In an effort to make more consistent posts for this blog, I am going to be posting once per month, at the end of every month. Since my previous post in which I recommended a hedge on the S&P 500, the S&P 500 index has appreciated by +2.83%, with the VVIX and VIX indexes both appreciating by +6.85% and +11.81%, respectively. Since the sudden decline of July 19th, the SPX has risen +3.77%, with the VVIX, VIX, and SVXY (short implied volatility fund, mid-term exposure to VIX curve) -18.27%, -21.33%, and +8.06%, respectively. From July 14-19, the SPX declined -2.65%, with the VVIX, VIX, and SVXY +18.60%, +37.78%, and -9.71%, respectively. One thing I will continue to reiterate is that I am not "bragging" on my "market call-outs", as I believe I do not make those predictions. I am simply summing up the market action during which I analyzed for, and how accurate my expectation for future volatility was. One important clarification: simply because I recommended a hedge does not mean I was bearish on the market over a longer timeframe. It is critical to know that, yes, the hedge would have performed well on the contracts I analyzed, but I also believed in not only further upside in the index, but also downside for volatility (especially implied volatility). With the performance summary and clarifications out of the way, let us get to some market updates and my analysis.
Market Positioning
As I have said in previous posts, the market participant in which I pay the closest attention to is that of dealers/market makers/intermediaries. There are a variety of reasons that would take multiple pages of explanations, but, in summary, I believe they have the best access to short-to-medium-term information. This can be due to order flow considerations, managing inventory, taking on risk for the purpose of a theoretical edge given by superior quantitative models, etc.. I will also analyze that of Leveraged Funds positioning, as they best represent the current buy-side investment appetite for a given asset class. Dealer positioning for S&P 500 futures contracts has increased long positions by +18.63%, increased short positions by +2.57%, and increased spreading positions by +19.17%. Leveraged funds (a.k.a. Hedge Funds, CTAs, Family Offices, etc.) have increased long positions in ES contracts by +25.81%, increased short positions by +14.81%, and increased spreading positions by +18.74%. Clearly, there was a demand for long ES futures exposure over the past few weeks, and I would not be surprised to see this demand continue in the future.
The purpose of this graph is just another positioning visual. As one can see, the 4 largest traders (as identified by the CME group) have been predominantly net short of ES futures contacts for quite some time, not making any dramatic changes. Nothing too crazy to note here.
In terms of dollar flows in and out of futures contracts on the S&P 500, Nasdaq 100, and Russell 2000, flows have been relatively consistent over the past few weeks, with little change. There is nothing that really stands out here.
The next part of my analysis will be consensus positioning within the volatility asset class, more specifically, the VIX futures and options system. The current Z-Score for the long-short positioning for Non-Commercial market participants on /VX is +1.47 (historical data is from 12/29/2020), which suggests that Non-Commercial market participants are somewhat long exposure to implied volatility, but nothing that suggests an extreme deviation. Exposure for long, short, and spreading for this participant has all decreased by -5.53%, -3.31%, and -0.16%, respectively, from 6/22/2021. The Z-Score for Dealers within the implied volatility space via exposure by VIX derivatives is -0.234 (since 12/29/2020), and exposure has all increased for long, short, and spreading positioning by +1.64%, +15.95%, and +2.25%, respectively, from 6/22/2021. Leveraged funds have a Z-Score of +0.72 (since 12/29/2020), and long, short, and spreading exposure has all increased by +13.77%, +11.76%, and +6.90% from 6/22/2021. Just as a frame of reference, long and short open interest in VIX derivatives for Dealers, Leveraged Funds, and Non-Commercial market participants trends tends to trend between 81.03% - 94.76%, 66.68% - 85.57%, and 71.86% - 85.53%, respectively. Dealers are almost predominantly net long VIX derivatives contracts, Leveraged Funds are predominantly short, and Non-Commercial participants are predominantly net long, so it is most important to look at how open interest for these market participants varies over time, and whether there is any dislocation/exaggeration between them in a relative sense.
In terms of net contract positioning, there does not seem to be any extremely obvious points of market exaggeration or dislocation of opinions between said participants. The main points that I would consider is that there was a broad market demand for implied volatility derivatives over the past few weeks (this is to not surprise), with the majority of participants getting net long implied volatility. In terms of S&P 500 derivatives, there has been a demand for long exposure, with participants increasing long exposures on a relative basis. In the next section, we will look at what option markets are pricing in over the next month, and what this could potentially mean.
Consensus Positioning Within Options Markets
The first market that we will consider will be the options listed on the S&P 500 Index (SPX). The forward prices derived from at-the-money with 29 days to expiration (August 27, 2021) is 4408.84 (assuming no dividends during the period, 0.05% 30 day interest rate from US T-Bill), representing a -0.23% decline in the index by maturity of these options. The VIX is currently at 17.70%, forecasting a realized volatility of 17.70% over the next ~30 days. I will next present an Option-Implied Probability Distribution, derived from butterfly prices. There is a detailed derivation showing how this method approximates the second derivative of the change in call price with respect to strike across all strikes, which approximates the risk-neutral density function of said option prices. Below I will post links to a report by Goldman Sachs that describes this practice, and a YouTube lecture that goes into the mathematical minutia of deriving this approximation.
These butterfly values of SPY were taken as of 4:12 EST of today with an August 27, 2021 expiration. The summation of an infinite number of strikes would amount to 1.00 under the probability density curve, but this is not accurately possible, as there is a limited number of strikes available to trade off of for the S&P 500 ETF, SPY. I chose $20 points in each direction, representing +4.545% and -4.55%. Theoretically, one could extrapolate an infinite number of strikes with a few different methodologies, as well as derive an infinitesimally small "step" between option strikes to get a continuous curve, but this is above the purpose of this post. The black bar represents the current ATM option strike as of today's close. The summation of these derived approximations is 0.93, representing how there is 0.07 to be accounted for. These values can be found in the deep portion of the "wings", and the probability of SPY reaching any magnitude of these wings by August 27, 2021 is extremely small, hence my exclusion. In practice, however, it would be necessary to include these values to et the most accurate picture possible. There are a few important takeaways here. First, that the single most likely event to occur is that the SPY finishes at $430 in 29 days, with a market-implied 5.5% chance of occurring. The probability of finishing lower than $440 by expiration is 28.5%, and that of higher is 61.0%. This suggests overwhelming bullishness as derived by option prices. Another note, the average ATM implied volatility for the August 11, 2021 expiration of SPY options is 10.755%, and that of the ATM expiration of August 27 being 12.94%, so the implied volatility between these two expiration is 14.47% (there is a less-rigorous formula for this, located in "Option Volatility and Pricing". Now, I understand that these values significantly underscore that of the VIX index. This can be due to the associated time premium prevalent in farther-dated options, but also how the VIX entails more of the wings associated within its calculations, also making it a great proxy for a 30-day variance swap on the S&P 500. This minutia is for another post, so I digress. In addition, the Put/Call ratio as displayed by TDAmeritrade is 1.224, and (the following is from AlphaQuery) the P/C IV ratio is 1.08, P/C as volume is 1.3, and the P/C by open interest is 2.08. Clearly, there are a variety of methods to analyze how market players are positioning and pricing in future index levels. The Implied Probability Distribution is probably the most accurate of the bunch (in terms of deriving implied future levels), considering it takes into account a more mathematically-inclined approach, as well as more market information.
Now that we have considered the SPY and SPX, we will move to positioning on the S&P 500 E-Mini futures contracts. For the sake of consistency, we will also try to keep as close to the 30-day time period as possible. On the EW4Q1 E-Mini futures contract (30 DTE, current price of $4,393.75), there is 5,996 call options OI, with 4,814 calls being OTM. On the same contract, there is an open interest of 52,312 put options, 51,781 of them being OTM. No, there is not a typo. There is clearly bearish market positioning in terms of open interest within options on the E-Mini S&P 500 derivative.
In terms of options Greeks, these first-order measurements of sensitivity (Delta and Vega) also indicate bearish positioning. Delta represents a measurement of sensitivity for an option, as it represents the theoretical price change of an option for a $1 move in the underlying asset. Vega represents the theoretical change in option value for a 1% change in implied volatility on the underlying asset. For the EW4Q1 E-Mini futures contract, there is a negative delta in terms of both OI and volume, with the aggregate delta being -419 (ever 1 point move in thus contract represents an overall -$419 change in value of the market's positioning in options) for volume, and -1,501 for open interest. So, a $1 change in this contract would equate to a -$1,501 change in value of said options. Vega is positive in both scenarios, as a rising implied volatility benefits both call and put options. There is a 4.30 and 8.72 put/call ratio for volume and open interest, respectively. This indicates the extremely bearish market positioning within the derivatives space on the E-Mini contracts space over the next 30 days.
In summary, there is not only a demand for exposure to implied volatility as given by market participant positioning numbers (via CFTC), but also bearish positioning on the SPY ETF, and especially bearish positioning on ES futures contracts. The vast majority of market participants are positioned for a pullback.
Market Breadth (Price, Volume, Volatility)
I will continue to reiterate this on every post: it is imperative to analyze any investment decision on a multi-factor, multi-duration basis to get a good understanding on what is truly happening beneath the surface area of price. It is simply not enough to buy something that your friend said was the next Amazon, or base a sell-signal off of a moving average of RSI. My implementation of this is very simple, yet relatively powerful. It is of price, volume, and volatility (implied volatility, as well as implied vol-of-vol risk). Now, you can extend this further by measuring and mapping a variety of securities by factor exposure (ex. high short interest, low leverage on balance sheet, market capitalization, high beta, etc.) on a multi-duration basis, but this is beyond the scope of this post.
On a 1-month basis, the VIX, VVIX, and SPY are all in positive territory. I will not go into detail on the mechanics behind the VIX and VVIX index, as I have extensively covered this in past posts. The VIX, VVIX, and SPY have all appreciated by +12.05%, +7.54%, and +3.43%, respectively, over a 1 month timeframe. This can mean a couple of things, the more important of the group being how the underlying systematic risk prevalent in the S&P 500, as communicated by implied volatility pricing, as well as the pricing of jump risk within the S&P 500. If price is rising, as well as volatility, this is a bad combo. It would be optimal for volatility, more specifically implied volatility, to decline, giving the investor more certainty in his/her investment. In addition, current volume on the SPY ETF is down against all respective volume averages across timeframes, with the 1-day, 5-day, 1-month, and 3-month being -9.93%, -14.08%, -31.02%, and -30.27%, respectively. This indicates a thinning market breadth, as a rising price, rising systematic risk, and thin volume puts the SPY ETF at risk to a pullback.
Another ley thing to note is how the VIX index tried to breakdown from its current regime on 6/29/2021, hitting a low of 14.10, and then subsequently appreciating to its current value of 17.70. One of the reasons behind this failed breakdown is how, at the same time of the "fake breakdown", the VVIX index (tracks implied vol-of-vol risk, is what prices VIX options and futures) was actually hitting its trend line upwards that was formed back in April (look at the daily chart of the VVIX index, notice a upward trend in the index level from this date). It is extremely important to note the behaviors that are occurring between market variables, more specifically, the relationship between implied vol-of-vol and the VIX index. If one has been rising, and the other has been drastically falling, there is clearly a disconnect somewhere. When the VIX tried to break its current regime, and the VVIX did not break trend, implied volatility subsequently increased. Since the VIX low on 6/29/2021, the VIX, VVIX, and SPY are all up +25.53%, +6.57%, and +3.03%, respectively.
Also, in terms of the forward index level of the VIX, derived from VIX options prices (assuming a continuous-time, risk-neutral world) is 20.54% by August 25, 2021 (26 DTE). This represents an appreciation of +16.05%. This makes intuitive sense, as an explosion upwards by the aggregate implied volatility index is not uncommon (volatility clusters, mean-reverting nature of volatility). One interesting idea to analyze this phenomena would be to utilize the Hurt exponent. This is a measure of the memory in a time series and is used to classify the series as mean-reverting, trending, or a random walk. Depending on the choice of the maximum lag parameter (i.e., whether we are looking are short or long term), the results can differ significantly (one could easily incorporate this as a risk factor in a multi-factor model with fractal characteristics, but again, I digress). Furthermore, due to the negative carry that is inherent in long volatility strategies (on the VIX futures curve as well as options), a higher expected value (in the short-term) is not too surprising.
In summary, market breadth is quite think, with a rising price of the SPY coupled with increasing uncertainty (the VIX), as well with the uncertainty of said uncertainty (implied vol-of-vol, VVIX). Markets are getting a little bit cautious in how optimistic one should be (at least in this respect).
Realized and Implied Correlations
This will be a quick note, but below represents the historical cross-asset realized volatility correlations between a variety of asset classes, the most notable being the 20 day, historical 6 month correlation between the E-Mini Nasdaq 100 and E-Mini S&P 500 futures on a constant 30-day maturity futures contract.
The E-Mini S&P 500 futures and the E-Mini Nasdaq 100 futures have a historical rolling 20 day historical volatility, over a 6 month period, of 71%. What is interesting is how this has evolved over time. There has historically been a very positive spread between the rolling 20 day realized volatility of Nasdaq futures versus S&P 500 futures. However, this has recently hit a local low, printing negative values, as well as how the historical correlation of volatility between the two has local lows, suggesting either the beginning of a fundamental shift in the relation of these two indexes, or a potential opportunity to get long correlation via correlation dispersion trading strategies (again, beyond the scope of this post, but please keep this important market dynamic in mind).
Next, we will look at how option markets within the E-Mini S&P 500 and Nasdaq 100 futures contracts are pricing in future realized correlation of 20 day volatility within the 30 day constant maturity futures contracts.
First off, listed derivatives on these futures are implying a 89% correlation between the realized volatility of these two contracts, +25.35% more than the current realized value of correlation between volatilities. Not only has the realized spread hit negative prints, but implied correlations have also hit lows (again, with a considerable premium to that of historical realized volatility correlations, another form of a carry trade opportunity). If an extreme market sell-off were to occur, cross asset correlation would tend to converge towards 1 as liquidity needs would hit every corner of a portfolio. For this reason, if one were to choose to be long correlation as a form of a hedge from a broader market dip, one could put on a long correlation trade, again, with the specific mechanics of this setup beyond the scope of this post.
In summary, realized, as well as implied, correlations between 20 day volatility of the E-Mini Nasdaq 100 and the E-Mini S&P 500 futures contracts are at lows, with still a considerable premium in the forecasted realized correlation of volatilities between the two.
Conclusion
The purpose of this post was to go somewhat in-depth on how a variety of market participants are positioning, as well as pricing in future risk. From what I can gather, participants are somewhat uncertain about what the future might hold, with the vast majority of positioning in the ES space being extremely bearish. Thinning market breadth, as well as a rise in systematic risk, coupled with correlations being at lows, allow for a reasonable price in obtaining protection to the downside. Is it possible that this rapid rise in the aggregate stock market is not only "strong" economic data, but also the extreme short bias priced into volatility and S&P 500 derivatives, causing a "short squeeze" like we have never seen before? I would not be surprised if there were a somewhat reasonable pullback that is short-lived within the foreseeable future. My next post will go more towards analyzing the volatility landscape, term structures, short-volatility strategies, and other ideas.
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