Welcome to the Risk Show

It wasn't that long ago when the world last really tasted risk. Bonds exploded higher, the VIX could not be contained and the equities had some highly contagious disease. Then we somehow all got comfortable with write-offs, fines, and very tame projections for profits. Companies were crushing their 'lowered expectations' and we're all feeling rosy about being long the market. We broke 1200 in the S&P!

Then what?

Moody's and Fitch downgraded the PIIGS sovereign debt to junk

The Euro Currency went into free fall.

The long end of the Yield Curve breached levels that it hasn't sniffed since last November.

Stocks are nuclear waste. Who wants this stuff in their book?

Funny how the world's market opinions can change instantly. As short and micro rates around the world begin to uptick, there is one noticeable decline. The yield curve. In fact, as LIBOR has continued its assault on .40% {a HUGE % gain, though still in the general area of virtually free} the entire curve has appreciated in value and fallen in yield. Most notably, the 30 delta combo {15 delta put & the 15 delta call} has moved its premium to the CALL as the fear quotient in the 30 yr bonds has reached a fevered pitch. {The combo is usually constructed by equal-distant calls and puts. Price is derived by subtracting the less expensive from the more expensive. 9.5 out of 10 times the PUT is more expensive than the CALL} 

To me, this occurrence signifies one or two {or both} possibilities:

1. Paper, that is real customers with real portfolios, have been caught with their pants down and are scrambling for protection in a rapidly increasing underlying. Many of them have been selling calls as a means of yield enhancement. Now that some of those calls are within 5 or 6 points of ATM, they are being forced to cover their positions. Locals {pit traders} know this, and have ratcheted up the prices accordingly.
2. Someone knows something. If 'they' can ship in enough long calls the impending rise in the underlying will be a very profitable event. Traders say that there has been an increased presence of call buyers, but nothing to specifically warrant this type of move in the combo.

Don't forget that Pimco has laid the boundaries for this quarter by selling 145K 114-119 TYM strangles. Those prices roughly reflect 3.50-4.15% yield on the TY. With the TYM10 currently printing 118.255 as I type, it isn't hard to notice that we're at the top end of that range. Not surprisingly, they {Pimco} are selling the TYU 114-120 strangle. That's a bet that yields will hover between 3.25-3.95% until the September expiration on August 20th, 2010.{obviously, these numbers are slightly skewed because they are collecting premium that would offset these levels}

We played the 4% number earlier in the year with long call spreads and were nicely rewarded. Going forward, we would like to piggy-back Pimco's levels again using options so as to have unlimited upside with minimal exposure to the downside.

From MAN Financial Desk:
This mornings activity in TYU options was feverish to say the least. The well advertised seller cranked out 10K today bringing his two day total to 15K. The enclosed yield chart of ten-yr cash for the last 12 months shows extremes of 3.10%-4.00% and the aforementioned strikes are by no coincidence darn close to those levels (3.20-4.00%). Take into account premium collected and breakevens widen. We expect this account to continue with this exercise as this appears to be a mortgage-convexity replication trade whereby you own treasuries and sell vol against.
In the short term TYM 119c currently have 145K open positions and expire in 16 days (May 21st) and we believe the acct is short this strike. A penetration of 3.50% with any force would cause a scramble that may also trigger derivative/convexity issues to accelerate the recent emotionally charged market.

~LH