Going to extremes
Published on: September 16, 2020 • Duration: 20 minutes
This week we look at whether the options activity of the retail traders will have a lasting impact on the US equity market. Some of the data points are extreme, but that doesn’t mean that the outcome will be. The volatility of volatility has been very well behaved considering the volumes that are trading. In the Chatter, we focus on the resurgence of Brexit uncertainty and the part that sterling could play in offsetting the risks. In the Whisper, we look at positioning in gold. Unlike US equity options, it’s no-where near extreme.
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[00:00:05] Was the recent pullback in the US equity markets merely a blow-offfromthe excessesthat had built up duringtheSummer’soption fueled demand for tech stocks? Or is this thebeginning of a longer downturn? What should we be looking for signs that this pullback might besomething more than just an air-pocket in an over-bought equity market? That’sThe BigConversation.
On Monday, US equities were rebounding again.Was the sell-off over the last weekthe beginningof a protracted reversalor just a breather on the way to higher prices? First, we need to decidewhether thissummer’saccelerationinoptions activityis going tohave a long lasting anddestabilizing effect on risk assets.As we discussed last week, the primary players in thesummersqueeze higherin techwere the retail accounts, who were building huge aggregateoptionspositions via persistent, but small scale purchasesof50 contracts or fewerper transaction (50contracts gives rights over5000 shares). In total, these volumes have been accounting for over50% of total options volume, overtaking the efforts of institutional investors.Theinstitutionaltechspecialist, who has been dubbed the“options whale”,was building positions which wouldhave affected the volatility markets more than the underlying equity. Many of their positionswere delta neutral, wherea call or call spread is offset by the sale ofthe underlying stock, whichremoves the directional bias.The simultaneous purchase and sale of calls at different strikes willalso reduce the volatility impact.A long call spread is whena calloption is purchasedwhere thestrike of the optionisnear the money andat the same time acall is sold where the strike isfurtherout of the moneye.g. ifthe stock is trading at 100 dollars,youmight buy a call at 105dollarsandsell another one at 110 dollars. The selling of a higher strike call reduces the overall impactbecause it partially offsets the lower strike long call position.As an example: when you buy a 105call versus a stock at 100,the actual exposureof that optionmight be 25% of the stock. So,if onecontract is 100 shares, then themarket maker who sells the call will buy 25 shares to be hedged.But, if the investor sells the 110 call, the market maker would buy that call and sell stock to behedged. The 110 call might have a delta of 15%or 15 shares. Therefore if the market maker sellsthe 105/110call spread to the investor, the lower strike requires a purchase of 25 shares and thehigher strike requires a sale of 15 shares, thus the net position that the market maker enters intois a purchase of 10 shares to be full hedged on thecall spread.Thus,the directional impact onthe stock is reduced.A very large scale buyer of hedged call spreadswill, however,stillbe puttingupward pressure on the implied volatility–this is the option price itself, but even here, the natureof call spreads will also limit the scale of the demand for that volatility–they might be buyingvolatility at the 105 strike, but they are also sellingit at the 110 strike.Therefore,thereal driversof both the squeeze higher in pricesandvolatilityarethe retail players. Not only were they buyingoptionsoutright, but according to Susquehana,anoptionsmarket maker, theyare buying shortdatedoptionswith onlytwo weeksless leftbefore they expire. As discussed last week, thegamma, orthe amount ofstock needed to hedge a change in the underlying stock price, increasesas expiry approaches.The retail crowd were driving up theimplied volatilityof the optionsanddriving up the price of the underlying stocks. But thestructuralrisks to the market are not asgreat aswe might think. Yes, there is a sense of euphoriain thatthe market has been gettingoverbought, but the retail crowd are buying options,which limits losses to theamountof the premium paid.Now, if these traders are putting all theirfree cash flow into options premium,thenthey can wipe out their savingsentirelyand if they have borrowed money–i.e. trading onmargin, then they could be left withlosses in excess of their capital. But this is not the same as1987when retail traders were sellingoptionsin order to generate income. In these instances,losses can be unlimited.In early 2018, when we had the vomageddon experience, it was againdriven by investors who had been selling volatility as an incomestrategy.Even in March ofthisyear, short volatility positions were undersignificantpressure,as we can see fromthe movehigher in the volatility-of-volatility index(the VVIXfor short). Today, the VVIX has hardly budged.There is not the same level of embedded short volatility andfurthermore,selling implied volatilitytoday makes sense if it is significantly in excess of the actual volatility of the underlying asset.Ifyou can sell volatility at an implied volatility of 30 and the market is moving around on an actualvolatility of 20,a well managed position should be able to make money.Today’s long volatilitypositions are not as structurally damagingaswould be anexcessive build-up of short volatility.Market makers are paid to take on these risks and manage them, although the moves havebecome extreme.When Apple’s share price was rising, so was volatility. But when the shareprice reversed and fell, volatility fell as well.Thisagain implies that retail traderswere buyingcalls–which is therightto buy the stock, pushing up both the level of volatility and the shareprice. As the stock fell, these traders were selling to try and lock in profits or reduce losses, sellingboth the stock and selling volatility.This feels much more like transient, rather than entrenchedmarketactivity. Losses will still hurt, but as long as leverage has not been used, the woundedshould still be able to fight another day.And remember, some of the squeeze higher in impliedvolatility is because, as we approach the US election, the VIX curve moves up sharply. Soon thefront month contract will be October, where the future is currently at32.I don’t think the optionsmarket is necessarily the place to look for signs of contagion.Therefore, what should we belooking for to see if this hasmorphed into something more structural than merelyshort termover exuberance?Many assets haveexperiencedexplicit intervention from the Federal reserve,whoarebuyingvarious types ofbonds inthe secondary market.When we look at US 5 yearinvestment grade credit default swaps, wecan see that the spread hardly movedevenwhen theVIX waspushing higher. The market pricing of credit is still showing few signs of fear, suggestingthat therecent move lowerin the equity market is merely unwinding some of the excesses of thelast couple of months.If we compare the Investment Grade and High Yield ETFs with the S&P500, we can see this more clearly, with the S&P having spiked higher and then unwound most ofthese gains during a period in which the corporate bond ETFs had already peakedand plateaued.This looks like a round trip of euphoria for the equity market. In many ways this is borne out bythe put call ratio from the CBOE–this also reacheda short-term low(meaning lots of calls andfar fewer puts)before reversing over the last few days. Here, the put call ratiohas been invertedand although we can say that the ratio recently reached an extreme, over the last couple of yearsthe ratio islargely coincident with the performance of the equity market. The ratio and the S&Preversed together. This still implies that the pull back in the S&P and Nasdaq were an equityspecific story.The Wall Street Journal has also outlined how unusual the summer activity hasbeen. Single stock optionvolumesin terms of nominal exposure reached 140% of the underlyingstock activity. Itsvery rare that the nominal value of single stock optionsis in excess of the volumeof cash equities. Three years ago, single stock options were closer to 40% of the cash volumes.Sentiment Traderresearch housealso show that the largest volume in single stock options were on shares which were having the bestperformance–price led the interest in options which thensupported the performance of theindividualstocks. If huge amounts of leverage had beenapplied, then this would be worrying, but these call positions were initiated from the long side.And giventhat the moves in the equity market are probably self-contained, it is unlikely that theUS Federal Reserve will announce any additional support at theFOMC meeting on Wednesdayof this week. The Fed are probably relieved that some of the excesses have been removed.Theywill still be closely monitoring the performance of equities, where the Nasdaq has bounced offthe 50 day moving average. If needed, the Fed can intervene between meetings as they did inMarch and April, but it is unlikely that we will seethe sort of catastrophic declinesin risk assetsthat we saw in March.If anything, the expectations for downside from here will be a grindingmove, a death by 1000 cuts, if the jobless numbers begin to pick upandthere’s anabsence ofany extension to the furlough schemes. Obviously,this will be highly politicized over the next fewweeks, with neither side wanting to be seen asunsupportive for jobs.Remember, this is a marketthat is driven by flows and not fundamentals, though some of the technical indicators nowreflectthe influx of individual investors who were largely absent in the market prior to this year.BeforeFebruary, when the volumes of single stock options started to pick up, the equitymarket wasalmost entirely driven by 401k inflows channeled through rules based funds such as Risk Parity,plus the ongoing corporate buybacks that are still a feature today in the tech sector, but havedropped off acrossmost of theold economystockswho haveneeded to takegovernmentsupport.Bond yields are also unlikelyto give us any clues about the future outcome. Thereshouldstill be some downside to yields if the slow death of the non-tech corporate sector continue. But,if defaults rise,whilst creditspreads remain tight,then it is unlikely that we will see a risk off rallyin bonds.If bond yields were to start rising too quickly,then the US Fed wouldno doubt talk upyieldcurve controlstrategiesin whichtarget specificlevels of yield.Thatthereforeleavescurrencies as the most likelyrelease valve forincreased levels of risk. A weaker dollar has been aboon for commodities and should have been a huge positive for EM equities.ButEM equitieshave marginally outperformed the S&P500over the last couple of months.Thebig level to watchon the ratio of the S&P500 ETF vs the MSCI EM ETF is the neckline of a potential head andshoulders formation. If this breaks, EM equitiesoutperformance would start to accelerate.So far,the tone for EM has been set by the underperformance of the EMFX complex. The weakness inthe dollar over the last couple of months has been predominantly against G10 currencies,especially the Euro and other European FX.Some of the basket-case currencies, such as theTurkishLira,havecontinued to weakenversus the dollareven as the Euro has rallied. Eurozonepolicy makers are already starting to worry about the strength of the Euro, although there aren’tas many policy tools at their disposal, having only just signed off onasignificant package ofsupport.If the recent dollar bounce off the lows,start to build momentum, then financialconditions will start to tighten and this will cap risk assets.September has historically been oneof the trickier months for financialmarkets, but the weakness that we have seen recently hasbeenmainlybeen confined to equities, with a small spill over across multi asset portfolios thatforced a risk reduction in some commodities. Credit remains artificially well behaved and bondyieldshave been in a tight range. The US dollar is therefore the most likely candidate to give usclues of any further contagion.
[00:11:40]Brexit’s Back.In the last couple of days, the UK’scurrency has started to react tosomenew developments in the Brexit negotiations and uncertainty about an extension to the furloughschemes. Goldman Sachsareincreasingtheirrisksthat the UK undergoes a clean Brexit, with nodeal in place.Given the enormity of the corona crisis, it’s not surprising that the Brexit discussionshadbecome far less newsworthy within the British media.But the time-lines are now gettingtight. The UK wants a new deal agreed by the EU summit on October 15th–that’s one monthaway. That deal needs to be ratified by 31stDecember of this year otherwise the UK exits thetransition period with no deal–making a clean break.The currency market has only just startedrepricing this uncertainty.The dollar hadbeen on the back foot versus European currencies, withthe euro leading the charge after the European Union completed its bailout package and long-term budget proposals in July, helping sterling rally even as negotiations started to falter a fewweeks ago.The euro surged from 1.12 to 1.20 and this helped other European currencies,including the British Pound, rally as well. Even as the discussions between the UK and the EUwere deteriorating, sterling wasstilltouching the two-year highs at 1.34.This has now changed.Sterlinghas reversed back below 1.30 and against theeuro it is closing in on the 10 year lows.Bearish bets on sterling have increased dramatically in the last couple of weeks. The volatility ofputs over calls on Sterlingversus the dollar–these are the risk reversals, has surged in favour ofbearish bets, indicated by the sharp decline in the line on this chart.Sterlingvolatility has alsobeen pushing higher, compared to broader based measures of FX volatility which are stillrelatively subdued.Normally, when sterling is falling, we see the UK’s FTSE100 start tooutperform because many of the large cap names in the index generate revenues overseas,which, once converted back into sterling, bolster earnings in local currency. So far, this hasn’thappened.We can see that the DAX has performed extremely well versus the FTSE during thecorona crisis period, mainly because the UK’s FTSE is made up of old economy and value namesthat have struggled during this period.TheDAX has, in fact,outperformed most of Europe, alsomaking new all-time highs versusthe Stoxx600 (though the DAX index is calculated with adifferent methodology).Non the less, we would have expected the FTSE100 performance toimprove if the pound is weaker. If the pound is heading back to the 1.20 region versus the dollarand new ten year lows versus the euro, then the FTSE should start to reverse some of its recentrelative underperformance, though I don’t think it will be as emphatic as we have seenduringother periods when sterling has been on the back foot.UK banks are also pricingin a clean, or nodeal Brexit in that they’ve been underperforming both their US and European counterparts.Thecurrency should be the release valve for the UK’s monetary and fiscal policy. A recent Reuterspoll showed that investors overwhelmingly expectthe BoE to extend its QE program, with themajority of those expecting it to happen in the next couple of months.So far, the BoE hasexpanded its balance sheet at a rate that is on a par with the US Federal Reserve, but lagging thatof the ECB and way offthe pace of the Bank of Japan (who, incidentally, are expecting to maintaintheir current policy path even after Abe’s departure). The UK certainly has more firepower at itsdisposal.Equally important will be the decision by Chancellor Rishi Sunak over whether to end orextend the current furlough scheme. It issoondue to roll off, but already politicians are lining upto demand that the job support continues, with fears that otherwise there could be a loss of uptomillions ofjobs.Even prior to the COVID crisis, the UK’s newly elected Conservative Party wasgoing to break with tradition and boost its fiscal spending. With sovereignty over its own currencyand an extension to its QE program, the primary release valve should be the currency. We have 5already seen the UK’s bond yields converge with those of the US. Most of this is due to thedramatic declines in the US yield. Whilst this may make the hunt for yield via US assets lessattractive for UK investors (which should support the UK’s currency), thegovernment will crankup the printing presses and this should continue to put additional pressure on sterling.We canloosely use a 1.18 to 1.35 range for sterling. Around 1.18 is where sterling traded when a cleanbreak was previously expected(and excluding the COVID lows). The 1.35 level is where optimismover a deal was high.We could view a weaker currencyas a negativebecause itwill impactinflation, pushing the prices of imported goods higher. But, in an environment in whichglobaltradevolumeshave declined, the UK will benefit from a weaker currency.There may be a muchlowerBrexit negotiationtolerance from Europe as well.During the pandemic period, Germany’sexports to the UK have dropped sharply. The threat of lower UK demand for German goodswasalways one of theUK’sbargaining tools, but if demand has already fallen, Germanywillbe makingthe adjustmentsalready-a dry run for the impact that might have been expected if the UK makesa clean Brexit.A new bout of Brexit uncertainty willlead to a slowing down of direct foreigninvestment. Of course, this could all be resolved in the next few weeks of negotiations, but thewindow remainsfor uncertainty.
The Chancellor has still to decide–either extend the furlough and keep the printingpressesrunning, or let the support roll off and watch the unemployment rate shoot up again. Both ofthese would be negative for theUKcurrency.The UK therefore has a better shot than mostcountries at reaching a higher inflation target–not that thiswould be good timing for many ofthe population that are already reeling under the effects of theCovidcrisis. But inflation hedgeswould make sense for the UK–even though inflationcurrently remains subdued.Bond yieldsshould go up–but this is a world of either QE or Yield CurveControl (or both) and therefore Idon’t think we’ll get much of a reaction there, unless we get a big change in the global regime,led by the US.Sterling is now a little oversold,butsterling shouldstillfallfurtherrom heretoadjust to the uncertainty–helping the UK to make a welcome adjustment to offset the slowdown.This should not be considered a negative outcome.One of the key advantages of havingsovereigntyover a currency is the ability to make adjustments inadversity.
[00:18:00]Prior to the COVID crisis picking up momentum in March, gold had been performingwell even when the USD was strengthening.Gold was primarily following the move in US realyields, which have sunk back to record lows in the last fewmonths. Gold is inverted on this chart.Over the last couple months, gold has also received a boost from a weaker US dollar.And thetailwinds for gold have been well documented. It has been the second biggest consensus for USinvestors, though it hasbeena distant second to US mega cap tech. But how stretched is goldnow?Firstly, it would be reasonable to anticipate that monetary and fiscal support will continue.Although it is unlikely that the Fed will ramp their QE program any furtherat this week’sFOMCmeeting, an additional fiscal package is expected, because of the ongoing threat of job lossesnow that the currentfurlough schemes have rolled off.The combination of fiscal and monetarysupport has driven inflation expectations back to where they wereat the beginning of the year,unwinding thatCOVID shock. They may not have exceeded these levels, but higher inflationexpectations will get priced in if more fiscal support is expected. What is key is that inflationdoesn’t need to appear any time soon, onlythatthe expectation that it will arrive in the nearish future.In terms of positioning, various parts of the gold sector are not particularly stretched.When we look at shares outstanding, which is like open interest, for the main goldETFthe GLD,it hasreached, but not exceeded the previous highs of afew years ago.When we look atpositioning in the gold futures market, net non-commercial (also known as speculative) positionshave actually been falling in recent weeks. Yes, overall the positions are toward the upper end ofthe range, but they are by nomeans excessive.There is a similar story for gold miner ETFs.Positions have built up toward the top end of the long rangeandgiven that gold prices haverecently made new all-time highs, it would appear that the consensus is still more verbal thanactual.Institutional investors have still not yet fully embraced the move. In a world where policymakers are in the driving seat for asset prices, it is clear that gold has not been engaged withanywhere near the same gusto as theUS tech sector. Gold is being driven by fundamentals, butif it picks up the flow story that is currently driving tech shares, then the upside potential couldbe quite spectacular from here.
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