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

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."

Guarding and Grinding

At times the environment is simply conducive to the aggressive, long style trading that I've grown accustomed to. Most of my grinding comes in the form of 'Micro Interest Rates' (usually Fed Funds and Euro Dollars) and a surprise move in the discount window Thursday created a porthole of opportunity to press the positions I felt as if I'd been milking for so long.

Hindsight trading is 20/20 and as usual, I wish I'd emptied my entire holster on Friday afternoon instead of holding back the last few rounds. In talking with some of the other traders around the desk, they too all expressed a feeling of lament for being reserved in their efforts. Yet, there's something to be said about that bit a reservation. It's that piece of me that has probably produced some of the longevity I've enjoyed through my trading career.

I discussed some of my early trading venues in an earlier post, but I didn't truly earn my trading stripes until I stepped into the Bond Options pit at the CBOT as an autonomous local. This pit, more than any other, taught me to press a winner but to never be without bullets.

It was the spring of 2005 and the volatility was getting cheap. Though none of us were clairvoyant, we could all feel a trend starting to develop. This trend would continue for almost 3 painful years and would encapsulate nearly 20% of the all-time low month/month volatility readings including a mind boggling 4.2 print in August of '06. {Historical Vols} But this is the place where I learned to watch the few titans amongst the our pit locals.

These "3 Kings", as I'll call them, were traders that would never sell premium on the first pop, rather they would sit back and watch what real paper was doing.  They all possessed that unique ablitiy to fearlessly buy it higher and sell it lower. As if they were all taught by the famed Jesse Livermore (Reminiscences of a Stock Operator), they never saw it as chance to empty their pockets when the first bid appeared. Rather, they were the ones buying it (usually through the pit brokers) from all of the smaller locals, myself included. Not that I wasn't happy to sell my book for a perceived profit, but it confused me as I watched the 3 Kings books swell under the immense weight of millions of dollars of gamma.

Then it happened. The real paper showed up. Not that small retail customers deck, no, these were the big houses that had to move a position. I suddenly learned an enriching lesson: real paper is 'price-insensitive.' They needed the options and they were willing to pay up in order to get them. Guess what, I was fresh out of bullets. I had let go of the options I had stomached as losers for the last 2 months, and for what? 4 extra ticks? It hardly seemed worth it. Yet there, across the pit in their own corner, the 3 Kings continued to bid premium in the face of paper. The unthinkable occurred next. It was like a game of chicken and PIMCO blinked. Their bid jumped 10 ticks and the 3 Kings unloaded the wagons. They dumped every bit of the longs they'd gobbled from the locals and in the process they even offered all the little guys around them a chance to get some real edge. They had created a marketplace and they had dictated what the price would be.

My first game-changing lesson was complete. I saw that if you sell on the first pop, you haven't guarded your longs and now you may miss the real trade. I would have plenty more opportunities in the next few months and years to practice this skill and ultimately refine it to the point I felt comfortable pressing it. The real mark of a learned skill is the ability to teach it to others...but that's another story.

One down. A multitude left. And as I finish this, I realize that my holster is re-loading quickly.

LH