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Setting the stage for what we will unpack further later this week. Mainly key talking points, today, coupled with a few aesthetic changes, if you have not noticed already (e.g., graphic above).
A less eventful couple of days, albeit uncertainty remains. On the geopolitical front, an easing of conflict appeared with Biden and Xi stressing their need to get ties back on track. That is adding to Russia’s withdrawal from Kherson, Ukraine.
Regarding crypto, a focus for some of last week’s letters, the happenings are awing. Allegedly FTX “transferred billions of dollars in customer assets to their trading firm Alameda,” Substack newsletter Market Sentiment had written.
As a an aside, we will soon feature a conversation with a former emerging FX and yields trader at Goldman Sachs Group Inc (NYSE: GS) who now works in DeFi. We will unpack the recent volatility, its driver, and follow-on implications.
It was allegations about the firms’ relationship, as well as allegations by competitors, that ultimately incited an implosion and bankruptcy. In short, per his posts on betting and Kelly criterion, founder Sam Bankman-Fried (SBF) showed a risk tolerance “far outside” the normal.
For more on the debacle, check out the Daily Brief published on November 10, 2022, as well as the letter published on November 9, 2022.
In our letters last week, we said the compression of implied volatility, evidenced by a shift lower in the volatility term structure, particularly at the front end where options are most sensitive, was to add to any macro-type repositioning, with follow-on buying support coming from the reach for “Deltas and leverage” to the upside (call options).
Peccatiello offers an interesting explanation: “[A]t this point of the year incentive schemes drive people to be much more willing to pay and chase upside.” Preferred are the “convex structures” that would benefit from “outsized” rallies. In traders’ monetization of put protection they owned, as well as reach for upside calls (to not miss out on a potential reversal), skew is at lows and, if the assumption is that “further tightening monetary policy and draining liquidity off the market might cause some problems down the road,” per Wintersberger, bets that pay when markets trade lower are attractive.
Adding, a big takeaway, though not discussed explicitly above (but in past letters), we’ll see a loss of structural support from hedging flows; ultimately, the very poor hedging that’s going on, heading into the next rally, is going to set the stage for a large tail. Traders, who aren’t as well hedged, will seek protection and this will pressure markets, adding to any macro-type selling.
In the coming letters, we’ll go into more detail and discuss how to structure a new trade on this information, such as the one unpacked in a recent case study of ours.
Graphic: 65-minute profile chart of the Micro E-mini S&P 500 Futures. Check out this refresher on the shape of volume profiles.
Please direct your queries to |||EMAIL_ADDRESS||| or Renato Capelj#8625 on Discord.
Do not construe the materials herein as advice. All content is for informational purposes only.
Heading into the 2022 equity market decline, institutions repositioned and hedged their downside, even allocating to commodities, which worked well for the first couple of quarters.
Due in part to this, the 2022 equity market decline was like no other experienced during 2021.
Instead, the monetization and counterparty hedging of existing customer options hedges, as well as the sale of short-dated options, particularly in some of the single names where implied volatility (IVOL) was rich, lent to lackluster performance in IVOL.
Eventually, entities were squeezed out of trades not working.
That means participants rotated out of options and commodities, all the while a macro-type re-leveraging ensued on improvements in inflation data, an earnings season that was better than expected, and “crazy tax receipts,” among other things.
The most recent advance climaxed the week of the August monthly options expiration (OPEX).
Why? Well, heading into that particular week, markets were rising at a fast rate, and call options (i.e., bets on the market upside) were highly demanded.
Those, on the other side of those call option trades (i.e., counterparties), hedged in a manner that was supportive (i.e., counterparties sell calls to customers and buy underlying to hedge exposure).
Eventually, traders’ activity in soon-to-expire options became concentrated at certain strikes – particularly $4,300.00 in the S&P 500 – while IVOL trended lower. The counterparty’s response, then, did more to support prices and reduce movement.
This is because, with the passage of time and declining volatility, options Gamma (i.e., the sensitivity of an option to direction) became more positive and the range of spot prices, across which Delta (i.e., options exposure to direction) shifts rapidly, became a lot smaller.
When options Gamma exposure is more positive, market movements may have a positive impact on the counterparty’s position (i.e., movement is beneficial). If movement is beneficial, and the counterparty is not interested in realizing that benefit, they may hedge in a manner that can stifle market movement.
This is, in part, what happened, in the late stages of the rally. That said, however, soon after the S&P 500 hit $4,300.00, the near-vertical price rise began to sputter and follow-on support, both from a fundamental (e.g., liquidity) and volatility perspective was soon set to worsen.
Why? There was an OPEX that would trigger “a big shift in market positioning,” Nomura Holdings Inc’s (NYSE: NMR) Charlie McElligott explained.
In short, participants’ failure to roll forward their expiring bets on market upside coincided with a message that the Fed would stay tough on inflation. So, it’s the case that after the OPEX, those same bets that were prompting counterparties to stem volatility and bolster equity upside were not rolled forward.
Instead, these bets expired and this is visualized by the drop in Gamma exposures, post-OPEX.
Graphic: Created by Physik Invest. Data by SqueezeMetrics.
Accordingly, this expiration, combined with technical and fundamental contexts that were prompting funds to “reload[] on short sales,” shocked the market into a higher volatility, negative Gamma environment. In this environment, put options, through which the vast majority of participants speculate on lower prices and protect their downside, solicited far more pressure from counterparties.
Adding, if markets were to continue trading lower, traders were likely to continue rotating into those put options that would bolster this pressure from counterparties.
This happened as shown, below.
This demand for put options protection was reflected by a bid in IVOL. To hedge against this demand for protection and rising IVOL, counterparties sold underlying, compounding bearish fundamental flows.
In expecting markets to trade lower and more volatile, Physik Invest sought to initiate new trades.
At the time, in mid-August, call option premiums were attractive, in part due to interest rates, all the while IVOL metrics seemingly hit a lower bound.
This was observable via a quick check of skew, a plot of the IVOL levels for options across different strike prices. Usually, skew, on the S&P 500, shows a smirk, not a smile.
Graphic: Retrieved from Cboe Global Markets Inc (BATS: CBOE). Updated August 17, 2022. Skew steepened into $3,700.00 and below $3,500.00 in the S&P 500.
This meant it was likely that short-dated, wide Put Ratio Spreads had little to lose in a sideways-to-higher market environment. Additionally, call Vertical Spreads above the market were relatively more expensive.
Given the above context, the following analysis unpacks how Physik Invest traded options tied to the S&P 500 leading up to and through the August 19 OPEX, into the Jackson Hole Economic Symposium.
Note: Click here to view all transactions for all accounts involved.
Sequence 1: After a skew smile was observed, through August 12, 2022, the following positions were initiated, while the S&P 500 was still trending higher, for a net $7,616.68 credit.
Positions were structured in a way that would potentially net higher credits had the index moved lower.
Sequence 2: While the S&P 500 was trading near $4,300.00 resistance, by 8/19/2022, all aforementioned Ratio Put Spread positions were rolled forward for a $452.26 credit.
From thereon the market declined and, by 9/1/2022, all positions were exited for a $6,963.84 credit.
Summary: In total, the sequence of trades net a $15,032.78 profit after commissions and fees.
The max loss (minus unforeseen events) sat at ~$6,790.00 if the S&P 500 closed above $4,350.00 in OCT. Because the Ratio Put Spreads were initiated at no cost, any loss, if the market went higher, would have been the result of the trade’s Vertical Spread component. Overall, this trade netted in excess of a 200% return; the trade’s profit was more than two times the initial debit risk, a multi-bagger.
Reflection: Heading into the trade, it was the case that IVOL performed poorly during much of the 2022 decline. This was likely to remain the case on a subsequent drop, hence the wide and short-dated Ratio Put Spread.
Still, in spite of the Ratio Put Spread exposing the position to negative Delta and positive Gamma (i.e., the trade makes money if the market moves lower, all else equal), if implied skew became more convex (i.e., implied volatilities grow more rapidly as strike prices decrease), the position could have been a large loss.
So, if the flatter part of the skew curve (where the position was structured) became more convex, which is not something that was anticipated would happen, then the only recourse would have been to (1) close the position or (2) sell (i.e., add static negative Delta in) futures and correlated ETFs.
In the second case, then, the trade would have been allowed time to work and turn into a potential winner, particularly amidst the passage of time.
Additionally, in accordance with Physik Invest’s risk protocol, more units of the Short Put Ratio Spread could have been initiated on the transition into Sequence 2. These units could have been held through Labor Day, then, and monetized for up to an additional ~$4.00 credit per unit.
Though additional units of the Vertical Spreads could not have been added, due to the strict limits to debit risks, there were still months left to that particular component of the trade. With lower prices expected, there was little reason the Verticals should have been removed fast.
Going forward, should the context from a fundamental and volatility perspective remain the same, only on a rally could Physik Invest potentially re-enter a similar position.
