A former life

This is too great not to re-post!

{there is some NSFW language}

I think I've had this exact conversation...more than once!


UPDATE: Here's the QE2 version with some choice words for the Fed and "the Ber-nack"
~LH

Silence wasn't golden

In some respects, I find it very difficult to write after getting pounded. At other times, it's actually a stress-relieving endorphin that allows me to refocus my thinking.

To be blunt, some of our assumptions of the QE2 announcement and the subsequent market follow-through were just wrong.

I do want to update some of our larger trades now that we've had a rally, a pull-back, and rolled plenty of our inventory.

----------------------

In the 30 yr bonds:

We sold out of our longs in the 137 calls prior to the QE announcement.

In the March Euro Dollar:

We rolled our March 9925-9950 put spread out to the June 9925-9950 put spread. We executed near the highs of the move for a cost of 1 tick. This will provide us with 3 more months to catch the credit event we still believe is looming.

In the March and May trees:

We have covered the March and we're in the process of covering the May. We originally put the on for a credit to the 1 leg and we're now selling them for even money. This helped us finance our ED put spreads and we are actively looking for ways to get some more premium shipped in, ideally in the FFs.

The NOB is still at 25 year highs. The range on Wednesday was almost 2 points. {that's 64 ticks at a price of $156 per one lot} Though it settled off the highs, it was up over a point. At this point, we have no position on as we attempt to reload and find a position that will allow us the capture what we think is the impending flattening.

~LH

IM rants

This was just way too funny to not post.

The article in reference is from Bloomberg and you can read it for yourself right HERE

Neapolitan Man: that article, was like parents telling their teenager they are going out of town for a week and not to throw a party

LH: LOL

Neapolitan Man: it was so absurd

LH: yea, and that the key to the liquor cabinet is hid under the sink

LH: ...

Neapolitan Man: yea

Neapolitan Man: as they are pulling away the kegs and nitrous tanks are pulling up

LH: hahaha

LH: wait, what? who brings the nitrous

LH: {but it sounds awesome}

Neapolitan Man: the bankers do

Neapolitan Man: this isn't your normal kegger

Neapolitan Man: they are going to rape and pillage with 200 billion every month

LH: yea

LH: but

LH: for how long

LH: and can we assume that when they turn off the spigot

LH: the world reverts?

Neapolitan Man: i don't know, if it is up to lloyd it will go on for at least a year maybe 2

LH: damn

Neapolitan Man: the world will never be the same

On a side note. We're convinced that the one of the better plays for the next few weeks is....wait for it.....

LONG GAMMA 

By purchasing equity gamma or yield curve gamma you get the exposure to the following upcoming events:

1. First Look GDP {10/29}

2. Nov Elections {11/2}

3. Fed Meeting {11/2 - 11/3}

4. October Unemployment data {11/5}

5. Treasury Auctions {11/8 - 11/10}

6. QE2??????

~LH

Execution that hurts

Yesterday, on the 1.25 point sell off in the US {30 year} we decided to play the 'mean reversion' game and take a shot at getting long some upside calls.

We purchased the December {Z} 137 calls for 20 ticks. Our motiviation was as follows:

1. We are currently at the 60 day support level in the USZ {roughly 130}

2. We are anticipating a stock sell-off as well as the corresponding bond rally following next week's supposed QE2 announcement.

3. A trusted adviser taught me that when all else fails and you have no idea what to do, buy gamma.

{they're currently priced at 11-12}

Other things we've done or rolled out of.

1. We have taken 75% of our E0X 91-93 put spread off. We purchased it for 3.5 and have sold it for an average price of just under 5 ticks.

2. EDU v FFU, we purchased 28.5s in the spread and sold 31.5 and 32s {completely exiting the trade}

Finally, my Philosophical rail Defender alerted me to the following theory about the Nov 3rd announcement. Fascinating opinion. {this text comes directly from an IM conversation}

So here is my 10 delta prediction, {we'll get} no explicit announcement of QE, stocks tank, PIMPCO takes it on the chin and puts back {their long book of} MBS to Bank of America. The Govt does a Citi/GM style bailout with BAC. {As a result} Geithner gets ousted {and either} El Erian or Gross will move into the drivers seat at Treasury. They will then propose a bailout of state pensions via the Treasury issuing 100 year bonds at 6 pct in a swap for all pension assets. Then the Fed continues to stealthily purchase everything not nailed down.

~LH

Big Ben needs to be susupended

So, did you enjoy Bernanke's speech this morning? Jan Hatzius didn't, at least from a 'we need QE2' standpoint. His comments:

From Hatzius:

BOTTOM LINE: Chairman Ben Bernanke adopts a cautious approach to his speech, reiterating that he sees a case for adopting more stimulus but that any decision depends on the costs and benefits of the nonconventional policies. The speech contained few details of what form additional easing could take, although Bernanke clarifies that he regards additional asset purchases and/or a tightening of the FOMC’s guidance language as the primary tools. Overall, the speech is consistent with our expectation of a QE announcement in November.

MAIN POINTS:

1.       Chairman Bernanke re-emphasizes the FOMC’s dual mandate of attaining the longer-run sustainable rate of unemployment and mandate-consistent inflation. With regard to the former he argues that “the bulk of the increase in unemployment since the recession began is attributable to the sharp contraction in economic activity … rather than to structural factors.” Bernanke thus refutes the idea that labor market mismatch has pushed up the structural unemployment rate significantly.  Given this large amount of slack, Bernanke notes concludes that “it is reasonable to forecast that underlying inflation…will be less than the mandate-consistent inflation rate for some time.”  The tone of this speech is consistent with the "bite size" approach to asset purchases that we have come to expect in the wake of earlier speeches rather than a "big bang" approach.

2.     Given this deviation from the FOMC’s mandate he argues that “there would appear--all else being equal--to be a case for further action.” However, Bernanke is careful to stress that “possible costs must be weighed against the potential benefits of nonconventional policies.” The chairman provides few specific details but clarifies that he sees asset purchases and forward guidance as the primary unconventional tools too boost the economy. His remarks contained no comments on price level or nominal GDP level targeting.

Summarizing a complete conspiracy theorist:  Jan is saying that Ben will NOT be doing QE2 and in the process he'll "preserve some of the Fed's mystique".

I would a love a non-event QE2. Either the kind where the Fed says, "we're going to do $1 Trillion in easing and oh yea, by the way, we've already done $500 million-ish" OR the kind where they say, "you know what, we are seeing some good data leaking out of all sectors and that means we don't need stimulus!" If this was to happen, I would imagine a 2 day correction in the S&P of 5-7% with a one week target of 10-12% bottom line support. That would help explain some of the current pricing and fear in the S&P combos that are currently priced at 3.7 to 1 for the put. {ie vs 1170 in the SPX the 1075-1275 combo cost 10.75 to the put, $14.75p v $4.0c}. Market makers aren't going to let you just get long downside OTM put for nothing, you've got to pay a hefty sum for the rights of protection. Baby steps to November 2nd!

One "Ben" just came off of suspension, the market will be calling for the other one be suspended if QE2 doesn't happen!

~LH

Conversation with a King

Remember when I introduced you to the 3 Kings? They were the three champions of the bond option pit whose trading savvy and skill produced millions of dollars in profits all while taking down paper from the masters of universe {read PIMCO & Goldman Sachs}. Most of these guys have moved on to 'greener pastures' and left the pit-life to the younger kids. But traders are creatures of habit and the longer you're in the game, the harder it is to turn off the constant internal dialog that was the key .

Knowing he couldn't turn off the dialog led me to ask about our current NOB dilemma. We've struggled for the past few days to construct a trade that limits our exposure while allowing us to capture what price action we anticipate in the coming weeks. Knowing that the kings had insight and perhaps the most valuable key: trading experience, I decided to seek out that wisdom.

Interestingly, it started with a question. He asked why we thought the NOB was going to make a retracement from its new 24 year high (149 bps)? I laid out our argument and theory.

• Paper is LONG the short end of the curve and getting longer. It has been the trade of least resistance and all pushed 2 year and 5 year yields to record lows. {Our office has discussed the real possibility of the 5 year yield going to 1% for the last 3 months...its almost there}
• There aren't necessarily 'sellers' in the long end {and ultra long} rather there is just a lack of buyers with respect to the huge amount of dollars being poured into the short end.
• We believe that a prevailing opinion is that: its better to be long these securities and in the worst case scenario they will to take delivery.
• The 5-7 year future {7-10 US Notes} hold the real possibly of recovery. 
• The biggest players have started to put on yield flatterns via the option complex.

He laid out his view of the playing field. Though similar, he saw the crux point from a different angle.

• The trade has been for paper {PIMCO} to hedge all of the mortgages they've bought over the last 2 years.
• Paper sees the government as the backstop of all these mortgages and {spoiler, this has a touch of conspiracy theory to it, PrD would be proud}since there was no way for the government to actually buy all the rotting paper out there they cut PIMCO in on a very sweet deal and virtually guaranteed their principle investment.
• Paper isn't viewing the 5-7 year trade. Rather they are staking out the QE2 announcement for the correction of the current trend.
• He suggested looking back 3-4 months and see what happened as the NOB self correct from 125 down to 110.
• He envisioned a 'non announcement' on November 2nd's Fed Meeting will result in a massive sell off in the 2-7 year notes.

The question we are forced to answer is: Are we on the mountain top getting ready to ski down the double black diamond or are we at the halfway point and preparing for the assault up 29,000 feet?

Realistically, are we traders that follow the trend or look for the mean reversion? I'd argue that we're the latter. Now to craft a play.

~LH

Executing for the Why

I am enjoying my front row seat the the show this morning.

In the blue trunks, standing slightly shorter now, is Interest Rate Volatility. In the red trunks, growing more powerful by the second, is the 4 ton gorilla named market angst. I've got to be honest, with all the movement recently {albeit in one direction}, the impending QE2 scenarios, Bernanke's 3 point attack as outlined at Jackson Hole, and the every pundit in the world calling for a Bond Bubble {and subsequently a massive sell-off}I thought that IRV would put up a little better fight.

NOPE!

The pummeling is merciless and I'm starting to get squeamish watching this. One of our market brokers said, "This is the lowest I've ever seen Mid-Curve EuroDollar straddles {vol} in all of my years down here." That must be bad.

Interestingly enough, we're long this rapidly rotting volatility. The other day we purchased E0X92 straddles vs 9929 for an average price of 16.5. Our current hedging has left us short deltas from an average of 9934.5 at roughly 60% hedge ratio. However, our next sale isn't until 9947 and at least prior to the NFP number, our first buy is around 9921. Good luck Mr. Gamma.

~LH

Booking Expectations

The addition of the newest office member has added an exponential increase in our trade idea generation. Though we have been substantially quiet in many of our markets, it hasn't been for lack of ideas, rather we're experiencing a total lack of conviction. As I type now we're in the midst of another spectacular bull session for the Euros. LIBOR has downticked to a paltry .28906%. In the last 15 trading days, the Green December ED {2012}has rally almost 40 ticks. The expectations of long term QE are all but assumed to be relevant from now through the 2012 calendar.

We're stuck with the questions of how profit in the zero interest rate vacuum. How do craft an option play that capitalizes on the market's perceived risks {that the market continues to drift toward zero? Over the past few days large ED customers have been buying thousands of EZ2 9925 calls at 1 {>30K}as well as the EZ2 9900-9925 call spreads at 4.5 and 5 {>40K}. Seriously!?! That's 40 ticks away and has 65 days til expiration. That's unbelievable. Though given the the last 15 days, it doesn't seem like much of a stretch huh?

Now we're drifting higher in price, lower in yield. The markets can't keep rocking higher, can they? What happens when QE2 gets released?

One of the more poignant arguments I've stumbled across lately is in a Bianco research piece. This piece focused on the amount of QE2 and hinges off of a Bill Dudley speech recently given to the Society of American Business Editors and Writers. Dudley stated that "$500 billion of purchases would provide about as much stimulus as a reduction ion the federal funds rate of between half a point and three quarters of a point." They then surmised that Dudley reached this conclusion by using the Taylor Rule to approximate a neutral funds rate.

"Using core PCE as a measure of inflation, the Taylor Rule places the neutral funds rate at -1.50%...With the fed funds rate essentially at 0%, the Federal Reserve has used asset purchases as a means to further decrease rates. These purchases have created almost $1 trillion in excess reserves as of 9/22. Taking Dudley's statement at face value, $1 trillion in excess reserves has already pushed the "implied funds rate" to somewhere between -1.00% and -1.50%. A further $500 billion in QE would push the rate to somewhere between -1.50% and -2.25%." {http://www.arborresearch.com/biancoresearch/}

Ouch, especially for our market. Maybe the large ED customers have read this idea too and are hedging best they can. Can you actually get negative interest rates?

~LH

Perspectives on the Market?

Being friends with your broker can have a unique set of perks. Flying wingman to an economic round table turned out to be just that, a fantastic perk. I wound up in the audience for a Morgan Stanley Smith Barney market discussion moderated by Consuelo Mack that included the following:

*Jeff Applegate {CIO MSSB}

*Bob Dole {Sr. Managing Director at BlackRock}

*Dr. David Kelly {Chief Market Strategist at JP Morgan}

*Christopher C. Davis {Chairman of Davis Advisors}

Below are my notes, a few quotations, and a comment or two

All four men stated, unashamedly, that they expect to see the next ten years produce 8-10% inflation adjusted returns from equity holdings. In order to achieve this rate of return in an individuals portfolio they suggested being overweight equities, underweight bonds, and an acute focus on Emerging Markets {BRIC}

Davis argued that we're doing ourselves a huge disservice by staying in Money Market Accounts. He noted that the Perils of Passivity {being in a safe haven like cash} are essentially backward thinking. He equates cash to "The Returnless Risk", citing that in the lifespan of his father, the dollar has lost 92% of its purchasing power.

Kelly proposed that the idea of current massive volatility in the market becomes much more muted when you change the time period to a 10 year moving average. He said that historically speaking, current volatility is very average when viewed through this lens. His recommendation was, "have a plan, stick to it." I found it rather cliche and dull. Remember that the further out you take your volatility lens, the less muted weekly, monthly, even yearly events become. I expected deeper wisdom from a Ph. D in economics.

10 year moving average of the S&P yearly volatility. We're average right now, huh?

Applegate had a unique outlook for the near term. He mentioned the date December 1st. No one in the media has said a thing about this to my knowledge and he made a compelling argument. Obama's Committee on Deficits makes it official recommendation about how to fix our current situation. The only other time this type of committee has been around was during the Reagan years. The outcome of that committee was a change in the retiring entitlement age from 65 to 67. Applegate said that this will happen again and the result will result in pushing our debt further out the curve. The 'media' effect will say that our budget is looking much better and the stocks will continue to head higher. I don't have an opinion on whether this will happen or not, but it was interesting.

Here are a couple of  one-liners and some of the interesting correlations they cited though providing no actual data were:

*14% of disposable income went to debt servicing in 2000, now we only use 12.1%

*The largest component of Consumer Confidence is the Unemployment Rate

*Attractive P/E ratios are the precursor for gains in Consumer Confidence

*High Unemployment is the precursor of gains in future equity valuations

*QE2 is coming

*The Bush Administration Tax Cuts will be extended for at least 2 or 3 years

On the whole, it was an interesting night with some people that I would dub "perma-bulls." I was a touch disappointed that there were no contrarian viewpoints to their arguments, though I am sure that bearish comments where NOT what they were hired to talk about. I'll finish with a quote from Sir John Templeton that I'm sure they would have engraved on their desks. {especially knowing where we've just come from and where they believe we're headed}

"Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria."

What does everyone else know...

I noticed this headline today on ZeroHedge.com

NYSE Short Interest Surges To Second Highest In A Year In Advance Of September Short-Covering Rally

Here's the accompanying graph that can be found here.

I don't really have much to say about this with one exception. IF we do get some type of hint at QE2 AND we have a broad market rally, it will be greatly exacerbated by the rush to cover these shorts.Oh and good luck getting real volume done when the HFT turn off their algorithms.

Sizing up my opponent

Mid-September and I have plenty of irons in the fire. Yet the daily grind in the Fed Funds is slow and sometimes arduous.  The idea of growing our single accounts into a larger, more macro-focused trading vehicle has begun to effect my thoughts and the process by which I believe trade creation occurs. The Greek philosopher Heraclitus wrote, "Nothing endures but change." {We often hear it translated just a bit differently as, "Change is the only constant."} My newer approach is to pull back from the one tree from which I'm picking apples and take a look around me to see if there is any low-hanging fruit on another trees nearby. Why strain for the next marginal piece of fruit in my tree when there is a perfectly good piece of easy fruit on the tree right next to you? All that to say, I want to expand the book and create a greater exposure and presence markets that relate to the FF.

I've been at this long enough to know that most of my trades don't just appear out of nothing. A majority are created out of a calculated premise, a lengthy discussion and the intangible of experience. However, if we are to aim towards a more macro goal, I think the process can shift to a round table conversation where we answer the following questions:

1. Where do I think we're going tomorrow in the products that we trade?
2. What is the best trade for tomorrow?
3. What is the best trade for the next few weeks {3-6}?
4. What is the best trade for the quarter?

 I don't necessarily have the answers to any {all} of those questions at any given point, but collectively the answers will emerge. What I've described is the goal. How we actually go about getting to that point; well that's the adventure.

::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::
I want to shift gears a bit and just briefly lay out some of the trades we've been working on over the last few weeks and months.

• In the FF we've been selling the 87/93 call spreads in December and February. We've been able to collect between .75 and 1 tick {1 tick = $41.67} and though they aren't "make your month" trades, they do help us finance our other positions.
• We've sold the March 68/75/81 put tree {-1, -1, +1} and collected an average of 1 tick. This trade leaves us short two downside puts and long one put that is currently ATM. If nothing happens in the Fed's policies or rates for the next few months OR we move higher in price {lower yields} we will simply collect our tick and be done with it. If however, we start to move lower, we're long a put spread with 1 naked short put below. The break even for this trade is roughly 9961.
• We've also done the May 68/75/81 put tree as describe above. However, we were able to collect an average of 2.75 ticks to sell the two legs and buy the one. The thought process and the theoretical payout is very similar.
• We have purchased the EDH {March 11} 92/95 {9925/9950} put spread in the Euro Dollars. Partially as a hedge against our FF put trees and partly to allow some credit risk exposure. Our thinking was if another European nation even hints at some type of sovereign wealth issue, the ED will react much more violently than the FF. We paid an average of 4.5 ticks {1 tick = $25}. The maximum this trade is worth is 25 ticks {less entry costs} giving us a very nice 5x1 on our money if it hits.

As far as what is out there but not quite ripe enough to pick? I think that the NOB is getting very attractive as a short position. The yield curve has been pricing in some type of QE2 coming out of tomorrow's FOMC meeting just as they did back in August. However, I find it difficult to believe that they will announce any type of easing coming out of an FOMC meeting. Perhaps they tweak the language, but nothing more. The chart below shows the generic NOB contract as generated by the CME. From its last top to the most recent bottom was nearly 80 ticks. At $156 per tick, that's a profit of ~$6,000 per one lot. I'm not sure how to best capture the pricing currently in the market. My gut says to get long USX {30 year Nov} put spreads and sell TYX put spreads for near zero cash outlay.

 ~LH