There is a clear correlation between the VIX and percent change in SPX. Sometimes VIX runs higher than the SPX change implies. I call that “overvixing” (overstatement of VIX). The opposite is “undervixing” (understatement of VIX).
When the market overvixes, typically it mean-reverts strongly with an SPX rally and a VIX drop. When the market undervixes, it typically doesn’t strongly mean-revert; it gradually gets more and more undervixed until an event that causes an overvixed drop in SPX. So, overvixing is corrected swiftly due to market maker vanna exposure while undervixing needs a catalyst to be corrected.
These terms were originally coined on the Wizard of Ops Twitter: https://twitter.com/WizOfOps/status/1450080292476182528
All corners of #FinTwit have their own personalities, and they need to be evaluated in the light of their industry. Here is my impression of these groups, and how I like to assess what they are saying.
Hopefully my red flags are helpful. If you want me to look at an analyst, please share in the comments. I always like finding some new sources of data.
I have yet to find a macroeconomist that has ever posted that "everything is fine". There is always a problem, and the problem will manifest in minutes instead of years. There may be validity to their claim, but study it for yourself, and figure out what metrics must be studied to forecast the problem is coming true. Also, find and read the opposing viewpoints. I put Fed watchers in this category, but they tend to be less doom and gloom. Zerohedge is in here too.
If they are not bots, they typically have a method that has massive blind spots. Technical analysts do not consider fundamental analysis; value traders treat growth like they will eventually get cleaned out; while growth sees value as antiquated. Short sellers troll everything. In some pockets they battle over equities themselves (like a biotech company with a binary event approaching), but more often than not the different strategies are what are being fought over. In this group, I will look at some theses, but validate them myself.
Because the bond market is more complex and opaquer than all other markets, bond traders troll more than any other. There are camps on either side, and the insults are frequent. The adage is that the bond market is the “smart money”… but it is more like the ego market. Because nobody has a complete grasp of bonds, many assert superiority by attacking the other camp. I just read both sides, and try to assess for myself. One funny thing is when one says another is a charlatan, or a liar, I follow them to get their point of view, too. 😉
Options traders get very deep in the weeds. This corner of #FinTwit is very mathy/quant, and in many cases is TMI. A lot of that is not as applicable to the typical trader, but it is interesting the more you dig.
There is also a weird dynamic in options trading circles that feel like everyone is on the same team. They are the most helpful, possibly because options theses typically are more related to multiple variables. Further, knowledgeable options traders know we aren’t competing against each other; we are trying to find edge within an ecosystem. I’m not afraid to ask questions of options traders. They typically answer well, and it mostly about internal system workings. There is some trolling, but I think that comes naturally in Twitter.
Energy trading is closer to a science than any other sector. There is very little new news in the #OOTT crowd. They know how much is being produced, what the consumption seasonality is, futures price flows, etc. Because these traders are knee-deep in it, their opinions are very well-informed. However, this also means there is very little edge. I listen to them, but typically there is almost always consensus.
I have not met one metals trader that said gold is going down. The assumption is metals are always going up, and their only job is to determine how deep any dip will be. To be honest, I have found maybe one that I will listen to even a little bit.
This article, "The Social-Media Stars Who Move Markets", inspired this post and my Twitter poll responses validated my inspiration. Then there is the trend of red flag posts. It is like the universe wants me to write this.
Offering #FinTwit content? Consider this an examination of conscience.
# 1. “Look at this fancy car, purse, house, jewelry!!!!”
Their non-investment posts are excessively materialistic. The goal is to make you believe they can afford these luxuries bc their trades are so good. Not only are they making money on their viewership (NOT trades), but if that is an attractive feature to you... please examine why you are trading. Successful traders treat their portfolios like a business. Withdrawals are only made if absolutely necessary. The trade of future earnings for a Ferrari is a terrible trade
#2. “This trading strategy works EVERY TIME!”
This statement ignores changing market environments. Even if there was a magic bullet, it would be front-run. Typically, when this is advertised, they're trying to teach YOU this strategy.
It seems great that now you can do this strategy yourself, but shifts responsibility for failing onto you. Now when you lose money, it is your fault that you didn’t follow the strategy correctly.
#3. “Diamond hands!! ” “HODL!!” “YOLO BETS!”
This person trades by emotion. They will scream at the computer when they are failing, and talk hyperbolic trash when they succeed (e.g. they compare themselves favorably to Warren Buffett). This is a psychological trick (In-Group Favoritism Bias).
They align their emotions to yours & you develop a favorable opinion of them. “Diamond Hands”, “HODL”, etc. are subtle ways this manifests; these terms make you feel part of a “retail team”, but you're being taken advantage of.
#4. The #FinTwit troll
They will mock others with the intent to invalidate their point of view. This is to distract you from the fact that their OWN point of view is fallacious or incomplete.
#5. “This just happened and it’s obviously because of THIS reason.”
This is retroactive attribution. They will say something that makes sense in retrospect, but has no predictive power going forward.
Further, it is short-sighted & is not data-based. Popular financial media universally falls in this category. When you read why the market moved on popular financial media, not only is there a low chance of it being correct, but also a low chance their logic will carry forward.
#6. #FinTwit Clichés/adages in problematic context
“Sell in May and go away.”
“The market can stay irrational longer than you can stay solvent.”
“Bulls make money, bears make money, pigs get slaughtered”.
These common adages are fun, and - when taken in context - they have an element in truth in them. But that’s the problem; it is that element of truth that leads you into a false thesis.
Take, for instance, the adage that gold is an inflation hedge. Look at gold’s correlation to inflation, M2 money supply, or value of the dollar. None of it works. We should demand data or clear logic to back “given” assertions. They must answer the why, at least somewhat satisfactorily.
#7. Using past performance to validate an opinion
Many successful investors have had a successful year or call that has been publicized; that call becomes the reason all their calls will succeed going forward.
Cathy Woods. Michael Burry. They're people, too. Their theses need validation as much as anyone’s. This isn’t to say they have no insight, but validate their theses yourself. Ask why. I mention Woods & Burry because now they're being “Burry-ed”. Had to do it.
#8. #FinTwit’s Constant Apocalyptic Proclamations
There may be issues with the economy, or the financial system, etc., but a couple things need to be understood when hearing these calls.
First, they're designed to stoke fear in you, not wise investment decisions.
Second, it is in no one’s best interest for the financial system to collapse. Even a government that most don’t trust will do whatever they can to stop that from happening, even if actions just delay the inevitable. “The Big Short”, “The Smartest Guys in the Room”, and other movies are anomalies, and even somewhat glorify positioning a portfolio for economic collapse. Be careful not to fall into that trap.
#9. #FinTwit Technical analysts that claim to be both the why & what of the market
This isn't against technical analysis (TA) itself, which I think has a place in analysis. When analysts say the market is moving BECAUSE of a technical reason, that’s a sign that they have no context.
Even if correct, a rally didn’t happen because a trendline broke, a bullish engulfing candle was confirmed, we reached a fib, etc. These are signs of something else. They fail as much as succeed and need context to be an effective trading strategy.
#10. Ego-Driven #FinTwit
They repeatedly show successes and never a failure. They are unwilling to see an alternate point of view presented in comments. Even obvious errors are not taken responsibility for (like a misspelling). That means their theses aren't receptive to alternate points of view, and they cannot be considered comprehensive. These #FinTwit people may be smart, but they are also very obnoxious.
Stay tuned for part two! Let me know your thoughts in the comments.
This is a post about one of the market correlations that has been consistent over the past decade+, although I will be focusing on 2018-current. The SPX/VIX relationship everyone *knows* exists, but only assumes the correlation and its meaning.
$VIX is many things, but at its core it is a measure of implied volatility (IV) on $SPX. This represents the supply and demand in $SPX options. The demand comes from customers while the supply primarily comes from centralized market makers (MMs).
Because the MMs have more uniform goals (to isolate and collect premium on their options), the supply side is much easier to analyze. When you look at the SPX/VIX graph, you can’t help but notice how correlated it is.
Essentially, MMs have a liquidity comfort level on their offerings given a daily $SPX level. This would be the historically standard premium they are charging you for options on a daily basis. Considering what we know about delta hedging, there is a clear causation as well.
If $VIX goes up more than the change in $SPX would indicate, that is a sign that MMs are less willing to sell puts at these levels (VIX overstatement) and vice versa. This is usually in the case of an upcoming event. Once that event passes, IV invariably comes back down.
When IV declines, that unwinds hedges and we see massive rallies. Lets take the Biden/Trump election in Nov. 2020 as an example. Here is a chart where orange is the $VIX overstatement and blue is the $SPX return pre-election.
Demand was clearly rising for puts pre-election. A lot of that selling was due to MMs hedging those puts. If VIX overstates, market participants are hedging. If the market does not drop below the aggregate premiums on the option chain, be ready for mean reversion.
This is from charm and vanna: decay in IV that decreases the value of customer hedges and decreases the amount of hedging needed by MMs. When MMs decrease their hedges, they cover their shorts. What happened after the election didn’t result in the world exploding?
Not only did the VIX overstatement mean revert, but SPX did as well. The election wasn’t even settled until much later, and the market already made the decision that the world was not going to explode no matter who won. Here's the cumulative chart during that time:
Do you need a quantitative measure of the deviation? On a daily basis, these are the returns of VIX overstatement when it is >-2.5 or <2.5. Those two “outliers” that need to be taken seriously are 3/5/2020 and 3/13/2020.
There is a strong indication that when VIX overreacts (+ numbers) downside abates and a mean reversion will happen. The VIX underreactions tend to be soon after the overreactions. This is a a solid indicator but needs to be taken in context of the market at the time.
I don't have data to prove it yet, but this indicator scales. If you see a strong overreaction in a short amount of time, you are likely to see a small bounce. Cumulatively it works too, but I think it scales on a function of a log scale, so I have work to do on that front.
In the end, the action is to monitor the deviations VIX has from its SPX correlation. Develop a thesis around the situation it is tracking and act accordingly. It is very likely that we will see mean reversion in both VIX and SPX.
This content originally appeared on the Wizard of Ops Twitter here: https://twitter.com/WizOfOps/status/1446117113735749638
Last April, Jerome Powell enacted a policy to encourage lending during the pandemic called the supplementary leverage ratio (SLR) exemption.
Banks have an SLR requirement that made them hold a certain amount of capital for every liability to ensure their risks were mitigated. This modification temporarily exempted US Treasuries and deposits (which is a bank liability to an account holder) from being counted in the SLR calculation. This exemption expires at the end of March, and Powell has given no indication whether he will extend it or not.
The consequences of the exemption itself relate to bank lending. While households reduced their debt during the pandemic, corporations and the government drastically expanded their credit. Therefore, companies that rely on uncollateralized debt to stay afloat (mostly startup technology, biotech, oil explorers, etc.) will have to pay higher interest rates, and will thereby be hurt by allowing this exemption to expire. On the positive side, if it expires, banks are forced to maintain healthier balance sheets, and will drastically reduce the chance of a market crash. So Powell is forced to make a decision that will have market implications.
To try to figure out what Powell will do, I created a game theory tree. There are two participants in the SLR game: the Fed and the market. Theoretically, Powell isn’t supposed to care about the government, nor the rest of the world, so we will take him at his word. It turns out this is the classic prisoner’s dilemma, except with asymmetric information.
The market has two choices:
1) Get heavily leveraged or
2) Don't get heavily leveraged.
Powell has two choices:
1) Extend SLR or
2) Don't extend SLR.
When Powell issued SLR, the market made the decision that it was permanent (hence the large rally in equities and bonds). Corporate and sovereign debt skyrocketed. As a result, growth stocks became highly leveraged, and we financed ourselves out of an oil price war. He knows what the market has done; he knows they essentially "admitted fault" in the prisoner's dilemma game. Powell's missions are full employment and inflation over 2%. Powell knows that not extending SLR gets him the latter.
Therefore, I think Powell will sacrifice the short-term market leverage bubble and let SLR go.
So, who would know this on Powell’s team? The banks!
The primary dealers take all the bonds no one else wants and receive insight into Fed deliberations. How are banks positioned? The negative repo rates shows heavy shorting of bonds, to the point of paying extra to lend them. That is very indicative of SLR going away.
I still think any dip in equities is a buy because of the massive inflation, but growth might take a big short term hit this week.
Also… Powell knows this is a big decision, and any time he’s faced with a decision like this he leaks to the press. So, tread carefully until this decision is finalized.
The Gamestop (GME) saga is a compelling one. In short, here’s the story:
A reddit group of retail traders called WallStreetBets has combined their efforts to exploit the market mechanics of options. Namely, this group identifies heavily-shorted stocks and then buys many short-dated calls, which in turn forces option market makers to buy the underlying to hedge their position. The funds that are short those stocks end up getting “squeezed”, meaning they must unwind their positions to satisfy their margin requirements. This creates a parabolic rise in the stock. The winners are the reddit group, as their calls increase in value in multiples. The losers are the short funds and the option market makers.
First, the overall market has had this feedback loop for a long time. Volatility traders and tech stock call buyers are the primary drivers of this bullish market since March 2020. This isn’t new; WallStreetBets just took it to the extreme.
Second, while I have no sympathy for hedge funds, WallStreetBets are not the good guys. The message board is filled with vile, egotistical sociopaths. They are seeking their own gain at others’ expense, and they gloat about that mission.
Further, these traders do not know much about the market mechanics they are taking advantage of. They know enough to be dangerous individually, and collectively they know enough to be dangerous to the whole market. I read many of the posts on their site; they are unequivocally wrong. Many of their ideas that I read about mechanically cannot happen (trying to squeeze the silver market through SLV options). Eventually, these people will be arrested, but for now their collective power must be respected and accounted for.
Since the GME explosion, quite a few stocks have seen rallies from speculation. Some of these buyers do not understand the parameters needed for a WallStreetBets short squeeze. BBBY and AMC were good examples; BB turned out to flop. What you need are liquid options offered weekly on a heavily shorted stock.
If you want to discuss this further, including some candidates for a play, please send me a note. My overall belief is once these stocks make their massive moves like GME, it will be wise to stay out of them. You are likely to lose money... no matter how you play it.
CHEX is an abbreviation that stands for "charm exposure".
Charm in option speak is delta over theta.
Essentially, when institutions buy puts for insurance or cover their equity positions with calls, they leave them on whether they are in the money or not. The market maker positions are against those positions, so what we are really measuring is how much gamma has an impact on the market maker hedging positions.
The results are compelling. In short, we have logarithmic regression equations with statistical significance and R^2 no less than .4, and in higher GEX environments (like now) R^2 at around .7.
The answer to these regression equations are the variance on the mean volatility in that GEX bin. Some of the answers predict these really slow days, which would make for excellent single day butterflies.
When you see little price runs, you can fade them by selling verticals and collecting premiums in high CHEX environments safely.
This post is in response to the article "UBS Faces Client Backlash Over Options Strategy".
Here is a synopsis of this article as the options trader sees it:
Investment banks are always looking for a silver-bullet strategy that is repeatable and profitable with outsized gains. It is something may work for a while, like this condor strategy, but eventually the math catches up. Repeated processes ignore the fact that market dynamics and options dynamics change, and you need to change with them as well as sufficiently manage risk.
VIX, VXX (VXXB), Term Structure, IV, TVIX: what is all of this?
With all the talk about VXX, and it being an indicator of future movement, and the VIX "fear gauge", etc., I want to make clear what these "things" are. It is vital to know exactly what you are looking at when you look at these signals and how they are different.
The first question you might be asking is, "Wiz, why don't you stay in your options lane?" My answer is, all of these are based off of the implied volatility of options. Options pricing is basically comprised of 3 variables and one exponential constant. Those variables are: the price of the underlying, the price of the option (as measured by supply and demand of the option itself), and interest rates. The exponential constant is time. We are going to focus on implied volatility (price of the option).
Of all the pricing models out there (BSM, Binomial, etc.), implied volatility is what is solved for at any given time. There is no independent measure of it. Time until expiration (and, therefore, time left) can be measured. You can assume a certain interest rate, and that remains an input to the model. You know what the strike price of an option is, as well as the price of the underlying. You also know the price of the option, the answer to the equation. But using all of those inputs, there are still variations in the price of the option that doesn't make the equation equal. This is showing what the supply and demand is of the option itself due to what the public believes is going to happen in the underlying. This is all boiled into one variable called implied volatility (IV). Further, if you have two different people using two different price models, you will likely get two different IVs! Moreover, it is implying the 1 standard deviation movement, so 2 out of 3 days (close enough), the movement of the underlying is expected to be at or below the implied movement that the IV is indicating.
VIX is a mathematical model trying to boil down all the SPX option IVs into a single number to gauge what the option-buying public is expecting the market to do. VIX attempts to measure the implied volatility of a range of SPX options between 23 and 37 days until expiration in both weekly and monthly option classes.
VXX (unleveraged), UVXY (1.5x leveraged), and TVIX (2x leveraged) are Exchange-Traded Products (ETPs) that are long volatility. They estimate 30-day volatility by buying a weighted average of the next monthly option expiration and the following monthly option expiration. So today, on January 11th, there is a little bit of January options in the VXX bucket and a lot of February options in the bucket. Every day, more Jans get sold and Febs get bought. February options were lower priced than in January for a long while, but have since gone up in price; hence, we have a situation where the people in charge of VXX are buying more expensive options and selling the cheaper ones (giving a red day on VXX despite the red day in SPX). What VXX is really measuring is the difference in price movement between January and February options, NOT option IV itself. Put into a corner, I'd say it is a so-so approximation of option buyers expectation of volatility. Since options are typically overpriced and in contango, in the long run, all of these products will decay. But don't get excited to short them; good luck finding a share to borrow.
Term structure is a weighted average of the options in a single expiry. The weights depend on how it is calculated. Basically, it tells you how much the IV is in that expiration date (again trying to boil it into a single number for each expiration), then draws a chart for all the expirations. This at least gives you an idea of the expectation of the implied volatility differences over terms... a little better than VXX to understand the option-buying public's expectation.
Finally, what does this all mean for trading? CNBC calls the VIX the "fear gauge", which I understand how they can assign it that, but it is not really true. Since the CBOE basically dictates the initial prices through their market makers, it doesn't necessarily reflect the public's fear except at extremes. If SPX is plummeting and everyone in the world is buying puts, then yes, it is measuring fear... but on a day like today where SPX is down, but not down enough to justify the IVs the options were at, you can see VIX and SPX going down at the same time. You can see that as a lack of fear... but the more accurate assessment is lack of movement compared to recent history. So hearing anyone calling the VIX the "fear gauge" is like nails on chalkboard to me... trying to boil a complex thing into a polarizing soundbite. You must also keep in mind that this is only measuring options traders, and option traders have different motivations. Some are hedging, some are speculating, a majority are market makers trying to play spreads between bids and asks on small ticks and orders (most of the option HFT is doing exactly this)... so it is very difficult to read the incentive for moves in implied volatility particularly on slow days.
So ultimately, what does a stock trader do with VIX on their trades? The answer is absolutely nothing except on big moving days. That is, days that are more than the IV is projecting, and see if the volume is way up or not too far up and see if a crash is imminent. But that's about it. If you are an option trader, the VIX is sort of relevant, but there are more important things to account for. For instance, what is the skew, horizontal and vertical? What is the implied movement vs. the historical movement, are these options overpriced compared to history? If so, is there a reason? But to be honest, I haven't really looked at the VIX with anything other than a passing glance in quite some time.
A term structure is the mapping of the underlying’s volatility at different expiration dates. The volatility of an expiration date is determined using a weighted average of multiple strikes on the same expiration date. When you compare all of those implied volatilities for each of those expiration dates and graph them, they make a chart. Here is an example:
Note, the implied volatilities you see here are for the term of the option class. So if you are looking at weekly term, the implied volatility number shows the implied volatility between the expiry you are looking at and the one that expired in that term before it. So for instance, if you are looking at weeklies (like you see here), the number at the second green dot is showing the implied volatility between the first and second dot, not the second dot and today. Keep that in mind.
So how does this help with your strategies? Typically, the term structure looks like the exact opposite of what you see above, a swiftly rising curve that flattens at the top. This is called contango, and expresses the increased uncertainty further out in time. When the curve looks like it does now, it is called backwardation. This happens when the short term is highly volatile and option traders expect the market to return to normalcy in the future.
When the market is in backwardation, as it is now, I love to put on calendars. This is because the near-term options are overpriced relative to the options in the outer terms. That makes the trade extremely forgiving if wrong on direction, and allows for multiple sales of options against the same long option. So if I have a hint on direction, I will put on a calendar (especially if bearish), and if I don’t I would consider a double calendar at the long strike’s implied movement strike. These kinds of trades have excellent return to risk. The capital required may be a little higher, but the probability of success is extremely high. The SPX double calendar I have on right now taking advantage of this term structure has an 80% chance of 30% gains over the next 2 weeks.