30 April 2013 - DAX Straddle Update

Missed the highs of 7960 this morning on the DAX but would probably scalp some gamma here at 7930. The straddles are showing me a delta of (87 - 13) = 74 here so would probably sell this entire amount of DAX and be delta neutral. Sitting on a pretty nice profit ATM as these straddles are almost at the breakeven and we still have FOMC tomorrow and the big ECB disappointment/surprise on Thursday.

29 April 2013 - Daily Thoughts

First things first - the GBPUSD short did not pan out as GDP beat expectations. Fortunately I had shorted at a good level with a tight stop (my standard on most binary events), and in only half size, the trade hasn't cost me much.

USDJPY has bounced right off the 100 barrier and down a couple of figures to trade as low as 97.34 today. At these levels I'm intrigued by selling puts around the 95 strike - for example, the 19th June 95 put is sellable for 66 pips, putting a breakeven at 94.34. I can't see USDJPY erasing all the gains made since the Kuroda-bomb.

In other events global equities are performing strongly today - probably over the news of formation of a coalition government in Italy. We have a stacked week of data ahead of us: Fed, ECB, and NFP 3 days in a row. It's gonna be a bumpy ride!

25 April 2013 - The End of Austerity?

So lately the European equity markets have been acting strange. Bad data? Quick dump followed by a fierce rally. Does this sound familiar to you?

Yep, at one point this market action happened in the US - when the market was hoping for QE3.

We've had bad figures from Germany and the rest of Europe for weeks now but the market has shrugged it off and has bounced (since the Cyprus fiasco). What this tells me is that there must be a lot of expectations baked into next week's ECB decision on Thursday.

DAX 7800 Straddles (at time of writing) are offered for 155.90 points for the May 3 expiry. You could probably even get them for 154 points if you fired orders in slightly better than mids. These are vols of about 16.5 according the Interactive Broker's inbuilt calculator and equates to a breakeven of +/- 2% of spot.

Here's a chart of the DAX with the straddle's breakevens marked. I like this trade as further ECB measures could drive the DAX back to its highs of the year. If the ECB disappoints, and with high expectations priced in, I could also quite easily see the DAX dive back to its lows.

Furthermore, in the coming week, comments from various finance ministers, central bankers and so on will be closely watched by the markets and could possibly provide some gamma scalping opportunities to "cheapen" the straddle before Thursday.

Let's track this trade:
Long DAX 7800 Straddles @ 155.90

Note that it doesn't include NFP as the straddle expires at 7 am New York time.

 

25 April 2013 - An Interesting Observation and a Trade Idea

So what you see here is a chart of a Copper ETF vs. the S&P 500. It is interesting to note that copper, which is generally known for being a economic barometer has recently broken down, even while the S&P has reached new highs. The last time copper was around these prices (might not be exact because this is an ETF rather than spot copper or copper futures), the S&P 500 was sitting at 1064.88, a whopping 30% below current levels.

I'm not really sure what to make of this, apart from the fact that this exemplifies China fears (this would make sense as iron ore too has seen better days). As for trades around this, not too sure right now - perhaps plays on companies who use copper as an input?

As for actionable trade ideas, what I'm liking right now is being short DUST (a 3X daily leveraged inverse gold miners ETF) vs being short the GDX (gold miners ETF). This trade should pay off given the large two-way movements in gold miners we have seen and are seeing which causes massive decay to occur in DUST due to it's daily rebalance. When GDX goes down, DUST increases in size - thus "buying low", and when GDX goes up, DUST decreases in size - thus "selling high". The risk to this trade is that gold miners start trending in one direction, which could cause the DUST leg to either become far too large, or far too small.

Another downside to this trade is borrowing costs which can be up to 10% p.a. on DUST and a few percent on GDX.

This is a long term trade, and requires appropriate position sizing (the DUST leg should be a small percentage of your capital). It should also be rebalanced/closed entirely when large moves occur (though we want this to be very loose, hence the small percentage of your capital).

This is what it looks like when things go bad and big moves occur in short periods of time. You would have made 43% * 3 = 126% on your GDX leg, but would have lost 255% on the DUST leg. Note that only unidirectional moves cause big problems. What we want are big daily moves, but no trend.

In the long run, this trade makes bank. 50% * 3 = 150% profit on the GDX leg, and 109% loss on the DUST leg. Not bad, considering the trade has gone terribly in the last six months.

As I think lower gold prices have already been baked into gold miners, since they had started a rapid decline from November 2012, I would even be tempted to take a small long bias (by shorting more DUST) than I should. In summary, this trade could go very wrong - but the risk/reward is compelling in my opinion. Let's track this.

Assumes a $100,000 account:

Short 1656 GDX @ $30.19 = -$49,995

Short 234 DUST @ 85.47 = -$20,000 (this equates to an exposure of $20,000 * -3 = $60,000 due to the inverse leverage factor)

The difference of roughly $10,000 in net exposure is due to my small long bias.

24 April 2013 - A final observation for the day

So the market appears geared up for a rate cut from the ECB next week and European bond yields have been hammered of late. French 10 year now yields just 1.75%. That's low, especially when stacked next to the US rate of 1.70%.

With French economic projections being lowered seemingly every other day, and the US base rate being lower than the European base rate even if the ECB cuts 25bps next week, this spread certainly looks very enticing.

24 April 2013 - Defending barriers, and why banks do it

Continuing on from the previous post where I mention USDJPY behaving as if a bank is strongly defending a barrier at 100, I hope to clarify what this means for those who may not know a great deal about barrier options.

Supposing a bank has sold a 'One-Touch 100' option worth 20mio USD to a customer who believes 100 will be broken before a certain date. This means exactly what it says on the tin - the customer will receive an instant payout of 20mio USD should 100 break. From the bank's perspective, then, they have a strong incentive to avoid 100 being touched. Traders and management at the bank may decide the risk-reward of putting in a large offer around 9980 is attractive.

Let's say they put up an offer in size of 500mio at 9980. That is probably large enough to withstand all but a concerted effort by other banks or funds to break the barrier, since algorithms and other traders will often show offers more readily below 9980 knowing that there is a large offer behind them. How much is the bank risking? If they get lifted, the price will very likely gap - but in a liquid market like USDJPY, they should be able to get most of their money back by a big figure at most. Let's assume the worst case scenario occurs and they lose 1 figure on 500mio - that's a $5mio USD loss. The flipside is when they successfully defend, they get the full payout of $20mio. At a 4:1 payout ratio for worst vs best case, and with the worst case in all eventuality having less than a 20% probability of occurring if executed correctly, you can see why it makes sense for the bank to defend vigorously.

In reality banks rarely have such outsize 'pin risk' on their books completely unhedged, but the pace at which USDJPY has appreciated in the last month certainly makes it possible that some banks have been caught off guard. In my opinion, the option probably expires by the end of this week, for two reasons. One, the longer you try to defend a barrier the greater the risk of failure, so it's unlikely the life remaining is very long anyway. Secondly, Golden Week -  a series of Japanese national holidays - starts next week and most customers will avoid paying for an option that includes these much quieter days. The week before Golden Week begins seems like a natural time to set as the end of an option.

24 April 2013 - Daily Thoughts

An update on my positions in the Nikkei and USDJPY. Both have performed very well this week. I have now taken profit on the Nikkei as I think there'll be a bit of consolidation here below the 14000 level and since the move from 13000 has essentially been a straight line up. I will be looking to reenter around 13550 for a move to 15000 which was my original long-term target.

USDJPY has exhibited very interesting price action over the last couple of days. It's got to within 11 pips of breaking the psychological 100 mark, but keeps getting rebuffed around 9980. From my observations and past experience this suggests there is a large barrier (and perhaps more than one) at 100 which is being protected by a bank or fund. For those who are confused about exactly what this entails, I'll talk about this a bit in the next post. In any case, I am still long with the targets of 100.50 or end of trading Friday remaining unchanged.

I have initiated a short of GBPUSD ahead of tomorrow's preliminary GDP data. I have sized this to half my typical position size since I'm not very convicted. Cable has been pretty much rangebound over the last week. Still, I think the r/r behooves me to put some money on the table.

24 April 2013 - Hang Seng vs ASX Spread Trade

I've been looking at a spread trade between two stock indices lately: long Hang Seng vs short the Australian ASX 200.

There are a few reasons to like this trade. Over the past year, Chinese stocks have underperformed global stock indices, while Australia has kept pace. Year-to-date, the ASX is up 6.8% while the HSI is down 2.7%; since this time last year, those numbers read +13.7% and +4.9% respectively.

On a macro level, with the global downturn in commodities I expect upcoming Australian economic numbers to suffer - and feel that China slowdown fears are overdone (it is still by some distance the fastest growing large economy in the world).

A look at the HSI to ASX ratio as a time series below suggests this to be a good entry point for a mean reversion play. The current ratio is around 4.3 where the mean is about 4.7.

In general also the ratio trade performs well when both stocks are at high levels - the current value (marked in red below) is quite an outlier.

There are a few ways to put on this trade. Perhaps the simplest way is via volatility balanced (roughly 4:1) sizes in a spread-betting account, to avoid currency effects. Stop-loss the ratio at 4.15, the lowest point of the last 3 years, and target a return to 5.0.

Note: Another good reason to be bearish the ASX follows from my analysis of P/E vs sovereign yields earlier this week. The P/E ratio for the ASX is 21, higher even than the S&P 500 - despite 10yr yields in Australia being roughly double that of those in the US (by contrast, the P/E for the Hang Seng currently is 11).

21 April 2013 - A better look at P/E for indices

You'll often hear people talk about P/E ratios for an index being far above or below their mean, with the implied suggestion that it is misvalued. I was thinking about this concept over the weekend and found the argument unsatisfying: in particular, I felt that a rational investor cannot look at P/E ratios in isolation but must consider other potential sources of return when allocating his capital.

The most natural asset to compare P/E with are sovereign bonds, as a liquid, often held investment and as a useful 'risk-free' measure (for a given value of risk-free, of course).

My hypothesis is that a rational market should eventually bring P/E 'yield' in line with sovereign yield, with a risk-adjusted premium. Simply put, if AAPL is going to return your capital in 10 years whereas treasuries are going to take 50 years, in the absence of a market or AAPL meltdown I would expect money managers to plump for AAPL.

Below is a chart of 10Y treasury yield vs the historical P/E of the S&P 500 Index from Jan 1970 to Dec 2007, along with a non-linear line of best fit. As can be seen there is indeed a significant relationship between yield and P/E, as my hypothesis predicts.

The relationship however gets particularly interesting when we add in the data post 2008.

The data points in the red oval are from late 2008 and 2009 when the SPX plummeted. An interpretation of the fact they stayed so high for so long was that - despite the speed of the crash - it still wasn't fast enough to match the wipeout in earnings during that period.

Since the crash, the SPX has recovered nicely and is currently near its pre-2008 highs. The period from 2010 to present is highlighted in the green oval above. As we can see, despite the fact that the P/E for the index is above its long term mean, it is still undervalued relative to its historical relationship with treasury yields.

There are of course a variety of explanations for why this may be the case. Lingering fears over the situation in Europe, the US fiscal deficit, stubbornly high unemployment and a permanent reduction in growth potential of the Western world (in the face of competition from China and other EM) are the most obvious. However, all of the above have occurred in the last 40 years at some point or other, and the relationship has held. It is my view that SPX will return closer to its predicted P/E ratio.

That ratio, utilising the equation from the graph with all current data, is about 25 - compared to a current reading of 18. In other words, SPX has a potential upside of roughly 40% from here. Even if that is too ambitious a reading, I prefer being long SPX than short at these valuations.

Note: The equation of best fit for both differ in form, but choosing an exponential form for the first graph would result in nearly the same R^2.

19 April 13 - Daily Thoughts

The major action-driver earlier this week - gold - has stabilised over the last few trading sessions leaving the market concentrating mostly on earnings season in the US with a relative paucity of data out this week.

I continue to hold longs in USDJPY and the Nikkei Index, the former entered at 9675 and latter at 13250. I expect to take off USDJPY above 100 or prior to Golden Week, whichever comes sooner. My position in Nikkei is a longer term trade and I am ultimately targeting a move to 15000, though I will be watching closely for signs of overextension given the rally since November.

I am also closely watching GBP with intention to short, likely vs the USD or AUD. British economic data released this week continued to paint a depressing picture of the economy, and the MPC/government seem out of ideas to halt the decline.