A TIME FOR TAIL RISK HEDGES IN BOTH DIRECTIONS

• Options Activity:  In total, there were about 3 times as many put transactions today as call transactions.  If those are predominantly investor buys, dealers must hedge by shorting S&P futures contracts.  A downside break of 3300 takes gamma below the $1Mn level (bearish).  The probability of touching 3300 is currently 81%.  The flip point has moved up and lies between 3235-3250. The probability of touching this level is 51%. OTM puts took a hike up in value today.  Dark pools remained buyers Thursday, despite elevated valuations.

• Volatility:  The consensus is higher volatility in the foreseeable future.  There seem to be a lot of reasons for volatility to rise but it’s not yet priced in. We remain near the floor in VIX and vol-of-vol is just beginning to rise. The VIX call buyer, often referred to in the markets as “50 cent” is back.  

• Auction Market Process:  A buying tail six minutes into the open at 3302. After the World Health Organization said it was “too early” to declare the spread of coronavirus a global emergency, the rebound from Thursday’s selloff was lead by technology, utilities, and real estate.  

• Bonds:  High yield and junk remains the most dangerous part of the credit market.  Treasuries are already in breakout mode.  Yields are down over fears of coronavirus contagion and nobody knows how this will turn out.  China continues to step up its efforts to contain the disease.  (Treasury inflows are generally driven by inflation fears and economic slowdowns.)

• Precious Metals:  There are growing shortages of palladium, now the most valuable precious metal on earth.  In addition, trading volumes are exceeding physical supplies.

• Macro:  Increased numbers of dead and suffering from the coronavirus took markets down in early trading, Thursday, until the World Health Organization chose not to declare a global emergency over the outbreak.

Taken Together

We are currently seeing inflows into secular growth (e.g. technology and consumer staples), defensives (e.g. Treasuries, precious metals, healthcare, and bond proxies (utilities and real estate).  Much of the fuel for the rally – namely, central bank liquidity, trade deals, improving economic reports, and chronic short covering are coming to an end.

It is increasingly difficult to be bullish here – easier to be neutral at best.  Putting on some tail risk trades, either directly in the volatility ETPs, or by buying some deep OTM short-dated VIX options makes sense. Treasuries will rally in a risk off move and it may be a good time to build a position here. Lastly, one might consider tail risk hedges in either direction as the potential for continuation in this “melt up” rally remains.

• Options Activity:  Over the past few days, we’ve noted underpriced OTM calls being accumulated, seen in the data largely between 3330 and 3400.  Simultaneously, protective puts have been accumulating in the 3250 to 3300 strikes.  So “…max pain” at the put floor and gamma flip at 3250.  These same high dollar-gamma levels also mark auction brackets and even fit within the range for this week’s implied move.  Wednesday’s AM activity began with more call buying but ended with put buying (posted earlier).  In the event of a shock, all of those long calls might be expected to exacerbate volatility.

• Valuations:  Calls remain underpriced and OTM puts continue to get a bid.  Dark pools buyers Wednesday.

• Volatility:  VIX futures rose to a high of 16.5 overnight.  Vol strategies have increased weighting in the front month.  VIX is primed and ready.

• Auction Market Process:  A selling tail at 3337.50; a down-auction to 3312 overnight.  Rotation in S&P futures overnight, following yesterday’s close, between the low and 3325.  3325 is the level to watch for rejection.

• Macro:  Oil’s slump deepens.  Gold down and sideways.  Treasuries and the Yen on a roll.  Sector-wise, utilities remain strong.

• Calendar:  Weekly jobless claims data:  Can the consumer propel an economy whose manufacturing sector has weakened?   More earnings …and INTC is the market mover to watch.

Taken Together

Clearly, fears associated with coronavirus contagion continue to weigh on risk.  In addition, the market is top-heavy on calls – both long and short!  Frankly, I’m a little surprised at the market’s continued appetite for calls and the paucity of new positions in ITM puts.  Deep in the money puts are a synthetic short position.  At this writing, it looks like S&P futures may open at about where we closed yesterday.

• Options Activity:  The contraction in long gamma we saw with last week’s OPEX currently allows $SPX a little more room for momentum-based moves.  The high gamma strike lies above at 3350 with 3375 and 3400 coming in second place.  Increasing gamma at those levels would be bullish.  Today was the third day in a row for a 10,000 lot position at the 2690 put strike. 

• Valuations:  Calls remained underpriced while OTM puts were bid up as investors continued to hedge against a sharp downside move.  Dark pools were buyers today.

• Volatility:  SPX down 0.28% and VIX up 6.2% Tuesday.  Expiration of January VIX futures is Wednesday.  The front month VIX spread between February and March is about to contract the level of contango.  While there seems to be a bit of anxiety among volatility traders related to Super Tuesday (Mar 3), it would take a large vol shock to invert the current positive term structure.  Notwithstanding, vol-related strategies are gaining traction.

• Auction Market Process:  A prominent point exists of control at 3250.  Another test of the recent high at 3330 sold off on news but promptly found buy stop orders initiating new positions and day-traders exiting short positions at 3320. From an auction perspective, those levels mark the current balance area with  3330 marking a selling tail and 3320 currently serving as the auction bracket low.

• Macro/Currencies:  Weakness in gold and continued strength in $DXY, Tuesday.  Concerns about China’s gold purchases may be short-lived, however. Palladium sharply lower on coronavirus fears but, it too, quickly found buyers.  Still another reaction to fears of coronavirus contagion brought down Treasury yields and powered a rise in bonds.

Taken Together

Fears associated with coronavirus brought $SPX, $HYG, gold, copper, and palladium down and triggered flows into Treasuries and volatility strategies.  Sector rotation into Utilities continues.  Clearly, traders are jittery at this level.  Dark pools and gamma exposure, however, supports continuation.

Note:  Bullish options strategies to consider at these levels include put-writing strategies to build equity exposure, defensively, and long calls, currently “on sale.”  Hedges appear to be focused on 3300 ($SPX) and the 20 strike for $VIX.

• Options Activity:  Friday’s drop in gamma exposure is physiologic, not pathologic and related almost entirely to OPEX.  Hedging activity portrayed by new volume and open interest in March is noteworthy.  Gamma flip now lies at the put floor (3250).  Short calls at 3400.  Dark pools remain steady buyers.

• Valuations:  Calls underpriced  and OTM puts were bid up as investors continued to hedge against the possibility of sharp declines.  Time to be a premium buyer.  This may account, in part, for a significant amount of calls being rolled up and out to March.

• Volatility:  24 Jan 20 Weeklys pricing in a $27.81 move up or down by the close of this Friday.  This represents a contraction since last week.

• Auction Market Process:  Following last weeks sudden range extension, a period of balance is likely.

• Macro/Currencies:  Gold’s reaction to the Asian index lows, last night, is notable. CFTC Commitments of Traders shows speculative net futures trader positions in $DXY to be firmly in a long position but shrinking and currently in its weakest position since June 2018.

• Calendar:  CFOs in Davos, central bank meetings, and more earnings.  On Friday, US housing jumped to 1608K from 1380K, the biggest one-month gain since October 2016 – likely due to warm weather and low-rate steroids.

Taken Together 

After 23 weeks, market took out the upper margin of its implied move …almost a 2-sigma move.  What makes this so unusual is its occurence in the absence of a preceding selloff.   Managers seeking yield, moving into $HYG, a relatively illiquid and high risk asset.  In another effort to obtain yield and simultaneously provide safety, utilities got a bid last week.  

To sustain the rally, we most need to see:  strong earnings and guidance and high performance in the Financial sector.

How buying begets buying via delta auto-hedging algorithms and gamma acceleration.

Explained.

Follow the sequence labeled 1-4 to understand how delta and gamma contribute to the ramp we’re seeing.