Why it might make sense to craft a tail hedge now!
Say you’re bearish but find yourself confused by the market. You want to partake in the action if things go south, but not 100% certain, what could you do?
First, you could build some conviction by identifying potential reasons why you think the market could dip lower… Then, devise a ‘tail hedge’ to profit if things indeed go south.
Let’s break down these two steps this week.
In our past two articles, we've highlighted a couple of reasons why we lean bearish. You can find them here: S&P500 Vulnerabilities: from Money Supply to Sectoral Imbalanc & Why we’re watching the Bond/Equity Volatility. But as each week unfolds with more drama, let's revisit the market.
The first idea we want to bring up is the rates-equity dislocation.
On the equities front, we observe the following:
The conventional wisdom has long held that low rates are good for stocks. However, with stocks rising while the Fed hikes rates, has this relationship been disrupted? From 2020 to the end of 2021, we clearly observed this classic dynamic. However, from September 2022 onwards, as stocks continued their ascent despite the Fed's rate hikes, a distinct shift became evident. Could this Equity-Rate dislocation be a by-product of the AI hype? Consider Nvidia’s stock price, which seemingly pinpointed the Nasdaq's low point.
Question is… Is the AI hype a strong enough factor to permanently alter this relationship?
In terms of overarching themes, there are generally defined up and down trends. AI ETFs seem to provide a rough gauge of the sector's peaks and troughs. With the previous peak in 2021 happening in the ETFs right before Nvdia peaks, again now we see a similar trend with the ETFs seemingly having peaked while Nvida trades slightly higher still, and we wonder for how long more?
If this signals a pivot for Nvidia, then the Nasdaq, currently buoyed by AI hype, could falter.
Now, turning to rates: What could drive rates higher? A string of robust US economic data regarding jobs and inflation has emerged. Recent figures for CPI, PPI, and NFP all exceeded consensus estimates, suggesting a robust US economy. Such data might embolden the Federal Reserve to maintain its tightening cycle.
One way to interpret robust economic figures is through an economic surprise index, such as the Citi Economic Surprise Index. This metric quantifies the differences between actual economic outcomes and projections. A positive number indicates that the economy is outperforming expectations.
When you overlay the Citi economic surprise index against the 13-week change in 10-year yields, a clear correlation emerges. When the economy outperforms predictions, yields tend to move in tandem.
This increase in yield represents a significant deviation from its nearly 3-decade trend. Broadly speaking, the Nasdaq 100 Index hasn't experienced such a pronounced change in yield trends since its inception.
On Volatility, Erik Norland from CME highlights an intriguing observation: the relationship between the yield curve slope and VIX when viewed from a 2-year average perspective. He suggests that equity volatility and the yield curve follow cyclical patterns, typified by specific periods:
1) Pre-Recession & Recession -Flat yield curve and high volatility
2) Early Recovery – Steep Yield Curve & High Volatility
3) Mid Expansion – Steep Yield Curve and Low Volatility
4) Late Expansion – Flat Yield Curve and Low Volatility
Plotted, the cycle looks like this for the 1990s period;
As well as the 2000s;
Given our current position in the Equity Volatility-Yield Curve cycle, we might be bracing for higher volatility ahead as we're likely situated near the cycle's bottom left quadrant.
If the trifecta of rising yields, waning AI hype, and a nascent high-volatility regime comes to fruition, then investing in tail hedges might be a savvy move.
One potential structure for a tail hedge could be the 1X2 ratio put spread. This strategy could offer protection against adverse market movements, with the flexibility to structure it so that initial costs could be negligible or even result in a net credit. Additionally, the put ratio is typically a long vega strategy, which could be beneficial in a high-volatility environment.
The 1X2 ratio put spread can be set up by taking 2 positions,
1) A short position on the Nasdaq 100 Index Futures with a strike price below the current level
2) A long position on 2 Nasdaq 100 Index Futures with a strike price further below the short option strike
At the current index level for the Nasdaq 100 Futures March 2024 contract of 15,520, we could take a short position on the March 2024 put option with a strike price of 14,800 at 304.25 points credit and 2 long positions on the March 2024 put option with a strike price of 13,800 at 122.5 points debit. The setup cost of the put ratio is 304.25 – (2 * 122.5) = 59.25 points, resulting in a net credit. The maximum loss occurs when the underlying asset settles at 13,800 by option expiry, leading to a potential maximum loss calculated as follows:
Long put options both expire worthless: -122.5 * 2 = -245 points
Short put option: 13,800 – 14,800 = -1000 + 304.25 = -695.75 points
Maximum loss = 940.75 points
Considering the potential for loss and the associated risks, several profit scenarios emerge. If, as we discussed, the yield trend shifts and the AI hype subsides, the Nasdaq could potentially plummet. If the Nasdaq falls beyond the 13,104 level by option expiry, the strategy could be profitable. Conversely, if the Nasdaq remains range-bound at its current level or rises by expiry, we could also benefit from the initial credit received. Each 0.25 index point is equivalent to $5.
The charts above were generated using CME’s Real-Time data available on TradingView. Inspirante Trading Solutions is subscribed to both TradingView Premium and CME Real-time Market Data which allows us to identify trading set-ups in real-time and express our market opinions. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/
Disclaimer:
The contents in this Idea are intended for information purpose only and do not constitute investment recommendation or advice. Nor are they used to promote any specific products or services. They serve as an integral part of a case study to demonstrate fundamental concepts in risk management under given market scenarios. A full version of the disclaimer is available in our profile description.
Reference:
yardeni.com/pub/citigroup.pdf
cmegroup.com/openmarkets/economics/2023/A-New-Equity-Index-Options-Volatility-Cycle.html
cmegroup.com/markets/equities/nasdaq/e-mini-nasdaq-100.contractSpecs.options.html
First, you could build some conviction by identifying potential reasons why you think the market could dip lower… Then, devise a ‘tail hedge’ to profit if things indeed go south.
Let’s break down these two steps this week.
In our past two articles, we've highlighted a couple of reasons why we lean bearish. You can find them here: S&P500 Vulnerabilities: from Money Supply to Sectoral Imbalanc & Why we’re watching the Bond/Equity Volatility. But as each week unfolds with more drama, let's revisit the market.
The first idea we want to bring up is the rates-equity dislocation.
On the equities front, we observe the following:
The conventional wisdom has long held that low rates are good for stocks. However, with stocks rising while the Fed hikes rates, has this relationship been disrupted? From 2020 to the end of 2021, we clearly observed this classic dynamic. However, from September 2022 onwards, as stocks continued their ascent despite the Fed's rate hikes, a distinct shift became evident. Could this Equity-Rate dislocation be a by-product of the AI hype? Consider Nvidia’s stock price, which seemingly pinpointed the Nasdaq's low point.
Question is… Is the AI hype a strong enough factor to permanently alter this relationship?
In terms of overarching themes, there are generally defined up and down trends. AI ETFs seem to provide a rough gauge of the sector's peaks and troughs. With the previous peak in 2021 happening in the ETFs right before Nvdia peaks, again now we see a similar trend with the ETFs seemingly having peaked while Nvida trades slightly higher still, and we wonder for how long more?
If this signals a pivot for Nvidia, then the Nasdaq, currently buoyed by AI hype, could falter.
Now, turning to rates: What could drive rates higher? A string of robust US economic data regarding jobs and inflation has emerged. Recent figures for CPI, PPI, and NFP all exceeded consensus estimates, suggesting a robust US economy. Such data might embolden the Federal Reserve to maintain its tightening cycle.
One way to interpret robust economic figures is through an economic surprise index, such as the Citi Economic Surprise Index. This metric quantifies the differences between actual economic outcomes and projections. A positive number indicates that the economy is outperforming expectations.
When you overlay the Citi economic surprise index against the 13-week change in 10-year yields, a clear correlation emerges. When the economy outperforms predictions, yields tend to move in tandem.
This increase in yield represents a significant deviation from its nearly 3-decade trend. Broadly speaking, the Nasdaq 100 Index hasn't experienced such a pronounced change in yield trends since its inception.
On Volatility, Erik Norland from CME highlights an intriguing observation: the relationship between the yield curve slope and VIX when viewed from a 2-year average perspective. He suggests that equity volatility and the yield curve follow cyclical patterns, typified by specific periods:
1) Pre-Recession & Recession -Flat yield curve and high volatility
2) Early Recovery – Steep Yield Curve & High Volatility
3) Mid Expansion – Steep Yield Curve and Low Volatility
4) Late Expansion – Flat Yield Curve and Low Volatility
Plotted, the cycle looks like this for the 1990s period;
As well as the 2000s;
Given our current position in the Equity Volatility-Yield Curve cycle, we might be bracing for higher volatility ahead as we're likely situated near the cycle's bottom left quadrant.
If the trifecta of rising yields, waning AI hype, and a nascent high-volatility regime comes to fruition, then investing in tail hedges might be a savvy move.
One potential structure for a tail hedge could be the 1X2 ratio put spread. This strategy could offer protection against adverse market movements, with the flexibility to structure it so that initial costs could be negligible or even result in a net credit. Additionally, the put ratio is typically a long vega strategy, which could be beneficial in a high-volatility environment.
The 1X2 ratio put spread can be set up by taking 2 positions,
1) A short position on the Nasdaq 100 Index Futures with a strike price below the current level
2) A long position on 2 Nasdaq 100 Index Futures with a strike price further below the short option strike
At the current index level for the Nasdaq 100 Futures March 2024 contract of 15,520, we could take a short position on the March 2024 put option with a strike price of 14,800 at 304.25 points credit and 2 long positions on the March 2024 put option with a strike price of 13,800 at 122.5 points debit. The setup cost of the put ratio is 304.25 – (2 * 122.5) = 59.25 points, resulting in a net credit. The maximum loss occurs when the underlying asset settles at 13,800 by option expiry, leading to a potential maximum loss calculated as follows:
Long put options both expire worthless: -122.5 * 2 = -245 points
Short put option: 13,800 – 14,800 = -1000 + 304.25 = -695.75 points
Maximum loss = 940.75 points
Considering the potential for loss and the associated risks, several profit scenarios emerge. If, as we discussed, the yield trend shifts and the AI hype subsides, the Nasdaq could potentially plummet. If the Nasdaq falls beyond the 13,104 level by option expiry, the strategy could be profitable. Conversely, if the Nasdaq remains range-bound at its current level or rises by expiry, we could also benefit from the initial credit received. Each 0.25 index point is equivalent to $5.
The charts above were generated using CME’s Real-Time data available on TradingView. Inspirante Trading Solutions is subscribed to both TradingView Premium and CME Real-time Market Data which allows us to identify trading set-ups in real-time and express our market opinions. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/
Disclaimer:
The contents in this Idea are intended for information purpose only and do not constitute investment recommendation or advice. Nor are they used to promote any specific products or services. They serve as an integral part of a case study to demonstrate fundamental concepts in risk management under given market scenarios. A full version of the disclaimer is available in our profile description.
Reference:
yardeni.com/pub/citigroup.pdf
cmegroup.com/openmarkets/economics/2023/A-New-Equity-Index-Options-Volatility-Cycle.html
cmegroup.com/markets/equities/nasdaq/e-mini-nasdaq-100.contractSpecs.options.html
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