31 May 2013 - Trade and view updates

A very quick wrap-up on performance of trades from my previous post. I'll follow up this weekend with a longer post regarding views and thoughts.

I exited S&P at 1680, believing we were in for a correction. This duly occurred - initially spurred by Bernanke's Congress testimony.

Nikkei, which I had exited at 14800 anticipating a sharp correction, actually continued to steamroll up to almost 16000 before an extremely volatile week of trading has left it around the 13400 mark currently.

The 19th Jun 1.28 EURUSD puts have been fairly profitable so far as I have been able to trade the gamma on them, however I am still hoping for a break of 1.28 before expiry to counteract the theta I'm going to end up paying on them.

Hang-Seng/ASX continues to profit, peaking at a ratio of 4.6 (currently 4.57) up from entry ratio of 4.15. I see no reason why this trend should halt here, though it's worth noting that 4.6 has been roughly the average ratio since 2009.

Gold has been a manic ride. It certainly hasn't got anywhere near my initial targets as it continues to exhibit inverse correlation with stocks. I exited my position at 1380 via trailing stop, and until we resume the upward climb in stocks I'm reluctant to re-short this.

USDJPY looks like I called it to a tee, selling the 104 calls and having it reach a peak of 103.60ish before tumbling 3 figures. Unfortunately, I had put in a stop at 1.0350 which I then left on by accident as USDJPY fell, thus cutting the profits of the trade significantly. Lesson learned no. 1: don't bother hedging before the strike for short term options unless you have changed your fundamental view. Lesson learned no. 2: put a stop loss on your stop loss.

14 May 2013 - Trade and view updates

It's been a little while since my last post. Here's an update on my positions, and new ones I've put on since.

First, long SPX and long Nikkei which have both worked a treat. The underlying rationale for SPX was the strength of American economic figures as well as the P/E analysis I performed earlier this year which suggested a 'fair' value for SPX was around 2.1k. As I said at the time, even if that reading was ambitious, I much preferred being long at current valuations - and continue to hold the position. I exited my Nikkei long at around 14800 though as I felt the market was overdue for a correction - so far I'm wrong about this.

Second, short EURUSD via Jun 19 1.28 puts. This has worked thanks to broad USD strength and not EUR specific weakness which I expected post-ECB. I will continue to hold this position as I think it complements long SPX, especially as a guard against Euro tail risk (which the market seems to currently be pricing as non-existent - OATS and BTPs prime examples).

Third, long Hang Seng vs short ASX has worked quite well. I entered the position at a ratio of 4.29 and it is currently at 4.41. The ratio has been as high as 4.5 recently, but the collapse in AUDUSD seems to be propping up ASX, relatively speaking. I continue to hold this position.

As for new trades, I am now short gold. With stock markets providing such headline-grabbing numbers I expect demand for gold to slump, though Asian retail is always a bit of a wild card. The trend of USD strength and Fed tightening fears also add some tailwind to the short in my opinion. Entry at 1442, stop loss 1500, target 1300.

Finally, after being long USDJPY for a long time I exited at 101.75. It is now trading around 102.40, and I've just sold some 2 week 104 calls for 50 pips. I like being short delta here for macro and market action reasons. On the macro side, with the Nikkei producing exceptional returns and stalwarts like Sony and Toyota reporting well, I expect stronger inflows of capital into Japan both from foreign investors and especially as domestic investors repatriate their money. On the market action side, there is a large hedge fund long presence in USDJPY. At some point these funds will start unwinding their positions (and game theoretically, it is optimal they do this sooner rather than later if they are aware of their competitors' positions) which could lead to a fairly sharp reversal. USDJPY options are also priced at high vols of around 13 in the 2 week, so I prefer selling calls to buying puts. Putting myself in a position of uncapped losses against a rising knife is definitely a highly risky proposition, so anyone looking to replicate this should have a solid exit plan in mind and be very aware of how much of their capital they are willing to maximally risk.

8 May 2013 - Trading Updates

So it seems the DAX Straddle trade was hedged out for a small loss (pretty much flat, really).

Sold 3/4 at 7930
Sold 1/4 at 8000
Average Selling Price = 7947.5

Long DAX 7800 Straddles @ 155.9 so this equates to a loss of 155.9 - 147.5 = 8.4 points.

I guess this didn't work out too well as I expected the market to be disappointed (this was my base case) and as a result, I hedged too early.

As for the gold miners trade I have on:

Short 1656 GDX @ $30.19 (Closed today at $30.44 / +0.83%) - P/L of -$414
Short 234 DUST @ $85.47 (Closed today at $80 / -6.40%) - P/L of $1280
Net P/L of $866 (position sized for a $100,000 trading account)

Borrowing costs were 9% and 1% on DUST and GDX respectively which (with just mental calculations) seems like it totals up to ~$50 for the week. The difference in daily changes exemplifies daily decay working in our favor. If DUST did not rebalance daily, we would expect a change of 0.83% * -3 = -2.50% instead of -6.40% (assuming both ETFs track the same underlying index, which may cause some slight deviations).

Note though that this isn't without risk though. When the market moves strongly in one direction without chopping about, expect huge losses and exposures to rack up for this strategy.

2 May 2013 - EUR puts

Picked up some 19th Jun 1.28 EUR puts for 38 pips after the ECB rate came out. The market's moved nicely in my direction since then but regardless of the short term action I like the trade as I think EUR continues to come under carry-based selling pressure over the month ahead.

On that theme I'm considering ideas such as shorting EUR vs AUD and TRY and other high yielders.

2 May 2013 - DAX Straddle Update

Will be hedging the rest of this  position which is pretty much delta 1 now at above 8000.

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.

29 July - Panic but therein Lies Opportunity

So with this morning's rout and VXX hitting fresh highs, I decided to square up the remainder of my calls.

As the naked calls purchased early this week expire today, I'm finding it difficult to replace it with more outright calls as IVs have gone way through the roof. Moreover, I see a strong potential for significant mean reversion in VIX futures on any positive news. With that in mind, I will likely purchase the $25/$28 call spread for about $0.75 expiring 5 August to hedge my position on the upside over the next week. 

In addition, VXX option premiums have gone crazy, with the 19 August $25 straddles going for about $4.75. This is way too high in my opinion and presents a compelling opportunity. With a breakeven close to $30 on the upside, I'm pretty content as I don't see VXX rocketing another 20% higher, unless of course the US defaults (a downgrade is pretty much priced in by now). Even if such a scenario were to materialize, I don't think think VXX will end up much higher taking into consideration VIX spot and future levels. Now on the downside, $20 does seem to me like a more probable target. However, considering I am short VXX as my core position, I am happy to take this risk. Furthermore, I intend to hedge this position by going short on more spot if a successful agreement is reached, although VXX would probably have gapped quite abit lower by then. Also, IVs are likely to die down as spot VXX moves lower.

Finally, I do still think an agreement will be reached but am now more pessimistic that it'll be completed over the weekend. Perhaps an eleventh hour deal on Monday?

27 July - Finally, Some Realized Vol

Within the first hour of trading, the VIX is up 10%, the August and September futures are up between 4 and 5% and the S&P is down over 1.3%. I believe today's sharp spike is due to the complacency I observed on Monday and Tuesday (more so Monday as volatility futures had begun a sizable move yesterday). Such complacency is often followed by panic and this often causes the market to overreact.

Although I've sold some VXX against my calls as VXX rose this morning and throughout yesterday, I still have half the calls with no offsetting position and am carrying quite a bit of positive delta. Now comes the hard bit - what should I do now?

I would normally be tempted to sell more VXX. However, given that such a move has occurred on Wednesday, I fear that if no deal is done, we'd see similar moves over the next two days. Thus, there may still be some upside in VXX and definitely a lot of downside in the S&P (as the rise in VXX has by far outpaced the decline in S&P).

With the way things are playing out, I believe it will take them at least the weekend to come to an agreement.

26 July - No Resolution Yet

In light of the comments I made yesterday, the S&P is still holding up modestly, though the VIX and its futures have begun to price in a worst case scenario.

I am going to begin scaling into a short VXX position against my VXX calls as these are way past their breakeven if you bought them early yesterday. Remember that in the end, I do believe a deal gets done, though I think it is an equity sell-off is in the cards this week before both sides resolve the situation.

Another thing which looks attractive to me is a short S&P/short VXX pairs trade as the spread has widened quite a bit. However, it is imperative that this is exacted using an appropriate ratio.I will probably be doing so over the next few days if these oversized VXX moves (relative to the S&P) continue.

25 July - Some Thoughts

The S&P 500 is looking pretty resilient this morning despite the weekend's failed debt-ceiling talks and overnight downgrades. VIX futures have not reacted as much as I feel they should have.

Although I believe a deal will ultimately get done as it is in both their best interests, I feel that equities and the VIX are showing a bit of complacency. As I already have a modest short position in volatility, I will use this morning's strength to get some of the weekly ATM VXX calls.

I still like the short VXX trade at this point in time but I feel we might see some panic and selling of risky assets later on in the week if a deal has not been made yet. If such a scenario emerges, I will then look to unwind my calls or sell some spot against my calls.

22 July - Typical Friday Trading

The morning session of London trading has been very quiet so far, with estoxx sticking to a 12 point range. Bunds are marginally down on the day and peripheral spreads over Germany continue to come in sharply from yesterday - 10 year Italy and Spain are 10 bps tigher, and Greece is 200 tighter (still 3000+ to go though!). Currencies are holding a tight range with the exception of AUD and NZD which are strongly bid . . . note that they stayed fairly stationary while EUR and EURCHF were rallying last night, so this may be a catchup of sorts. FX vols are tanking dramatically across EUR pairs, 1Y EURCHF some 1.5 vols lower than pre-leak yesterday.

My view on the leaked meetings from yesterday is that the announced measures are enough to provide a sustained 6 months of relief from Euro crisis tensions, similar to the reaction post-June 2010 Greece and post-November 2010 Ireland. Keeping this in mind I think there's value in entering a long Eurostoxx position vs a short S&P500 position, via Sep futures. Estoxx is trading around 2800 where it was 3000+ only 3 months ago, whereas S&P is brushing up against its pre-2008 highs . . . I also expect this trade to be fairly well hedged and probably outperform in the tail-risk scenario of no agreement being reached on the US debt ceiling.

Charts and ratios to follow.