Something strange is happening in the market right now

In the past few days, the S&P 500 (SPX) has risen to all-time highs. I mean, that’s strange given our current economic back drop. But that’s not what I’m talking about.

What’s strange about the current state of the market?

While the SPX is at all-time highs, the volatility indices have been rising as well. These indices include VIX, VVIX, and VXX.

If you don’t know what these are, that’s okay. VIX is an index that tracks the implied volatility of the SPX based off how the options for that index are priced. It is what the one month expected move in the market is, in a sense. VVIX is an index that tracks the implied volatility of VIX based off how the options on VIX are priced. VXX is an index that tracks the volatility based off the weighted balance of the first two VX futures contracts which trade.

For now, let’s focus on VIX. On August 25^th, VIX closed at 22. As of today’s close on August 31^st, it is 26.4. In percentage terms, VIX was up today 15%. (Many people don’t like quoting VIX changes in percentage terms — I don’t care).

In 3 of the past 4 days, we have seen VIX close higher than where it opened. This has happened all while the SPX has hit all-time highs in each of the past four days.

VVIX — also known as the volatility of volatility — has shown a similar trend to VIX, rising in 3 of the past 4 days. VXX — which is based off the front two months of futures contracts on VIX futures — has also steadily risen and shown similar trends.

Realized volatility is far below implied volatility options are pricing in

The volatility that is implied by SPX options is much higher than the realized volatility we’ve seen in the past 30 days. According to my calculations, realized volatility for the past month has been under 10%. Meanwhile, VIX has held strong above 22, and has continued to climb in recent days as noted above.

Why is this strange to me?

In general, you tend to see VIX fall as SPX rises. In general, there is an inverse relationship between these two items.

Today, VIX rose by 15% while SPX fell by roughly 0.3%. According to my data, this has only happened 5 times going back to 1993.

Note: The above chart is in percentage terms.

I’m not the only one that has noticed

Mark Sebastian, from OptionPit.com and frequent guest on The Options Insider Radio noted the following:

What he is saying here is that there is a huge difference between the volatility being priced the NASDAQ 100 Volatility Index — VXN — and the S&P 500 Volatility Index — VIX. This is interesting to me because the NASDAQ 100 is composed of non-financial companies and is weighted heavily towards those tech stocks. The very tech stocks which have been going parabolic in recent weeks (some may even say months).

In addition, Matt Thompson noted the following:

The 5-day average contango, which is merely the difference in the implied volatility priced in by the front month futures contract and the second month futures contract is at 16.9%, which was at the 99^th percentile since 2004. Also he noted what I noted earlier, that the VIX is much higher than the realized volatility on SPX.

What does this all mean?

This could mean a number of things. Ultimately it means there is a lot of uncertainty in the market, and options are pricing in more volatility than the volatility that we’ve witnessed in the last month.

This could mean that big money is hedging their positions with put options on SPX or call options on VIX or buying VX futures, all of which could cause the premiums paid to rise.

In addition, the VX futures for October are pricing in extra volatility due to the upcoming election. The pricing of these October futures remains elevated when compared to the September and November VX futures prices.

Investors are nervous about what could come in the next month or two. And they have good reason to be.

There is still no agreement on extended economic stimulus that the American people desperately need. Republicans and Democrats have still not agreed to a deal. As of the last update I saw, Republicans proposed a $1.3 trillion stimulus, which was rejected by Democrats. The House, led by Democrats, passed a $3 trillion stimulus back in May. They said they would be willing to lower their demands to $2.2 trillion. No deal is in sight, and that could have investors spooked.

Fact is, we are in a bubble

The last time market closed at all-time highs with VIX this elevated was during the late 90s tech boom. That was a time period which also coincided with easy Federal Reserve monetary policy and high speculation in stocks.

We are seeing similar behavior in the tech stocks and work-from-home stocks today. Apple, Amazon, Google, Facebook, Tesla, Nvidia, Zoom, and AMD are all examples of stocks which are booming right now.

But the pain for the American people is far from over. Continuing claims continue to remain above 14 million. The unemployment rate is over 10%. The economy is attempting to recover slowly. But stocks? They’ve ripped to all-time highs at a much more rapid rate. And the disconnect between those two has investors nervous right now.

Dark pools are not buying this rally anymore either

In order to understand what’s happening, check out the Dark Pools. According to the Dark Pool Index over at Squeezemetrics.com, Dark Pools have printed under 45% for 17 days in a row. In general, a print over 45% is considered to be bullish, and there tends to be a slight lag between dark pool prints and stock market returns.

This is meaningful to me because Dark Pools bought the rally all through April well into July. But they aren’t buying anymore.

Perhaps we will begin to see a return of selling to the market in the coming days or weeks. I know I’m on high alert for that right now and will be ready to short this market when the opportunity presents itself.

This week was rough for me

I got my ass kicked this week by the market.

It started early in the week, when I bought WORK and SPCE call options, just before the market reversed course on Monday and sold off in the final hours of the day. Because the SPCE options expired on Friday of the same week, I had no choice to cut this loser. Only to see it rip higher Thursday and Friday.

I started the week in a hole, down $1,100.

I spent the rest of the week trying to climb out of the hole, only to make the situation worse. End result, down $4,000 on the week.

How did this happen?

Getting in a hole sucks. Spending the rest of the time trying to climb out of the hole led me to making sloppy trades, overtrading, and putting on trades that I wouldn’t normally make on SPY and IWM that I told myself were “hedges” in case the market sold again.

I forgot what was working.

I forgot how I made $12,000 in a matter of weeks from May 27th to June 19th.

Nothing seemed to work.

Every trade went against me as soon as I entered it. Or so I thought.

Either way, it doesn’t matter what they did.

What did matter was my mindset sucked. I was in a bad mental state, and desperately tried to “undo” my bad trades from the early part of the week, only to have even more bad trades to “undo”.

I wasn’t doing what works for me.

I started trading options expiring this week. I started day trading more even though I very much prefer swing trading a position for 1-2 weeks.

I cut winners too soon (primarily due to short-dated options being traded).

I let losers run on too long.

I added to losing positions.

I put on positions that were not favorable from the get go.

I spent too much time this week hoping for my positions to go in my favor.

Now is a time for reflection

It’s the weekend. My trading week sucked. But I still live to trade another day.

Goal #1 and always: DON’T LOSE ALL YOUR MONEY. When the money is gone, the game is over.

I’m going to take this weekend to reflect on my trades. I will review past trades further and understand what happened and why it happened. I will try to understand what my mental state was when I entered into those trades.

Trading is hard. It’s hard to tell by all the so-called experts all over social media. They’d have you believe they make profits all day. You rarely see is the hard part of trading. The part where it beats the shit out of you and makes you question why you started in the first place.

I share this for anyone else who had a bad day, week, month, or year. It’s not easy. It’s not supposed to be easy. I knew that. You know that. So take time to reflect, take care of yourself, and objectively review those trades and improve the process. It’s the only thing I know how to do.

I’m sorry for anybody shorting this market

This is a difficult market to get a read on, that’s for sure.

Shorting the market right now is a fool’s errand. Whether you believe liquidity from the Fed is driving the market higher or not doesn’t matter.

The market wants to go higher. That’s where the path of least resistance continues to be at the moment.

Selloffs are very few and far between. You have to be tactical and quick with any shorts in this market. They can payoff, as they did for me on Thursday and part of Friday. But they stop working very quickly.

We are all waiting for the next big selloff. It may come. It may not. For that reason you have to be careful until we get there.

I learned my lesson last year

I got burned time after time shorting the market for the larger part of 2019.

I was focused on fundamentals, trade war headlines, and a seemingly deteriorating market.

So I shorted consistently all of last year. I came very close to blowing up actually. I was down 80% at one point.

It wasn’t until March of this year that my short positions paid of very handsomely and actually got me back to even despite the horrible 2019 year.

In recent weeks my trading has improved

I’m more focused on what VVIX and VIX are telling me in terms of volatility. If I believe these are trending higher, then I’m going to be biased to mix in long and short trades to capitalize on a move in either direction.

However, if VVIX and VIX are trending lower, them I’m biased to hold a majority of my positions long in the market, depending on what is moving on that given day. In recent weeks, I’ve been able to make good plays on the likes of XLF, GS, JPM, BA, UAL, RCL, CCL, F, TSLA, XOM, AMD, NVDA, VIAC just to name a few.

Take profits and cut losers

I like to play options that are 2-4 weeks away from their expiration date. Weekly options (5 or less days to expiration) are too risky for my style right now. I like to give my options a little breathing room.

I watch my positions like a hawk. When I begin getting down 20% I seriously have to consider cutting this position and taking a loss. Once I’m down 40% I cut it no questions asked.

I also try to take profits on 50% of the position around a 10% gain (or more if it’s there). Then I take off another 25% around a 20% gain (or more). The I leave the final 25% of my position to run to see how far it can go.

Last week I had a SPY put option that I let run, that went from $90 to $630 in a matter of days. In the past, I would have never let it go that far because I would’ve booked all of my profits too soon. But because I had already closed out 80% of the position at a gain, that last contract I was holding was essentially risk-free and I had no problems holding it for a little longer.

If you want to learn more about trading psychology, I highly recommend you check out my notes on Trading in the Zone by Mark Douglas.

Been playing lotto calls on big movers…

This market is insane. For that reason, I’ve been playing short-term call options on those names getting bid the most recently.

Banks, airlines, cruise lines, oil, casinos, retailers, are all industries I’ve dipped into and out of recently. I’ve traded it on short-term call options about 3-7 weeks out.

My main focus is to take of 1/4 of a position at 10% profits, another 2/4 position at 20-30% profits, and then let the remainder of the position run. Taking profits is critical to setting up risk-free trades.

That’s the way it has to be played right now.

It’s very very very easy to adopt a bearish mindset right now.

The market is going insane.

But I’m thinking about it like the tech bubble.

My main focus is to keep my holdings short. I never held any of my lotto positions past 2 days unless it was the 1/4 winning position remaining.

It’s much much easier to let winners run when you booked 3/4 of your position at a profit. Those runners have ended up making up my big home runs in recent days.

My best trade was UAL last Friday, which I booked at 361% profit. F also netted me 192% profit.

I cut losers at around 20-40% drawdown on these positions without any regrets. It’s worked out well so far. But that can change very quickly.

I was wrong

A few weeks back I was dumb enough to think selling would return to this ridiculous stock market.

I want to catch the next downturn. I think we all do.

Downturns provide opportunities for large profits.

Volatility events have been some of my most profitable times. The hardest part with shorting any market is being patient and strategic.

My gauge to short flashed

I have a few different metrics I monitor to gauge when are better times to short than others.

They began flashing on May 11 and 12, and sirens were going off on the 13th and 14th.

On the morning of the 14th, the market miraculously recovered. I felt like OPEX and VIX expiration would loosen up this market. Alast I was wrong. But, I ended up minimizing my losses from this due to position management.

Position sizing and profit taking

This is why position sizing and profit taking are key to succeeding in overcoming your emotions in the face of an uncertain future.

On May 12, I put on 100 SPY July 17 puts at the $110 strike for $0.03 per contract, totaling $300 (small bet).

On May 13, I took off 20 contracts at $0.06, for a total of $120. That was a 100% profit from the previous days price. Now, my cost minus proceeds received from this sale is $180 ($300-$120).

On May 14, I took off 20 more contracts at $0.10, for a total of $200. That was a 233% profit from the previous days price. Now, if I take the $180 above, and take off the $200 here, my cost minus proceeds now equals -$20 ($300-$120-$200). This means my remaining position is risk-free.

Risk-free? No way…

Yes way. I had 60 contracts left that could literally expire worthless, and I would have still made a profit on the entire trade. This is why it’s important to take profits along the way on any position you’re playing

Turned out I was wrong. But I played my signals, managed around the situation, and came out with a small profit (which actually turned into a small loss because I later added to it…).

But…I ended up with a smaller loss because I managed around an unknown future. At times in the past, I would’ve ridden the entire trade from top to bottom and loss damn near my full investment.

The return of selling in the stock market

I believe we are about to see heavy selling in the market once again.

We have seen the return of some selling, with the S&P 500 down 4.7% this week as of my writing on May 14th.

Why do I believe this?

Coming into this week, I expected a calm week with usual options expiration (OPEX) week behavior. From my observations, market makers can usually move markets and control price action more strongly some weeks than other.

Market makers can influence markets especially in times when volume is low and volatility is low. This week, the market has seen more selling than usual during OPEX week from my experience.

Not only that, but we haven’t seen the drastic moves in the S&P futures contracts overnight. Last week, it felt like every day we were seeing moves higher after a day of selling off during regular trading hours. See tweet below:

on moves 5-14-20

The last time I remember feeling like this during an OPEX week was for the trading week ended February 21, 2020 and we all remember what followed over the next month.

What are gamma levels saying?

On May 11, 2020 I noted that $2.2 bn in positive gamma was coming off books this opex Friday.

tweet 5-14-20

Now these options could have been rolled out or closed altogether. We never really know. But I expected much of this gamma exposure to be moved in a manner that would bring us closer to zero gamma.

With all the selling this week, gamma levels have now turned negative across the board according to spotgamma. This is not good if you are bullish equities right now.

spotgamme 5-14-20

While component gamma is still positive, per Squeezemetrics, and DIX signals that Dark Pools continue their buying binge, I can’t ignore headwinds that we are going to face in the next week or two.

squeeze 5-14-20

What headwinds are we faced with?

Will we see a second wave of infections?

What businesses are going to go out of business for good?

How many of the now 36 million lost jobs will actually be recovered?

What will be the recovery time of those lost jobs?

What kind of demand shocks are we in store for over the next year or two?

How far is the Fed willing to go with their monetary policies?

Will the Fed buy equities?

With all of these questions unanswered, it’s very difficult to be bullish right now.

I hate this rally, but…

I hate the current rally in the market.

Why?

Because it’s all liquidity driven.

But, this is the market that is presenting itself.

Expecting volatility to decline and the market to continue to drift higher seems to be the play right now. That’s how I see it. I don’t like it, but that’s what I feel from the price action in conjunction with the actions of the Federal Reserve.

The Fed has basically backstopped the entire credit market. It’s created some odd distortions in the market. I don’t trust that this rally is rational, but it’s happening.

A blowoff rally is a possibility at this point, in my opinion.

Why do I believe that?

The credit market is backstopped by the Fed. Interest rates are near zero. Profits need to made somewhere. The carry trade could thrive, which would mean short volatility should go well.

This would be violated when something else in the market, credit market or some other market, breaks. The cause could be inflationary, but would more likely be deflationary in nature, which could create a black hole effect.

Timestamp: originally posted on 5/4/20 at 5:47 pm. Purpose of timestamp is to help me review my opinions and see where I went right or wrong.

The rise of the carry trade

One great book I’ve been reading lately is The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis by Tim Lee, Jamie Lee, and Kevin Coldiron (Amazon affiliate link)

This book has been eye-opening to me. The authors have elegantly connected the dots between Central bank interventions, interest rates, the carry trade, bringing all of these elements together.

The concepts explained in this book made me understand why fundamental analysis seems to matter less these days and why Federal Reserve press conferences garner so much attention.

What is the carry trade?

A carry trade is a type of trade that makes money when “nothing happens” or when volatility is low (variance of price is low). This trade is similar to selling insurance, where you collect a premium in exchange for taking on downside risk of some event taking place.

A carry trade can be done in a number of ways. The term “carry trade” is a broad term that groups these different types of trades together.

What are the features of a carry trade?

The features of the carry trade include leverage, liquidity provision, short exposure to volatility, and a “sawtooth” return pattern of small steady profits punctuated by occasional large losses.

What is an example of carry trade?

One type of carry trade is a currency carry trade. In this trade, you borrow a currency that has a low interest rate, then use that money to buy another currency that pays a higher interest rate.

The goal of this trade is to profit on the difference between the interest rates.

However, one problem with this trade is that on its own, it doesn’t have high yields. The payoff for this trade is small, so to increase returns and make these investments more attractive for investors, those who do these trades employ significant leverage. Leverage on such trades could be 10 to 1, 20 to 1, sometimes even 60 to 1 leverage.

Why are carry trades popular with investors?

Carry trades generally will return steady profits for extended periods of time. This is what makes them attractive to investors. During boring times in the market with low volatility, these strategies are profitable.

What are the drawbacks to the carry trade?

When the carry trade loses money, it has the potential to lose a lot in a hurry. This massive loss potential is due to the amount of leverage used in a carry trade. Because the carry trade relies on stability in prices (low volatility), any behavior outside of “normal” behavior leads to high volatility and high losses.

In addition, carry trades have an effect of increasing liquidity as the carry trade expansion phase goes on. This leads to a carry bubble. As the carry bubble pops, the carry trade has the opposite affect on liquidity. The decrease in liquidity in the market happens because carry trades are forced to be reduced or closed altogether.

In this sense, the cycle of the carry bubble and carry crash and the economic cycle have become one in the same.

To be continued…

Good articles for more information

The World Is One Big Carry Trade – institutionalinvestor.com (intro below)

As I watched a 2,000-point sell-off in the Dow Jones Industrial Average on Thursday, March 12, I realized that Tim Lee — the founder and chief economist at piEconomics — had got it all figured out before he recently retired.

Along with co-authors Jamie Lee (no relation) and Kevin Coldiron in The Rise of Carry, he laid out his theory of how unprecedented levels — and types of — central bank intervention in financial markets over the past few decades have turned the global economy into a series of overlapping carry trades…

This article and series of articles continues to be a work-in-progress.

What is ACTUALLY going on in the repo market?

Dissecting what’s going on in the repo markets

There are two sides to every deal. The repo markets are no different.

On one side of the deal, there are banks sitting on a large supply of cash. On the other side of the deal, there are the hedge funds that are sitting on a large supply of Treasuries.

Banks lend cash to hedge funds and hedge funds place Treasuries as collateral to banks. Hedge funds are able lever up trades they make on Treasuries.

How do they do it?

One increasingly popular hedge fund strategy involves buying US Treasuries while selling equivalent derivatives contracts such as interest rate futures, and then pocketing the difference. This is an arbitrage strategy that hedge funds use that would generally yield small profits.

The trade is not profitable on its own, given the close relationship and price between the two sides of the trade. Hedge funds use leverage via the repo markets to increase returns.

In some cases, hedge funds take those Treasury securities they own, and place it as collateral in the repo market for cash. Those hedge funds then use that cash to increase the size of their trade and buy more Treasuries, and place it as collateral in repo market for cash once again. This process can be repeated over and over to leverage off the potential returns of this trade.

The arbitrage strategy above was once popular amongst dealer banks themselves. However, higher capital charges have led to their displacement by hedge funds, due to hedge funds greater ability to take on the risk of this trade.

There has been a growing clout of hedge funds in repo market, including Millennium, Citadel, and Point 42, which are very active in repo market and are also the most highly leveraged multi-strategy funds in the world.

So what really happened in September 2019 in the repo market?

This brings us to the market on September 16, 2019. The secure overnight funding rate (SOFR) more than doubled in the intraday range jumped about 700 basis points (repo rates typically fluctuate in an intraday range of 10 to 20 basis points).

The repo rate reached as high as 10% that day.

sept repo

Some have speculated that end of quarter pressures put on banks to meet those regulatory guidelines caused the repo spike.

However, you have to consider that these overnight funding Market issues arose in mid-September. Not at the end of September when you would expect banks to hoard more cash.

What happened in August and September that could have caused issues in the repo Market that rippled through hedge funds?

We turn our attention to Treasuries and their performance in August and September.

From July 31st 2019 to August 15th 2019 TLT (20+ year Treasury Bond ETF) increased almost 13%. This was following the Fed’s first-rate cut after the tightening cycle that we saw ultimately in December 2018.

tlt prices

The Fed cut the rate 25 basis points and the Treasury market responded with an outsized move on Long-Term Treasuries in anticipation more easy money Fed policies becoming a mainstay. The Fed reiterated that the rate-cut was a “mid-cycle adjustment”, but that didn’t stop Long-Term Treasury prices from surging.

From September 5th to September 13th the same Long-Term Treasury bond prices dropped 7%. This could be due to the fact that investors realized they over adjusted the price of long-term treasuries and were now adjusting prices down to reflect new expectations.

I believe much of the volatility in the overnight repo markets has to do with these large moves in Treasuries, which increased volatility in any trade related to Treasuries, which in turn would have an effect on leveraged trades made by hedge funds on Treasuries. Banks may have recognized this, and grew reluctant to provide cash funding to this market for this and other regulator reasons.

There is still a lot of research and learning I need to do on this, but these are my thoughts on the repo markets as of January 20, 2020. Please share your insights in the comments below.

Why are some banks blaming regulations on the spike in the repo market?

Back on December 31, 2018 (before our September 2019 repo blowup) the rate on “general collateral” overnight repurchase agreements (repo rate) went from from 2.56 per cent to 6.125 per cent. This was the highest repo rate observed since 2001 and was the single largest percentage jump since at least 1998.

Some (including JP Morgan Chief Jaime Dimon) believe that various regulatory measures introduced in the wake of the Lehman crisis designed to make the financial system safer ends up putting stress on banks at quarter-end and moreso at year-end.

What regulations are said to cause stress in the repo markets?

The Basel III regulatory framework, calculates a tiered capital surcharge on global systemically important banks (GSIB) and is based on factors like their geographical sprawl, complexity and absolute size.

These charges are calculated from a snapshot at the end of the year which means that the world’s biggest banks (JPMorgan Chase, Citigroup and Bank of America) are motivated to deflate the size of their overall balance sheet and trading book ahead of the end of every year, and then reflate them again afterwards.

This allows banks to essentially operate with less capital, boosting returns to shareholders in the form of stock buybacks and dividends.

Some believed that the spike in repo rates in December 2018 suggests that big banks were wary of playing their usual role in facilitating markets this year feeding the turbulence in the repo markets,

In mid-December 2018, the Basel Committee on Banking Supervision opened up a consultation on whether it should revise its quarterly assessment of balance sheets, noting that “heightened volatility in various segments of money markets and derivatives markets around key reference dates (eg quarter-end dates) has alerted the Basel Committee to potential regulatory arbitrage by banks”.

Some argued that regulators could also easily tweak the impact by calculating daily averages rather than using a snapshot, and move to a smoother sliding scale of capital ratios as opposed to the current tiered approach that encourages gaming.

Changes have not been made to these regulations however, and the repo market continues to wreak havoc on Fed policy as of January 2020.