Yesterday I posted a chart of the NYSE advance/decline ratio on which I highlighted that the past two weeks were more reminiscent of patterns we see during lows and not something we observe during advances. FWIW – right at the top I am also seeing our coveted Gothic Church Tower fractal, have a look:
Well, one of our fellow steel rats decided to chime in and shared some rather interesting statistics:
I see other things, that normally happen at lows. For example, ES open interest is about 2.9 mil cars. Last time it was that high in end of May – beginning of June. A time before that was in end of November 2011. Also significant low. Sept – Oct of last year was as high as 3.1 mil cars. I started to keep these records around that time, because I noticed that open interest increases when market falls. Its not a fact, just my observation. I could not find historical data, so can’t check if its reliable at all. Also, I understand that open interest may naturally increase towards expiration, because more and more people getting stuck, but during Jan – Feb this year it stayed around 2.5-2.7 mil. And right now we are nowhere close to expiration anyway.
Now let’s look at another chart that is looking rather peculiar, given that we are currently trading 14 handles below this year’s highs:
Just eight sessions ago the VIX was frolicking below the 14 mark, dropping as low as 13.3. Today we almost touched 17 and that’s an increase of 22%. And this, my dear steel rats, is exactly what I was referring to a few weeks ago when I suggested OTM put lottery tickets. While prices on the underlying have barely moved premiums on SPY or SPX puts for instance have risen simply due to a 22% increase in vega. Even calls bought near the top should have remained near break even, despite the 14 handle drop.
Case in point – SPY ATM calls bought on the 17th – after 12 days of theta burn and a 14 handle drop have only lost 60 bucks. Know your greeks folks!
But wait there’s more – make sure your tinfoil hat is in place and you have tightened those chin straps. Here’s another chart I posted two days after we painted those lows on Mr. VIX. Remember those peculiar spikes we saw on the SPX:VIX ratio?
Someone got to buy premium at bargin basement prices and whoever did is now smiling all the way to the bank. Despite the fact that the SPX is trading only 14 handles below its highs. Nevertheless all characteristics of the tape in the past week point toward an ongoing correction. But it may just be a sideways one. Which means that give it a few more days of this Chinese water torture and the Mole may just get excited about the long side again. For now I remain guarded – but the odds of upside continuation will increase vastly once that NLBL expires. The bears had plenty of chances here to take things down by a notch or two but thus far it’s not happening.
But the running theme of today’s post is that we seemingly have reached an inflection point across the board. I am seeing an almost identical configuration fall into place across both currencies and commodities. So let’s take a look, shall we?
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It’s Friday evening and I decided to go all Dirty Harry on your asses. The center of my post are two simple charts that I saved for the weekend – just in case you were feeling that sudden urge to make any big bets up here.
Exhibit A – our beloved volume profile chart – the gift that keeps on giving. I post this one regularly and I’m sure you’re all familiar with it. What’s salient about it right now is the fact we pushed right up to our current volume abyss, which thus far has been proven to be impenetrable.
Since Tuesday no real attempt to breach it has been made – every time we get close we seem to be running out of fuel. Which confirms that despite all the alleged risk appetite out there nobody is eager to take this thing much higher here – at least not right now. My take is that some after-hours or weekend event would be needed – some f… you candle that gaps the majority of traders and bridges the gaping volume hole looming above. Always a possibility but then there’s this:
Exhibit B is a long term view of the VIX. Since the 2007/2008 debacle we have a well established support line which over the years has been slowly dropping from about 17 to into 15 right now. Depending on how you draw it you can add another handle and thus 14 is your uncle.
Now considering these two charts the big questions you need to ask yourself right now is this: Is it really wise to be delta positive right now and right here? Even if we spike higher next week on heaven knows what after hours news event – is being long here worth the downside risk? Granted currently there are no technical hurdles on the horizon that would preclude us from reaching VIX 14 or even 13. But you have to ask yourself: What are the odds? Do you feel lucky, punk? Well, do ya?
Actually – I do. With a VIX this low I am starting to think about some delta negative strategies. The only problem is that I wish I had more technical reasons to be short here – and that’s the one big fly in our ointment. So we have to make a choice – either give this one a miss or use a strategy that will not cost us much if we wind up being wrong. Which by the way could easily happen – I am not going to sugar coat this and I have made it pretty clear recently that we are in technical limbo here. Even our inside day setup from Wednesday has been shot to hell at this point.
Given this the one medium term strategy that makes sense is to dip into some cheap lottery tickets – a.k.a. far OTM puts either front month or the next. Since August only has 7 days left I would go with September puts. If we push higher from here then you will lose premium but at least you won’t be vega squeezed and that should contain the damage. But if we drop from here and premium shoots up then we’ll bank some mighty coin. So a few lottery tickets it is – at least for this market megalomaniac.
In order to pick those lottery tickets we need to consider what our prospective support zones are. That’s basic reversal play 101:
On the daily we have the 100-day SMA at 1355, the 25-day Bollinger at 1320 and the 100-day Bollinger at 1290.
On the weekly we have a NLSL at 1340 and on the monthly a NLSL at 1320. So it seems 1355 to 1340 is our first range and 1320 is a strong contender for a little wipeout target.
Based on that I picked two lottery tickets – the September 135P and 132P on the Spiders. As you can see the profit potential is rather nice but it’s a rapid increase in vega that would result in an explosion of our premium. As a matter of fact – we could stay right here where we are and an increase in vega would bank us some coin.
As I said above – technically there is not much on the horizon that suggests a reversal here. But with a VIX near a historical support line it does not make sense to be long here – simplemente no vale la pena. The play I suggest makes sense but it’s a long shot and I call them lottery tickets for a reason. So if you decide to grab some of them then I suggest you only use a tiny percentage of your portfolio. You don’t want to lose any sleep over taking on speculative positions – if you do reduce exposure until normal sleep pattern resumes.
Enjoy your weekend.
As I was perusing the comment thread this morning I saw a few musings on how to best get positioned near a potential market bottom. The option strategies that were suggested are definitely reasonable (i.e. regular credit spreads) but IMNSHO non-optimal during times of rapid volatility spikes.
In order to set the stage observe that IV as expressed by the VIX has jumped by 30% in the past month. Thus I decided to put a together a quick and dirty write up on an exotic beast called a ‘reverse calendar spread’ – a.k.a. ‘reverse diagonal spread’.
Let me however precede the following with a caveat – I am not suggesting that a market bottom is already in the works but I’m pretty comfortable in proposing that we will see one in the next five sessions.
We all know that high volatility associated rapid sell offs offers tremendous profit potential – in theory. The truth of the matter is that even seasoned traders are often only familiar with the most basic option strategies, which unfortunately do not apply well in an environment of high volatility. Obviously the most straight forward approach here would be to simply sell vega via shorting puts but unless you have suicidal tendencies I would not recommend that as an actual option (pun intended).
Bull and bear debit spreads are generally poorly priced when there is high implied volatility (IV). When a bottom is finally achieved, the ensuing collapse in premium due to volatility crush often strips away much of your profit potential. Many a traders have been punished this way and often they are not even aware of what happened and that vega is to blame. So even if you get the timing right and are able to get positioned you may easily see yourself being stripped of most of your ill gotten gains during a snapback move following a capitulation sell-off.
This is why I propose at a simple strategy that actually profits from imploding volatility irrespective of market direction (theoretically – more on that below) and requires little up-front capital if used with options on futures or ETFs. Even better, as long as IV drops or remains stable (e.g. after a big push outside the 2.0 BB) it has little or no downside risk, thus reducing the bottom-picking dilemma. The strategy also offers some very juicy upside profit potential if things start accelerating to the upside and vega is being crushed, thus causing an increase in pain that is often referred to as a short squeeze. The basic idea of this strategy is the inherent opportunity offered by a sharp drop in IV. By neutralizing delta and gamma and getting short volatility, or short vega, the strategy is a great tool in our arsenal for banking coin near market bottoms.
As most of you rats already know a high VIX means that options have become extremely expensive because of a surge in volatility, which massively affects option premiums – calls and puts alike. This presents a conundrum for option buyers – whether of puts or calls – because it leaves you long vega just when you should be short vega.
Thus the most straight forward solution is to sell options which leaves you short vega and thus able to profit from a volatility crush. However, especially during times of a potential medium to long term trend change (i.e. bull market rolling into a bear market) it is of course very much possible for IV to push even higher. And if you are being caught short vega under these condition then it can very quickly lead to significant losses.
The Solution: Reverse Calendar Spreads
Traditionally calendar spreads are considered neutral strategies, involving selling a near-term option and buying a longer-term option, usually at the same strike price. The idea is to have the market stay confined to a range so that the near-term option, which has a higher theta (the rate of time-value decay), will lose value more quickly than the long-term option.
Another way to use calendar spreads is to reverse them – thus buying the near-term and selling the long-term, which works best when volatility is very high. The reverse calendar spread is not neutral and can generate a profit if the underlying makes a huge move in either direction. The risk lies in the possibility of the underlying going nowhere, whereby the short-term option loses time value more quickly than the long-term option, which leads to a widening of the spread – exactly what is desired by the neutral calendar spreader. Having covered the concept of a normal and reverse calendar spread, let’s apply the latter to SPY call options.
Back To The Real World – SPY Example:
All the above may be confusing to you so I put together an example with regular SPY options on the trusty TOS option simulator – a fun diversion for lonely weekends, for example if the local nudie bar is closed for renovations. Heck, it beats reruns of Friends – at minimum it’ll teach you a lot about option greeks.
As we are optimists I’m showing you the winning side first. The ThinkOrSwim simulator does a great job of showing you that you are effectively neutral delta and gamma. We have SPY trading near 130 and are currently counting 63 days to the expiration of the July 130 call. The trade is constructed using simple SPY call options. I think initial margin requirement for the spread shown above is around $200.
So assuming SPY trading near 130 and expecting a bottom in place soon (which again may not be the case – this is just an example) we buy one July 130 call and simultaneously sell one September 130 call, which leaves a net credit of ~$217 before any commission or fees. This should best be done by an experienced broker who can place a limit order using a limit price on the spread or you can use the TOS platform which allows you to automate the process and ensures that you are not being partially filled. It is very important to understand that the goal for this spread is to close the position at maximum 30 days ahead of expiration of the near-term option (Oct expiry), a bit sooner is better.
As you can see in the above chart – as long as vega drops from here you really don’t care where prices are going as you should be able to bank some mighty coin. If you expect only a short term spike then you may have to play this one with weekly options with the sell side being three or four weeks away but that is really outside the scope of this little example.
But of course we all know that vega would explode even higher should prices continue to drop lower – in particular if we breach the proposed support clusters I have pointed out in the past few days. Which really renders your profit potential during a drop associated with dropping IV nothing but academic. In essence on the very first chart you can ignore the simulated profit curve below the 130 price point. Why? Because it is unreasonable to assume that vega will drop if we continue much lower from here – most likely it’ll jump higher. On the inverse anything above 130 on the loss simulation above can be ignored as well as we most likely won’t see IV run higher if prices are starting to snap back.
Obviously I have skipped much of the meat on how to calculate and structure each side of an reverse calendar spread. But that really wasn’t my focus and there are plenty of great tutorials out there if you want to get into the nitty gritty. What’s important to understand is that a RCS can effectively be used during supposed market bottoms and may be preferable to other credit spreads.
Here’s an example of a regular vertical credit spread and with volatility falling in 5% increments. As you can see those profit curves flatten out rather quickly.
Getting the timing right of course is an art in itself but I thought that a 30 day window may be a good compromise. If you want to put together something more short term then you may look into playing the weeklies. But that’s a completely different story as they move a bit more like futures and react differently to theta burn.