It’s A Trader’s Market Now

February volatility has clearly signaled a regime change. We’re no longer in a market that rewards ‘hodlers’ to think less and hold more. It’s a traders market now.

The S&P finally snapped that ridiculous no pullback streak we’ve all been watching on Fintwit. (Picture below via Bespoke.)

And that break caused the largest short volatility unwind in the history of the VIX complex. The one day move on February 5th set records for the largest point move and percentage move in the VIX index. This includes data from the 2008 financial crisis.

This up move caused the VIX futures term structure to trade at levels last seen in the 2008 financial crisis.

Now the big question is whether or not this volatility will persist. Will equities work off the uncertainty and resume the 2017 uptrend? Or will 2018 look like a giant volatile and choppy range?

We’ve found it extremely helpful to watch the trend in credit spreads to determine the forward vol regime. When credit spreads widen volatility in the market will persist and stay high. When credit spreads tighten the opposite occurs — volatility comes down.

A quick way to check out credit spreads is to plot the ratio between SHY and HYG (SHY/HYG).

Credit spreads are on the precipice of breaking out and reversing the down trend from 2015. If this chart can breakout and hold then we should expect more volatility in the months ahead.

Right now it’s sort of in “no-man’s land.” In response, we’ve cut back on our aggressive short vol stuff and have started to move our focus into trades that will benefit if this chart breaks out. This is in line with our macro view that higher volatility is ahead.

Unfortunately, monetizing a forecast for higher volatility is tough. Pretty much anything that benefits from higher vol has a negative carry along with it (short high yield bonds, long VIX calls, long puts on SPX, long VXX etc.). All of these long vol trades slowly bleed you to death unless you happen to get in at the perfect time. It’s possible to do — but tough.

Luckily, there’s an alternative way to monetize higher vol if you’re willing to do some tactical trading. Historically speaking, long only mean reversion systems with one day holds have worked fantastic on equity indices during volatile conditions.

Tactical strategies in stock indices that buy on panic closes, hold overnight, and sell on the next day’s close can harvest a liquidity premium that appears when market participants freakout and dump their exposure.

There’s hundreds of way to write strategy logic that takes advantage of the overnight liquidity premium.

We have access to a genetic algorithm (hat tip to our friends at Build Alpha) that can scan for the top ones. Here’s what it spit out for the S&P.

  • Mon,Tues = 1
  • rateofChange(close,3)[0] < rateofChange(close,3) [2]
  • Stochastics(4) <= 20
  • If true, buy market and sell after 1 day

Basically, it’s telling us to buy when markets get really oversold on Monday or Tuesday and then to sell on the next day’s close.

The graph below shows the equity curve for the strategy all the way back to 1998. Performance has been strong throughout time — and the strongest during 2008.

That highlighted part of the equity curve on the right is the performance of the algo on “out of sample” data. When using a genetic algo it’s important to make sure you test it on unseen data to make sure it’s robust. The fact that this logic has continued to perform on unseen data is a great sign. It means the overnight liquidity premium in volatile conditions is real and not some spurious relationship dug up by a machine.

The next plot shows a breakdown in performance per year.

2002 did fantastic. As well as 2007-2008 and 2014-2015. All of these periods were characterized by high volatility and choppy price action — the exact type of environment were expecting in 2018.

The above trading strategy can be executed on either the SPY ETF or the E-mini S&P 500 futures.

Consider adding this tactical trading strategy into your trading book this year especially if credit spreads breakout and hold.

The above was an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.



SKEW Index Has Trended Straight Upward

Low Volatility Begets Low Volatility. Here’s Why…

The following is an excerpt from our monthly Macro Intelligence Report (MIR). If you’re interested in learning more about the MIR, click here.

The trading community has been yapping away about the VIX trading sub-11 and the extreme number of speculative shorts involved. They’re saying it’s gotta burst higher.

Their proclamations are presented with a chart like the one below which measures net nominal non-commercial positioning.

VIX Future Positioning

But these positioning charts are misleading. They fail to account for the growth in open interest. The VIX futures in particular become heavily distorted because open interest and volumes have increased 10x since they first started trading in 2004.

VIX Future Open Interest

Net nominal numbers therefore mean nothing. Yes, the total amount of net shorts is higher than it’s ever been, but that’s because more people are trading VIX futures than ever before.

It’s easier to see why this is true with a simplified example.

Say they’re 100 open contracts and specs are short 99 contracts. Well obviously that’s a crowded trade. If the specs race to cover, price will squeeze hard. Specs are short 99% of the open interest.

Now let’s say activity grows and there’s 1,000 open contracts. Of these, specs are short 600, or 60% of the open interest. Compared to the prior reading, net short 600 looks a lot bigger than net short 99. But in reality the first situation has a more concentrated spec position. Participants previously were short 99% of open interest instead of 60% of open interest now.

That’s why you need to make sure you’re accounting for open interest.

We know a number of you visit to look at positioning. We emailed the site owner Adam to ask if he was accounting for changes in open interest or not. As of now he is not accounting for them. But he’s rolling out an update soon to reflect the changes. After that update, the charts should give us a better idea of whether or not we’re at a true speculative extreme.

It’s worth noting that even without the update the 5-year percentile in VIX futures is not at an extreme. All the fuss on twitter was for nothing…

Futures Is Not At An Extreme

Given that positioning isn’t at an extreme (money managers are way too afraid to short vol in the Trump era), we’re in agreement with Goldman on what these low VIX readings mean. The data shows that low vol begets low vol, not high vol. Goldman conducted a study going back to 1990 to find out what happens to VIX and the market after VIX crosses below 11. The specifics of the study are shown below: Read more