Just because you see risks…doesn’t mean the market will price it in (yet)

I used to believe that risks to the market get priced into the market.

This is based off the efficient markets hypothesis. Once information is known it immediately gets priced into the market.

However, risks don’t always get priced in (right away) for one reason or another. Perhaps those risks are further off the horizon than believed. Perhaps those risks are going to dissipate soon. Perhaps those risks are not as significant as I believed they were.

Whatever the case may be, the market doesn’t always price in risks to the market right away.

Lesson learned

In October, I saw numerous risks to the market and strongly believed we would move down another leg lower in the S&P 500. I placed my bets accordingly, and it did not work out at all.

What risks did I see? A hiccup in the overnight repo market, beginning in mid-September. Hong Kong protests taking place every weekend, and U.S. Government officials denouncing China and supporting Hong Kong protestors. No signs of a real trade deal of significance. Slowing economic growth across the globe. A collaterialized loan market that’s looking more and more frothy.

I saw all of the risks, and here we are with the S&P 500 up 8.8% since October 8th, when the Fed made it known they would begin expanding their balance sheet with the purchase of Treasury Bills.

Markets are not efficient

Information can be priced in right away. Information can be ignored for days, weeks, months, or even years.

Risks can be priced in one week, and completely ignored the next week.

Markets are manipulated. No doubt about it.

But blaming my poor performance this month on market manipulation is irresponsible and definitely not a recipe for success.

I must learn how to trade around uncertainty and market manipulation caused by institutions and central banks across the world.

Trade the market you have, not the market you want.

Understanding the Kelly Criterion and Your Investment Decisions

According to Wikipedia:

Kelly bet is a formula for bet sizing that leads almost surely to higher wealth compared to any other strategy in the long run (i.e. the limit as the number of bets goes to infinity). The Kelly bet size is found by maximizing the expected value of the logarithm of wealth, which is equivalent to maximizing the expected geometric growth rate.

A Kelly bet is simply the optimal amount you should bet on a single trade (in my case) when you have some statistical edge (>50% chance with an even payoff) or some risk-to-reward payoff that pays off well despite low probability of success (e.g. a 30% likelihood trade that pays off 4 to 1 odds.)

Did the Federal Reserve Kill the Volatility Trade?

On October 11, 2019, the Federal Reserve announced they would begin buying Treasury Bills in an effort to ensure there are “ample reserves” in the banking system through the end of the year.

fed treasury oct 11

On October 11, 2019, the Volatility Index (VIX) sat at 17.4. Today on November 26, 2019 the VIX has recently closed at 11.5. As you can see from below, it appears as though this not-QE program that is “organically” growing the Federal Reserve’s balance sheet has effectively killed the long VIX trade.

fed vix chart

The case made that supports this idea is that investors are engaging in more risk on behavior, because they are basing their decisions based on the Federal Reserve’s prior balance sheet expansion programs (QE 1-3).

Because the Fed is purchasing T-bills, they have eased some of the money market pressures. Liquidity in the market has proven to be a positive catalyst to the market.

Why do I believe this?

It can’t be the trade deal.

That’s the only other source that has been moving the markets higher according to many daily stock market new reporters. And I don’t believe these markets are pushing higher on hopes of a trade deal.

I think the Fed’s easy money policies have once again eased tensions. For now.

A lesson to me

This whole scenario has taught me a valuable lesson about position sizing. I’ve learned to not be so overconfident in my predictions.

Every trade made is a small bet. Each bet will abide by the Kelly criterion.

Never go all in.

Grow your money slowly and strategically.

Live to trade another day.

Read

Barton_options on Twitter has been a great resource for me to learn more about the Federal Reserve operations and how it relates to the Treasury and the overall economy.

He recently wrote about this in a newsletter you can read here.

A Place for Scrap Notes and Scattered Thoughts

I will blog more often than I have in recent months.

The reason I haven’t blogged as much: I didn’t know what to do with this blog.

Until now.

I plan to use this blog as a place for scrap notes.

I plan to post thoughts and ideas that I come up with in the moment, and won’t focus so much on refining every piece of content I create.

A perfectionist fault

I try to make everything I create great. This prevents me from sharing many of my ideas as a result.

When I don’t have a fully formed, well-thought out observation, I don’t like to share it online. That’s why this blog is changing.

I want to get content out there as a means to force me to get comfortable putting content out there. It won’t always be pretty. It won’t always be polished. It won’t always be completely thought out. But it will be a place for me to document.

Every piece of content doesn’t have to be perfect all the time. This is a start.

This is what’s going to happen in the market this week

In this article, I’m going to review my past predictions and make some new ones.

On August 3rd, I wrote a post laying out what I thought would happen. Shall we take a look?

As I mentioned earlier, I expect IWM to pullback 5-7% since it broke the $153.50 support level earlier today.

IWM finished this week down 1.28%. I didn’t put a date on the 5-7% pullback, but this is something I expect to play out within the next two weeks.

This would give you a range of $144.95 all the way down to $141.90 coming into play.

At a minimum, I do believe that $145 will be retested. This is the level that IWM dropped to in May following the added tariff announcements. See IWM chart below:

iwm81019

SPY is a little trickier for me. It tends to whipsaw in price when volatility picks up, possibly due to algorithmic and HF trading. I think we see SPY revisit $285 range before the end of next week (Aug 9 expiry), but it’ll be a rocky ride.

SPY surprised me this week with the massive selloff that took place on Monday. I thought it would be a rockier ride to get down to $285, but we actually touched as low as $281.72 on Monday!

I was correct about the whipsaw though! Tuesday and Wednesday started off as days that looked like they were ripe for shorting, but the market ripped back almost 2% higher come Thursday, and 4% higher off Wednesday’s lows.

I believe that this upcoming week (August 12-19) will see SPY dropping as low as $279, retesting those levels reached around May 13 this year, in the midst of the May selloff that took place.

I’m also watching the $272 price level to get rested in the next two weeks. See SPY chart below:

I think VIX will also whipsaw next week, seeing a range with a low 14.7 and all the way up to 23.5. That’s just my guess.

This week, VIX saw a high of 24.8 and a low of 16.8. Not too bad of a prediction!

Next week I’m looking for a high of 26 on VIX and a low of 17. Keep in mind, when VIX is this high and with the current news, a much higher VIX is always possible.

I mentioned on my Twitter that I picked up some VXX call options and XLF put options to set up for whatever could happen next week.

These are a small part of my portfolio. I have positions both long and short in tickers or tickers derived from the ones mentioned above.

I’m always learning

I like the put predictions out there for the purpose of learning.

I don’t want to be seen as some prophet, because I’m not. I’m wrong a lot of the time.

My goal is to put predictions out there so that I’m accountable for them. One effective way to find out your biases is by putting things out there to be scrutinized.

Your scrutiny, insights, or questions are encouraged because I know they will help me (and probably you as well).

Cheers,

Court

Reviewing VIX from August 9, 2019

SPY was down 0.69% to $291.60 on Friday, and VIX was up 6.27% to 18.

VIX bounced off the 17 support level that I outlined in this post here. Here’s what I said Thursday even, after market close:

VIX hit the support level around 17 that I had set out in my post yesterday as a level to watch for. I think this line will continue to act as support and VIX will bounce going into close tomorrow.

The VIX level of 17 was actually laid out by me on Thursday, which can be evidenced with my TradingView chart I posted that day.

(I’m not saying this to brag. I believe it’s important for me to document every prediction and recognize why I was right or wrong. It’s the only way I’m going to develop a better intuition about market behavior.)

As you can see above, VIX did bounce above the 17 support level I laid out after dipping just below it on Thursday. VIX bounced off the support level going into the closing minutes of Friday, setting up a situation where VIX could spike again this coming Monday.

Stocks have recovered too quickly

SPY was up almost 2% today, erasing all of this weeks losses generated on Monday. Not only did SPY close the gap, but at this point we are up 36 basis points from last Friday’s close.

After a decline of nearly 7% off of its high, SPY has gained 4.2%.

We have exceeded a 50% Fibonacci retracement, and are very close to a 61.8% retracement from the all-time highs set in late-July.

Overbought conditions were reached on the RSI indicator, using 30 minute candlesticks as seen below. Peak overbought conditions were seen today around 12:30 pm.

SPY was moving sideways for a few hours later in the day, but broke higher in the final hour of the day.

In the last two days alone, from it’s bottom at the open yesterday, SPY has gained over 4%.

In my opinion, Monday was sold off too quickly and this recovery this week has also happened too quickly.

VIX hit the support level around 17 that I had set out in my post yesterday as a level to watch for. I think this line will continue to act as support and VIX will bounce going into close tomorrow.

VIX didn’t really sell off much on the 6th which surprised me. Some say that big money was picking up volatility options at this time.

If so, VIX getting sold off would make sense to me if options traders were taking profits on their trades Monday and Tuesday. The reason I think it makes sense is because when those market makers buy the puts, they are also going to have to buy the underlying stock to remain delta neutral.

I think you see adjustments from market makers impacting the markets. I also believe that today was more of a short squeeze combined with unwinding of VIX call option/SPY put option positions which jerked the market around in these past couple of days.

As those positions are done unwinding, which I think will happen in the next day or two, I think it’s likely that the market will continue to selloff and VIX will spike once again.

The risk hasn’t changed in three days

We’re still in a trade war with China.

Tariffs are still slapped on China.

China still isn’t buying US agriculture.

The yield curve is still very much inverted.

Central banks are turning to easy money policies.

Risk isn’t off right now. Have a small position in volatility and protect yourself against the turmoil.

102% Gain on Disney (DIS) Put Debit Spread

See the details below. I entered this position on June 28th because I felt like Disney was overdone. It did run up for a bit, and I was able to add to this position on July 12th. This particular option gained 213%! So much for the “don’t add to losers” rule.

My only regret is that I didn’t buy more.

stock

I do hedge all of my trades, and you should be aware of that. Here’s what the full picture looks like for DIS:

stock2

I lost $37 on call options related to Disney, which were bought as a hedge. Net, I made $208 across all Disney positions, and returned 52.3% after all hedges were taken into account.

SPY and VIX – August 7, 2019

CHART TIME

I’m watching the $2900 support level on SPY in the coming days. We saw a strong rebound off the lows set on Monday. A move above $2900 would be bullish.

I expect SPY to bounce off $2900 as it will become resistance on the next leg down. What do you think?

spy8719chart

VIX showed a lower high on the current trading day. This is usually indicative of a reversal in the price action. I’m watching the 17 support level for VIX. If we break below that level, the next support level isn’t until 14.

I’m not sure if I’m overly influenced by the news lately, but I think there is still the possibility of VIX popping higher, 50% or more from it’s current levels to it’s highs. This would bring VIX up almost to 30.

I believe that the markets are vulnerable right now, and you should be careful trading out there!

vix8719chart