), cost cutting, and other profit margin expanders continue. The major banks beat expectations, but their top-line numbers were not good at all (on a year-over-year and/or growth basis). The RNC convention has been tame compared to the mainstream media expectations. While I enjoy a good circus, it is been anything but. Seems like someone has pulled in the reigns on Trump and it seems to be a non-factor in the market. The DNC convention will most likely be a non-factor too, however the Bernie Supporters are pouring in and setting up camp. I have read about a supposed “FART-IN” at the convention, to show how they think the DNC stinks! It seems far more likely that the DNC convention will become the circus this year. courtesy of wikipedia Other than earnings, there is not much on the horizon that should impact markets directly. The Fed is sitting in the shadows and probably happy the media has other matters to focus on, like whether Melina Trump stole parts of Michelle’s speech – oh my! Seriously, no rate hikes are coming any time soon, certainly NOT before the election. The Aussie Dollar is selling off against the dollar, as investors expect the Reserve Bank of Australia (RBA) will cut rates. If they don’t we could see a rally in the Aussie. The silliness in the equation is the ardent belief the US Fed will be raising rates in the near-term. These currency markets can and will drive market volatility. Wish these central banks would stop playing in the free market sand box and give us a break.


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I especially agree with that last line.
Posted by: McRocket on July 22, 2016 at 3:41:41 pm