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

Summer is finally over

It was a summer filled with doldrums.

There were long stretches that I was on vacation. Ironically, there were even long periods where I should have been. The volume in our contracts was anemic and is just now beginning to pick up. Even so, I've found it increasingly difficult to regain my market feel. All of the moves have been one directional with virtually no two-way paper. It's hard to make a trade and then have to sit on a position for what seems like weeks just to see if the trend folds back around. The P of PnL has been tricky to come by, the L has been here frequently.

As my kids are now back in the saddle with school, so must I rejoin the ranks of the working. The plan will be to write at least twice a week. I want to outline the plays I think are worthy of a look and the discuss some of the thought process that we've put into out trading. I have been joined by a new accomplice from past life. And though I haven't figured out his moniker yet, his ideas have already permeated my thinking. Hopefully, he and Mr. Practical Thinker will start to contribute on a weekly/monthly basis. Their ideas are always fresh and thoroughly thought provoking.

In the next few days, I hope to put out a couple of our current positions as well as a few of our thoughts on what might come next.  

~LH

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