Why We're Revisiting Our Pre-Brexit Hedging Advice

The risk of a big volatility spike is higher than the risk of a big stock sell-off

Senior Vice President of Research
Jan 23, 2017 at 8:42 AM
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"... the SPDR S&P 500 ETF Trust (SPY - 227.05), an exchange-traded fund (ETF) that is the second most active security among individual stocks and ETFs, made its closing high on Dec. 13 -- the last trading day before the FOMC raised rates and upped its forecast to three rate hikes this year, compared to the two hikes predicted in its previous forecast. It is interesting that in the two immediate days after the FOMC meeting, as well as last week, the SPY failed to close above the Dec. 13 closing level."
    -- Monday Morning Outlook, January 17, 2017



With the S&P 500 Index (SPX - 2,271.31) and SPDR S&P 500 ETF Trust (SPY - 226.74) around all-time highs, the media continues to make references to the "Trump rally." The Trump rally lasted a little more than a month, which is about the time that has passed since the Dec. 13-14 Federal Open Market Committee (FOMC) meeting. Since this event, and as pointed out in this space during the past few weeks, the price action might be best described as the "Fed stall." With basketball season now in high gear, an analogy would be the team that holds the ball before halftime to take the last shot. Much like the score doesn't change, neither have the major stock market indexes, since the Fed meeting.

In other words, the SPX, the Russell 2000 Index (RUT - 1,351.84), S&P MidCap 400 Index (MID - 1,675.78), and the Dow Jones Industrial Average (DJIA - 19,827.25) have gone sideways since the Fed raised rates and increased the number of projected rate hikes this year to three from two. The Nasdaq Composite (COMP - 5,555.33), for the most part, is the exception, thanks to a rally from the end of 2016 into the second week of the year. Remove those trading days, though, and sideways movement is evident here, too. In fact, the COMP has moved sideways in recent weeks at the 5,550 area, which is 10% above the November 2016 closing low.

And need I mention the DJIA's 20,000 barrier that was in play around the time of the December FOMC meeting? In the meantime, on Thursday last week, the RUT ended at its lowest level since the Dec. 13 close (albeit only 2% below this level). Moreover, the RUT finished the week below its 2016 close of 1,357, as the shift from small-caps to large-cap equities that began in mid-December, when the RUT was 20% above its early November low, continues. While the "Trump rally" was driven by small-caps, the FOMC outcome in mid-December was enough to kill the November and early December momentum, and eventually generate profit-taking.

Much of the focus last week was on the Friday afternoon inauguration of our 45th president. As we mentioned last week, Morgan Stanley published a report about the possibility of "buying the election, and selling the election." In fact, there was a massive SPY January 125/124 expiration put spread purchased mid-week last week -- someone looking to cash out on the "sell the election" theory.

Also, last week was highlighted by numerous comments from Federal Reserve members, including Fed Chair Janet Yellen, who spoke twice. The rhetoric didn't change much, with hints of risks to the economy lower and more indications of rate hikes, mixed with a "wait and see" approach with a new administration coming into office.

So, with Trump and Yellen making headlines last week, the chart below bears the footprints of both figures, with the early November to mid-December Trump rally followed by the "Fed stall" that occurred after hints of more aggressive rate hikes in 2017 than previously expected, mixed with a "wait and see" approach to what the new administration will push through in the areas of fiscal stimulus, revised trade deals more favorable for U.S. workers, deregulation, and tax cuts. Potential buyers and sellers seem to be taking the same "wait and see" approach of the Fed before their next move.

spx daily 0120




A few data points on the sentiment front hit my radar last week, which I am trying to piece together. First, January CBOE Volatility Index (VIX - 11.54) call options expired last Wednesday, and -- as is often the case -- a huge majority of the calls expired worthless. This is not unusual, because call buyers typically purchase options at strike prices far above the futures' underlying price, since volatility futures are prone to sharp spikes of 25-50% in the blink of an eye.

In some instances, these call positions could be hedges to short futures positions, which -- per the first Commitments of Traders (CoT) chart below -- are currently at an extreme. Extreme short positions among large speculators on VIX futures usually precede volatility pops. And we have noticed that if a volatility pop occurs, it is usually after the expiration of millions of VIX call options.

So, to the extent that there is an extreme VIX futures short position among large speculators, some of which are no longer hedged, the risk of a volatility pop has increased. But, per the second CoT chart below, note how SPX large speculators are in an extreme net short position, too -- which is counterintuitive, because if you are positioned for stocks to go lower, you are likely expecting volatility to move higher.

cot lg spec vix futures 0120

cot lg spec spx futures 0120


Piecing this together, the best conclusion is that stocks do not have the same magnitude of downside risk at the moment relative to the upside volatility risk. Back in June, I said something similar to this on CNBC just before the Brexit vote, and suggested using a volatility vehicle to hedge Brexit uncertainty. From June 8 to its peak on June 24, volatility, as measured by the VIX, nearly doubled, as volatility crept higher and then eventually exploded. During this same time frame, the SPX was lower by 3.7%, implying a well-timed volatility hedge was worth it.

At present, there is not a major "known (event), unknown (outcome)" like Brexit or the U.S. election on the calendar. But, many market participants will be intensely in tune with the president's actions in his first 100 days in office. So, with an upcoming FOMC meeting only eight trading days away, a volatility-type hedge could be warranted.

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