A summer's quote

This was one of my favorite quotes from the summer. Much like my single most recommended read {Reminiscences of a Stock Operator}this is written in the language that I find myself thinking. Over the years, I've found it very difficult to find anything written in the same pattern that is my daily grind. When I do find it, my appreciation for the author soars. IMO, this could have been written about my thought process...

This is from Minyanville's Jeff Macke on 06.21.10.

"You don’t think American viewers can handle listening to both me and the Today Show simultaneously, Comcast? Please. Right now I’m admiring the red outfits on my friends Melissa Francis and Trish Regan, emailing Melissa to tell her I admire her outfit, writing this column, surfing the web, getting stock quotes, playing Google Pac-man, pitching you guys a business idea about which I’m only 80% kidding. We’re a nation of multi-taskers, spraying revenue opportunities in infinite directions 24/7/365. You guys want a bigger slice of the pie? Turn up the stimuli on your new division. Give it more Macke."

~LH 

Possible Plays and an Update

What's worth doing right now?

We've sat around for a couple of days scratching our heads over what should be done in order to best capitalize on our current environment. If you'll recall, the last posting on what we're trading {here}we talked about a long July put spread in the bonds and a long call 1x2 in the September EuroDollar Futures.

To be brutally honest, we've taken some heat on both. 

Bonds:

As we traded higher following the rapid decrease in the S&P the bond option volatility became jacked! Though it wasn't enough to offset the 3 point rally we suffered with a short 5 delta, it did lessen the blow and provide us an opportunity to roll it around. In order to capitalize on the sudden rise in volatility we executed the July 114 - 115 put spread 1x2. By buying one July 115 put and selling 2 July 114 puts we effectively traded into the July 114 -117 put spread 1x2. This offers us the chance to make a profit anywhere between 117 and 111 in the September bond future. It also creates a short vega position meaning that as the market calms down and volatility decreases, this position will gain in value. Our average cost for the trade is now 9 total ticks.

Euro Dollars:

Our 95-96 call 1x2 is a bit underwater. We initially paid 3 ticks on that trade and as of the close today it was quoted 1.5-2. I firmly believe that this is the correct play and would advocate adding to any longs you've accumulated. This European drama will end and you have plenty of time to have the Libor stay put or slightly retrace.

The Future:

The skew {combo/risk reversal} in the bonds right now is very well bid to the calls. {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} In the September options {expiration 8.27.10}the premium is +8 ticks to the call. This is the fear trade. Right now, locals {and paper}are scared that the bonds will make a dramatic run-up just as they did back in November of 2008. To capitalize on this, you should look at the September 104 - 108 put spread 1x2. Currently it is priced around 2 ticks with the premium going to the 108 line. This means that you can sell it for 2 ticks and be long 1 extra downside put. Here is my thinking. 

*If the market continues on it merry way and continues it assault on sub 4% long term rates, this trade will expire worthless and you'll keep your 2 ticks of profit.

*If the market makes a powerful correction in the next 95 trading days there will be a change in the combo. Locals and paper will realize that the puts are undervalued and that skew could flip as much as 12-16 ticks. When that happens, this trade will profit handsomely as you're actually long an extra put for just such an occasion.

*If the market screams lower, you do have exposure between a futures price of 108 and 100 in the September future. Just for reference, those prices represent a 30 year bond yielding more than 7 %.

~LH

Reviewing a week

It took me awhile to figure out why manufactures insisted on putting cameras on cell phones. Finally, it has come to me. They did it so that we can take pictures of white boards and be able to disseminate the information at a later date and time.

So here's a whiteboard shot of our calls for the week we just exited:

 The Red column is our agreed upon guess for the week's low and the Blue was our week's high. The small black numbers are the actual prices.

For those of you scoring at home, I created the little matrix below to help with understanding my chicken scratch.

Not a bad week, and though it is completely contrary to my nature, we would have fared pretty well as premium sellers {strangles or outrights}.

From an email with Mr. Practical Thinker:

"... I'm pretty impressed with our calls. I think it's safe to say we accidentally nailed the dual mindset of last week. There was the 'all-clear' knee jerk reaction which got us within $1 of the high of crude, 1 penny of the high in ECM, etc. AND then the lows which came off the 'drip, drip, drip' reality of second thoughts. Which reality will win mind share in the week ahead? Not a very positive lead for the former but the market sure is comprised of the optimistic sort. We shall see...."

He's right, the market is optimistic. They {the ominous marketeers}seem to have grown accustomed to shaking off the brutal headlines and forging forward. It will be interesting to see what happens IF the market ever has real buyer's remorse on the whole thing. You wont see a 1000 point drop in a few moments, but I would say that you'd see a 1500 point drop over 8-10 trading sessions! Like I have said previously, I would love to be long gamma!

~LH

Mentally taxing

There aren't many days that will rival May 6th. It's interesting how a 1000 point swing in the Dow will make everyone forget the April Unemployment report that came out May 7th.

As an option trader, I found a sick pleasure is watching the violent swings across every asset class. Whether it was the bonds gap higher or the S&P's crushing decent, I was fascinated at the power of their respective retracements.

My hope is that the locals in my former pits were all long gamma and had a chance to really stick it to paper! Though, history tells me that that is rarely the case. Paper has an uncanny ability to strip the pit of all gamma {and vega} prior to moves like May 6th. As usual, we were always the last to know.

Sitting on the desk, just a few moments before the wheels came off the wagon I witnessed an interesting phenomenon in the Fed Funds markets. Many of the back months futures (Jan 2011 and later) are priced by one or two very large firms and their algo-trading model. Usually these computers keep the markets a few ticks wide and though they're rarely afforded the opportunity trade these contracts, they will snap into action if something seems out of line. However, just a few moments before the massive selling in the S&P's the machines widened their markets. 30 seconds later, they actually pulled themselves out of the market entirely. When that happened, every other computer driven model was clueless and they pulled their markets as well, in EVERY Fed Funds market {even spreads}. As I looked around the room at the other various traders we came to the sudden realization that we were the only people dumb enough to still be making markets. As we scrambled to hit our 'PULL ALL' buttons, the chaos began.

Hindsight trading is 20/20 and everyone would be a millionaire. I was personally disappointed in my inability to buy some of the insanely cheap spreads in our markets. This past weekend, I was reminded by one of my old friends who says it best, 

"What beat me was not having brains enough to stick to my own game--that is to play the market only when I was satisfied that precedents favored my play." Reminiscences of a Stock Operator Lefevre.

It was favorable to buy everything at almost zero and then watch them all trade up 2 full ticks. If there's a next time, I pray I'll be able to pull the trigger.

~LH

Mixing ED with US

Here's a couple of plays we have on going into Friday's unemployment number. For the record, I fully anticipate a blowout number. Something in the neighborhood of +275K with bottom-line rate unchanged at 9.7.

I say this for two reasons. We need good news for the equities. Other than traders, I don't think anyone likes fear. The VIX is high and the risk aversion is creeping back into the marketplace. If there was a month to finally release all the census workers' hiring data, this is it. April was free of strange weather events and random holidays that would have slowed the hiring process. We should see the full effects from the the 1 million jobs the census created {though we'll pay for them later} and it will make the Mom and Pop investor feel more confident after the likes of the Goldman Sachs scandal. Secondly, I'm not sure that the market will care what the number is, and are looking for any excuse to rally equities and sell treasuries. The panic flight to quality this morning was overdone IMO and regardless of what the US Government releases in terms of data, equities go higher yields do too. So, in a round-about way, I think we get there with a banging number or not.

Since we were so convinced that the Ten Year is going to reject the 3.50% yield line, we decided that we would execute a put spread in the bonds. We selected the July 115 - 117 put spread for 25 ticks. It has a 12 delta. We don't actually expect to keep this trade until expiration, rather as we grind lower, we hope to profit from its appreciation and sell it out. Below is the chart:

During a conversation with a large ED options trader, he noted a couple of plays that he thought would be decent risk/reward trades. However, his most salient trade thought was that he foresees the 99.625 line as a 'pin risk strike'. By that he simply means that we may trade up through it slightly but when it comes to settlement, LIBOR will settle as close to .375%  as possible and the options written to that line will become worthless {both the calls and puts would expire at zero} We really enjoyed this logic and decided to put some skin in the game and test it out.

We purchased the EDU 99.50 - 99.625 call spread 1x2 for 3 ticks. If our ED trader hypothesis is correct, our call 1x2 will settle at 12.5 ticks netting us 9.5 ticks {Sept ED settling at 99.625}. If LIBOR explodes and starts printing in the .75% to 1.25% range we simply lose our premium paid (in this case, 3 ticks). If the world settles down and risk becomes a moot point again, our breakeven to the upside is 99.72 in the September ED. That seems like an unlikely{though entirely possible} level, but one that we're still willing to take a risk on.

~LH

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

Update

So there you have it. I guess it was sort of a push? I got 3 right, he got 3 right...but to be fair, my S&P call was pretty good too! However, since the X {November Fed Fund} market was technically Mr. Practical Thinker's, I assume that I owe lunch for the office.

~LH

Nostradamus

With Mr. Practical Thinker heading off to the Holy Lands today the Old Baron and myself decided to play Nostradamus and predict where the world would all be at upon his return.

The one with the most losses, buys lunch for the office.

~LH

"Failure is an orphan"

"...but Success has a thousand fathers."

I'd love to take the credit for calling out Wednesday's TY Note auction results and our two plays that netted 87.5% and 69% profits respectively {Highlighted in our last post}. I would love to be that guy, but alas...it was Mr. Practical Thinker.

Mr. Practical Thinker fathered the notion that the market would soundly reject a 4% yield in the TY. He was dead-nuts right. Looking into the Bloomberg article further we found a few points to be encouraging in terms of our pre-auction market analysis.

1. Indirect bidders {read: Foreign Banks} accounted for 8% more of the bids than they did in March. This is encouraging because we see this as a trade that has been initiated out of necessity. There seems to be  real risks in terms of the murky EU situation(s) and US economic recovery and the idea of locking up 50-100mm at close to 4% is a really nice hedge. 
2. The bid-to-cover ratio was 3.72 vs a rolling average of 2.87. Bloomberg cites that this was the most over-subscribed auction since at least 1994. Savvy investors of all backgrounds seemed to be able to identify how lucrative it was to get in on the nearly 4% yields.
3. "The Fed's preferred inflation measure, {Core PCE} an index based on consumer purchases of goods and services excluding food and energy, was up 1.3% in February from a year earlier, below the Fed's Target of 1.5% to 2%."* If treasury buyers are looking for a reason to get long, they have found it in the fact the real inflation is at generational lows. In our opinion, the fact that investors wont get your entire return gobbled up by inflation, coupled with the notion of nearly 4% yield brought additional buyers to the marketplace.

Here's what we're thinking. The $13 billion auction of 30 Year Bonds will be good, but NOT as good as the yesterday's TY. However, yields will drift lower as futures trade higher. We're looking for opportunities to buy TY and US put spreads as well as possibly cherry-picking some cheap volatility trades. Unfortunately, you will probably have to wait until mid-day on Friday {or maybe even Monday} to get the best levels on these trades. In the TY we suggest buying a put between 112 and 114 and financing it a put {or 2} lower than 110.5. For the US contract, we suggest buying a put between 113 and 110 and selling a lower strike.

~LH

*Wall Street Journal, "Fed Fear: Raising Rates Too Soon" by Hilsenrath 04.07.2010

Confucius say ...

"He who pick bottom, get stinky finger" (perhaps my favorite 'market timing' quote--obviously not Confucius)

Friday was a very abbreviated session that gave the credit markets a quick and solid beat down. Not only did every interest rate product move lower, but the spreads started moving as well (as opposed to the unilateral moves we've had recently)

To us, this signals a good sign. The marketplace is finally starting to price in a recovering US economy and all of the impending policy maneuvers that will accompany this revival.

Here's a few points of interest:

• As of the close yesterday, the Fed Fund Futures were pricing in a 43% chance of a 50 bps rate move at the January 2011 meeting. (Also known as an 86% chance of a 25 bps hike)
• Our closely watched NOB (Notes over Bonds) yield spread touched 86 bps on Friday. In the full session yesterday (Monday 4.05.10), it did NOT react as we had expected. Recently, when the short end (ED and 2 Yr Notes) sell off, the NOB goes negative (in relative terms, the 10's are underperforming in relationship to the 30's and the spread between their yields is increasing) Yesterday, even with a aggressive sell in the futures market, the NOB stayed constant at 88-89 bps. This signaled to us that the market wasn't fully convinced that yields were headed higher. Early price action today, confirms that assumption as they are drifting higher in early trade.
• General market consensus is that this week's auctions (all 8 of them ranging from 4 weeks to 30 years) will be met with mixed demand. Most talking heads have been harping on higher interest rates due to investors REQUIRING more bang for their buck. We disagree. Foreign investors were quiet at the last few rounds of auctions as they sifted out the mixture of data coming from the US. We anticipate very robust auctions and a drop in current yields (especially in the TY and US contracts).

We got long the following:

1. In the Ten Year (TY) we bought the 116.5 - 117.5 call spread for 8 ticks. Risk is 8 ticks, potential profit is 56 ticks (64-8). We're looking for a good TY auction on Wednesday and will probably be out around 14-16. {SOLD OUT AT 15 vs. 115.30 TYM10 Netting 87.5% profit}
2. In the 30 Yr Bond (US) we're long the 116-117 call spread for 13. Same parameters, just looking for a pop.{SOLD OUT AT 22 vs. 115.21 in USM10 Netting 69% profit}
3. We're still hedged up for a move to the downside in the Euro Dollar (ED). We still have the E0K 9837.5 - 9812.5 put spread 1x2 on for a half a tick. We're long the 9837.5s to be short 2X the 9812.5s. This trade pays off if the June 2011 ED settles below 9837.5 on May14th.
4. We took off the E0J put spread 1x2 for a 75% profit.

Closing thought:

• A large hedge fund in Greenwich CT. initiated a US 117 - 119 call spread 1x2 this morning. They bought the 117 calls and sold 2X 119 calls. They did 15K (15,000 x 30,000)! In my opinion, they have the same thoughts as us. The only difference is the timing (We put all of ours on yesterday) and size (We didn't do 15K)

This is the week of supply.

~LH