US 10y Yields are low

USD 10y Yields are low.

Equity market (S&P 500) and Bond Market (UST 10y) investors are presenting a divergent picture of the economy. Rally in Equity market to year to date highs on the back of better than expected economic indicators is not being supported by the fall in yields of bond markets. Why? Is this equity rally is not a sustainable one? Or Bond investors are worried of inflation but the Japanese style deflation? Is there a mispricing of the risk in the market? Before going further, let us review some historical data. Historically, equity market rally is accompanied by bond market selloff. This fact is shown in the Exhibit A. Data goes back to 1999.

Next exhibit shows the point under discussion




Clearly since early august both markets have diverged. This brings us back to the questions we are pondering above. On the question of sustainability of rally, this is more fundamental question as market is pricing in recovery and looking for stronger economy. The economic indicators that came in august, strong housing reports, strong manufacturing activity reports and better employment report and lower inflation numbers shows FED has succeeded in pulling economy out of ditch. That said market is definitely poised to rise higher at the behest of various government programs. So at least it is safe to assume for now market rally is sustainable (on a short term basis). Our next question is with regards to deflation vs inflation. Looks like Bond investors are supporting the case of deflation instead of inflation. Now question is the current bond yield levels of 3.5% are lower or higher. I believe they are at lower levels. I have fitted a simple regression model using libor-OIS spreads, SP500 as independent variables. I have chosen libor ois spread because, these days libor is setting lower and causing the yield curve to get pushed lower. After fitting the model, I found the model explaining the yields very well with a R square of 0.8. Now if that is the case then current low level of UST 10y yields are going to rise in near future. Yields might visit the area of 3.75 to 3.80 atleast.




How to monetize this rising rates view? Buy some treasury put options or sell some treasury call options. For this view, I will choose TYZ9 oct options.

Buy TYZ9 100 116 Oct puts at 0.54 ticks, 84,375.

Bernanke Saved my trade.

On Aug 9 i ahve recommended 119/125 bear call spread. This trade receives 200 dollars before commissions. the premise for this trade is that markets will stage a sell off. But surprisingly Equity markets started rallying and bond markets also rallying. This looks very odd.

First Trade Review: On 21st aug, this trade is deep in red on the verge of loosing 2000 dollars. Since i was doing a paper trade i was waiting for the trade to expire. at 10 A.M Bernanke came and stated he is seeing recovery signs. This gave a big boost to equity markets. Bond markets sold off. My 119 call that was ITM expired OTM. Huh what a relief.

Now on the other side, bond markets are not buying recovery but equity markets have already started getting in the mood of recovery.

bye for now. i have to go and play basket ball with my two boys

SourceL www.dismalscientist.com

Short 1000 98 EDM0 puts - Fed will not Hike

Financial Markets – Week of August 10th to August 16th 2009.
Last two weeks economic indicators telling the health of the economy have caused upward and downward revisions to GDP. Initial estimates of manufacturing activity have guided GDP estimates to as high as 4.5%. Consequently treasuries have sold off, equity markets have rised all over the week. Later this week retails sales painted grim picture about consumer spending. This caused GDP estimates to be revised back to lower 3.7%. This contributed to treasury rally and sell off in equity markets.
From this background, looking at Euro dollar futures and treasury futures for opportunities with the lens of market pricing of Fed hikes, treasury supply of debt I believe selling ED futures put options and buying treasury call options are two interesting trades.
Fed came out with it FOMC statement on Wednesday stating economy is showing signs of improvement, inflation is still low and it will keep interest rates low for an extended period at current levels. This means there will be no hikes in interest rates till second half of 2010 until this view gets revised due to incoming information. One important element is unemployment condition in the economy. This is a lagging indicator and there are more signs of worsening rather than improving. This will also force the Fed to not press the interest rate hike button.
Looking at ED strip, I see there is a gap of 40bps between EDH0 and EDM0. This means market is pricing some possibility of 25bps hike in the interest rates. But Fed is indicating otherwise. This makes a case for selling puts. So I would recommend selling puts EDM0. After deciding the contract, next element in the process is to determine the strike level of the option. Strike level of the option is based on the probability of the option attaining the level of by the time of expiry. After looking at probability chart 98 strike level is selected. Benefits of this OTM put are, this option is priced at 0.23 ticks. This means, breakeven level is at 2.23. In other words libor needs to be set atleast above this level for this option to get expired ITM. Time decay works in our favor. Cost of doing 1000 puts is 575,000. Margin requirements for this trade are approximately 600K. Although this trade ties up sufficient margin it is a good trade from the perspective of market pricing the hike, time decay and roll down perspective.
Risks to this trade are
1) Economic recovery takes at a faster pace
2) Unemployment picture brightens
3) Commodity prices rises and fear of inflation takes on hold.
4) Housing stabilizes.
Odd are that none of these scenarios are plausible.












Date
Time (ET)
Statistic
For
Actual
Briefing Forecast
Market Expects
Prior
Revised From
Aug 17
8:30 AM
Empire Manufacturing
Aug
-
5.00
2.20
-0.55
-
Aug 17
9:00 AM
Net Long-Term TIC Flows
Jun
-
NA
$17.5B
-$19.8B
-
Aug 18
8:30 AM
Building Permits
Jul
-
565K
576K
570K
-
Aug 18
8:30 AM
Core PPI
Jul
-
0.1%
0.1%
0.5%
-
Aug 18
8:30 AM
Housing Starts
Jul
-
580K
598K
582K
-
Aug 18
8:30 AM
PPI
Jul
-
-0.2%
-0.2%
1.8%
-
Aug 19
10:30 AM
Crude Inventories
08/14
-
NA
NA
+2.52M
-
Aug 20
8:30 AM
Initial Claims
08/15
-
550K
553K
558K
-
Aug 20
10:00 AM
Leading Indicators
Jul
-
0.6%
0.6%
0.7%
-
Aug 20
10:00 AM
Philadelphia Fed
Aug
-
1.0
-2.0
-7.5
-
Aug 21
10:00 AM
Existing Home Sales
Jul
-
5.10M
5.00M
4.89M
-

Bear call spread USU9 119/125

Markets have ended in a good mood last week. This week being data intensive we could see some surprises. This week, we have Treasury auctions (3y and 10y), FOMC meeting announcement and inflation data coming up. These factors have direct impact on long bonds.
Fundamental View
30y Treasury rates went up by 31bps last week. As economy is out of recession in terms of market indicators we could see another set of sell off this week. This can be punctuated by treasury funding. FOMC meeting could deliver another big dose of sell off in the market due to less down side risks. Finally rates can get low due to low inflation data. Also equity markets are supporting bond market selloff.
Technical View

MACD indicator shows trend direction is towards lower side. Also markets have not visited the previous high in early july of 122. There is a strong resistance around 120.
I will initiate short call position at 119 strike for USU9. This call will be insured by another long of 125 call. This structure is bear call spread. Net cost of this trade is 234.25 -31.25= 202 before commissions.

FOMC - a big HUH!

June FOMC statement came this afternoon and the report took away all the sizzle that was being expected by the market. One interesting thing in this report is Fed has come to an understanding that it has and will be deploying all the tools to keep economy from falling into a depression.

Fed has mentioned that growth rate fall has slowed down a bit. It has taken some comfort from how its monetary policy is helping the economy. Fed is still on it target to make its purchases related quantitative easing. Also fed has come to clear conclusion that lower fed fund rates will be there for a long period.

These things have clearly confirmed the hikes that are being priced by the market are incorrect.

so what next in terms of trading with in rates space. Expect a clear range bound market with falling volatilities in the front end. Long term rates have some room to rise but they will fall in the medium term.

tomorrow i will post some trades. BTW, i have been playing with IBM condor and so far this trade has done well (as of today it has made 1000 dollars profit).

Good Night
Chandra Khandrika

Economic thoughts

Public mood towards economic thought prevailing today is that economists, central bankers and regulators failed to see the crisis coming. Majority group started questioning the theories propounded and practiced in diagnosing the problems. Among economists we see people talking down Keynes and his followers who have prescribed government has to save the sick economy by providing adequate antibiotics of stimulus. On contrary they claim that irrationally predictable human behavior is cause of these problems and new set of tools and theories needs to be developed. In my perspective, neither Keynes is wrong nor was his predecessors wrong. There is an old proverb everyone is right from their own point. Each economic thought has two messages. First message belongs to the time when this theory was developed and second message gives a timeless message that is applicable to all time periods.
To understand modern day economic thought it is imperative that we understand how various people have left their long lasting impressions on this field. People like, Adam Smith, David Ricardo, Joseph Schrumpter, Alfred Marshall, Jeremy Bentham, Keynes, Milton friedman, efficient market theorists and behavioural finance economists. Although this list is not exhaustive but it would be apt to say that these folks have contributed towards the development of economic thought that we are witnessing today.
Smith came up with invisible hand theory in 1776 with the publication of Wealth of nations and became to be known as father of Capitalism. But Capitalism existed since the dawn of human civilization. Capitalism is not an object that needs to be discovered. Smith when started observing how people from various trades cooperate seamlessly to produce goods for mutual economic prosperity. This idea serves under all times and eras. But crooked human behavior can mercilessly subject some humans to appalling working conditions of production of goods for making profits. This makes people like Karl Marx to propound radical thoughts and make capitalism as an evil. We should not forget, in the long run only two regimes, democracy and capitalism prevails on the surviving living beings on the planet earth. David Ricardo came up with his theory of comparative advantage trade theory for mutual prosperity. As times have changed, global trade increased, industrialization has matured in western countries we have witnessed prosperity only to be punctuated by great depression of 1929. Economists have observed this crisis and its consequences and Keynes prescribed that government should bend over knees to support the economy by providing stimulus and central bank should become ultimate liquidity provider. Later on Milton friedman came up with his theory of monetarism stating that due to political nature. In late 70’s economic thought already loaded with shades of smith, Keynes, friedman evolved into a new direction in the hands of efficient market theorists. This has lead to development of fascinating derivative structures as chief risk transferring tools. Global trade machine has seen a gush of liquidity and wheels started moving at full speed. This machine came to a grinding halt when subprime crisis took hold. Behavioral economists have sensed now it is their time to rise to the occasion and prescribe solutions. This group says irrational exuberance displayed by people towards the appreciation of housing prices has caused the problems that we are seeing. To support their claim Shiller and akerlof came with their book animal spirits. Are they right? There is no one answer. Current crisis has clearly showed that we have not learnt enough in understanding the functional mechanism of capitalism. We have a long way to go and theories to date have failed and behavioural finance is trying to take a role onto itself to explain the problem. Will they succeed? Next crisis will tell that

Interest rates Update -10 yr futures

10y rates have seen a rise after seeing their historical lows. Since the housing markets went into correction, credit markets have started adjusting for new realities and consequently markets had seizure and Federal reserve had to become the ultimate buyer of the risk to bring markets to their normal levels. These actions have dragged 10yr rates to historical lows. But since then after some apparently known as green shoots, positive economic news and profits from financial sector has helped equity markets to recover globally. this sowed the seeds of recovery in investors minds and everybody started getting into the market. We have also witnessed during last two months housing sector has improved due to incentives like $8000 tax credit to first time buyers and very low mortgage rates. Improved consumer sentiment, lower job losses and finally the bankruptcy of GM and chrysler brought equity markets to new state. All these factors and rising treasury supply helped treasury rates to go up. From here where ....

Fundamentally speaking, treasury rates have further room to rise. Unless, some fed speaker insinuates about their support to low mortgage rates.

Technical analysis confirms the same mood. The candle chart shows a bearish trend formation. Due to some random cause there might be a chance for markets to rise (yieds fall) but atlease for this week treasuries are on the slide to fall

Better to initiate

short in 116 calls at 1-09 ticks. excluding comm and fees.

Managing Risk-Option Greeks

Option GreeksOptions are subjected to risks from, option underlying changes, option volatility and passage time. These three forces act together but not in unison to impact on the price changes in everyday trading. Individual forces can be viewed per se to analyse the dynamics. To do so, we have 4 sensitivities, namely Delta, Gamma, Vega and theta respectively.Delta: Change in Option price for an infinitesimal change (1 bp or 1/100 bp) in the underlying (futures price or swap rate or Libor rate)Gamma: Change in the Delta of the option for a shift in the underlying.Vega: Change in the option price for an infinitesimal change in the volatility of the underlying.Theta: Change in the option price due to passage of time.Vega skew: Change in the Volatility due to change in the underlying.Main sources of change in the option price can be attributed toa) Change in underlying (Yield Curve)b) Change in volatility (Implied Volatility)c) Change in option Moneyness (expiring in the money or out of the money)d) Passage of time (carrying value)
Analysis of DeltaDelta of an option connotes,· Probability that option will expire in the money or out of the money· Hedge ratio (underlying, to be bought or sold to make position Delta neutral)Delta Range: -1 to +1 for call and puts respectivelyDelta ITM ATM OTMLong Call +0.5 to +1 +0.5 0 to +0.5Long Put -0.5 to -1 -0.5 0 to -0.5Governing forces for the Deltaa) Delta dynamics with passage of timeb) Delta dynamics with yield curve changesc) Delta dynamics with volatility changesDelta dynamics with passage of time: Delta determines probability that option might settle ITM or OTM. As we approach expiration, there will be less chance for the underlying to move around. This will cause an OTM option to expire OTM by changing its current delta (probability) less than 0.5 to zero. Similarly, an ITM option will attain delta (probability) of 1. Tricky element will manifest through an ATM option. This option will have delta of 0.5 until before expiry and on the day of expiry this option delta will move from 0.5 to 1 and expire in the money or move to 0 and settle unexercised. This kind of radical movement causes option gamma to manifest wide swings causing huge PL movements.Option type Moneyness Before Expiry on ExpiryLong Call ITM between 0.5 to 1 1Long call ATM 0.5 1 or 0Long Call OTM between 0 and 0.5 0Delta Dynamics with Yield curve changes: Yield curve (underlying) changes will impact on the option by changing the moneyness. Rising yield curve may cause the moneyness of a payer to increase or decrease for a receiver swaptions.Option type Moneyness Rates Rise ChangeLong Call ITM Delta moves towards 1 from above 0.5 Delta increasesLong Call ATM Delta moves towards 1 from 0.5 Delta increasesLong Call OTM Delta moves towards 0 from below 0.5 Delta decreasesOption type Moneyness Rates Fall ChangeLong Put ITM Delta moves towards -1 from above -0.5 Delta increasesLong Put ATM Delta moves towards -1 from 0.5 Delta increasesLong Put OTM Delta moves towards 0 from below -0.5 Delta decreasesDelta Dynamics with Volatility Changes: Volatility impacts, delta by increasing the uncertainty with in the deltas. So higher volatility should suggest, an ITM option can move to ATM or OTM and OTM can move into ITM and so on. Therefore, Volatility’s impact is viewed as causing the ITM delta to go down; TM delta to increase and ATM delta remains same.Option type Moneyness Volatility Rises ChangeLong Call ITM Delta moves towards 0.5 from near 1 Delta decreasesLong Call ATM Delta remains at 0.5 Delta increasesLong Call OTM Delta moves towards 0 from below -0.5 Delta decreasesPL Impact: PL impact from the delta can be estimated by applying market change to the delta.PL = Delta* Market ChangeConventions for swaptions· Purchase payer equal to long call in terms of rates· Purchase of receiver is equal to long put in terms of rates· Sell a payer is equal to short call in terms of Rates· Sell a receiver is equal to short put in terms of ratesDelta can be measured in terms of yield rather than in terms of price. In a sell off positive delta position (short market) will gain and in a rally negative Delta position (Long Market) will make loss.Delta Direction for SwaptionsSwaption Type Delta Market positionPurchase Payer Positive Short the MarketPurchase Receiver Negative Long the marketSell Payer Negative Long the MarketSell Receiver Positive Short the MarketAnalysis of GammaGamma risk predicts how delta changes with respect to larger underlying changes. Due to large movements in the underlying, option delta changes and this will cause significant PL impact. For instance, an ATM option before expiry if settles ITM or OTM (crossing the strike) on the day of expiration then delta changes from 0.5 to 0 or 1. This sharp change in delta causes gamma to increase significantly.How Gamma works: For a long ATM payer swaption (long Call) position is long gamma. Whenever market rallies (yields fall), this position will loose delta and becomes less short. In other words, option will move from ATM to OTM. In this transition, Long gamma acts as cushion by adding PL. Similarly, when market yields rise due to a sell off, the position will become, ITM and gamma makes the position shorter.a) Gamma Dynamics for Yield curve changesb) Gamma dynamics for the volatility changesc) Gamma dynamics for the passage of time.Gamma Dynamics for the yield curve changes: Options most common and direct and largest source of risk comes from the underlying changes. Underlying movement can make an OTM option into an ITM option and vice versa or leave both ITM and OTM options on the edge at ATM. This kind of change has major impact from gamma to the option.Option Type Gamma Rates Rise changeLong Call ITM moves towards 1 from above 0.5 (Gamma decreases)Long Call ATM moves towards 1 from 0.5 (Gamma decreases)Long Call OTM moves towards 0 from below 0.5 (Gamma decreases)Gamma dynamics with Volatility Changes: Volatility being indication of uncertainty, it drives Gamma for ATM option down because, rising volatility suggests that market is going to move from current point to somewhere. This will make ATM delta to move from 0.5 to higher or lower. So, Gamma decreases. Whereas, for OTM and ITM options rise in volatility means no more status quo and rates will move to somewhere and they will be getting new money ness, which would be obviously ATM. This would cause, their Gamma to rise.Gamma Dynamics for the passage of Time: Gamma grows, as time to expiry gets closer. This will create even unthinkable gammas. Passage of time is worst enemy of ATM option writer. As we get close to maturity, gamma rises so high that it becomes impossible to hedge the option. Whereas, OTM and ITM options together enjoy the luxury of gamma decreasing to zero.PL ImpactGamma = ((Delta (new) – Delta (old)) /2)*( Market Change)^2New Delta = old Delta + Gamma*(Market Change)Swaption Type Gamma position Market positionPurchase Payer Long Gamma Short MarketPurchase Receiver Long Gamma Long MarketSell Payer Short Gamma Long MarketSell Receiver Short Gamma Short MarketLong Gamma position will contribute towards more delta in rising markets and less delta in falling markets. This kind of situation can be paraphrased as Gamma Trading.Analysis of VegaVega risk predicts the change in the option price due to the volatility change in the market.A) Vega dynamics due to yield curve changesB) Vega dynamics due to passage of timeC) Vega dynamics due to change in VolatilityVega Dynamics due to passage of time: Vega of an ATM option is highest and ITM and OTM options have lower Vega. Vega of and option decreases with expiry date getting closer. In other words, we will see the certainty in the option getting expired ITM or OTM. This shows, Vega decreases for options of all moneyness to zero.Vega dynamics due to change in Volatility: Vega rises with increase in implied volatility. ATM Vega will change slightly but OTM and ITM Vega rises. Significantly.Vega Dynamics due to Yield Curve changes: Yield curve changes alter the moneyness of the option. This will cause and option to move from being ITM to OTM and so on. Accordingly, Vega will change due to these yield curve movements. This change is referred as Vega skewAnalysis of ThetaTheta risk predicts everyday cost of carrying the option. There is no imaginable hedge for this kind of risk. As we are all certain time passes by. But, still it warrants, to get grips with the dynamics of the theta.Theta Dynamics due to yield curve changesTheta dynamics due to Volatility changesTheta dynamics due to yield curve changes: Yield curve changes alter the moneyness of the options. This will alter the theta profiles. For an ATM option carry will be highest and lower for ITM and OTM options. Theta for options that are close to expiry and ATM will be highest and for deep ITM and OTM options close to zero.Theta dynamics due to volatility changes: Theta for options increase with rise in volatility.

Analysis of Deals-Players-risk -Interest Rate Derivatives

Most of the swaptions, libor Caps and floors and CMS floors that I have seen are from the following players1) Inter Dealer market2) Customersa. Hedge funds b. Mortgage banksc. Agenciesd. Hedgers and speculatorse. Insurance companiesMentioned below an array of players with varied interests at different points on the volatility surface. These players judge the market and their own unique needs and buy or sell options.Interdealer brokers· JP Morgan Chase Bank NA-New York Branch· Goldman Sachs Capital Markets LP· Deutsche Bank AG-New York Branch· Lehman Brothers Special Financing Incorporated-New York Branch· Merrill Lynch Capital Markets Bank Limited-London Branch· Bank of America NA· Credit Suisse International-London Branch· Citibank NA· Bear Stearns Bank PLCHedge Funds· PFG Relative Value Opportunity Master Fund LP· Element Capital Master Fund Limited· Elliott International LP· Parkcentral Global Hub Limited· Caxton International Limited· Citi Vega Select Limited· DE Shaw Dihedral Portfolios LLC· FrontPoint Fixed Income Opportunities Fund LPMortgage Banks· Washington Mutual Bank· Wells Fargo Bank NAAgencies· Federal Home Loan Bank of Atlanta· Federal Home Loan Bank of New York· Federal Home Loan Mortgage CorporationInsurance Companies· MetLife and other insurance companiesInter Dealer market main function is to provide, liquidity to the market. So they are generally market facilitators. Hedge funds take a view on the market and execute strategies. Deals done by these clients can be analyzed and reengineer the strategy behind the flow. Agencies are main creators of the volatility through callable debt and mortgage backed securities. This group has special interest to hedge the assets on their books. Hedgers and speculators have very unique need to protect their assets so they enter into options market.Player Main Role Needs ProductsInter dealer Facilitate the market Bid Ask spread all productsMortgage banks Holders of mortgages hedge monthly cash flows Amortizing Caps/Swaptions Agencies issuers of callable debt Hedge optionality Long dated swaptionsIssuers of MBSInsurances seller of GIC, Annuities Hedge long term liabilities CMS Caps/FloorsOthers CRA hedge using digitals Digitals

IBM Condor option

IBM is trading in the around 105. The price action of IBM is very stable and range bound. Implied volatility of IBM is at 27.84%. Not really high level of volatility but at this level the condor looks very attractive.
10 July 95/100/110/115 condor at a net credit of 3000 and commissions of 59.80. This trade has a risk of 2000.
Breakeven points on up side and down side are 113 and 102. If IBM stays below 113 and 102 this trade makes sufficient money.

Close the calls if ibm trends in upward direction.

S&P 500's rally is unsustainable

S&P 500 closed at 942. Looking at this graph below shows similar kind of drop and retracement after the technology bust. This retracement in the S&P is due to benign low interest rate regime that kick started. The question is will this rally sustain?
Let us examine few things that have lifted in 2002. At that time long term interest rates were at 5% levels. Govt and individual balance sheets were not leveraged. Globally, China and India started showing leadership in manufacturing and service sectors. This has lead to capping the price levels for various products. In this kind of world a busted economy needed fuel of low interest rates and markets have rallied to their heights. Fast forward to today. We are already in low interest rate regimes. Fed fund rates is at 0-0.25% range. Consumer balance sheets are deeply leveraged and resilient consumer is in the process of deleveraging. Government has taken the role of lifting the economy by creating enormous deficits. China and India are displaying signs of growth in response to government programs.
This gives a clear indication that any kind of monetary or fiscal medicine at this point of time is sheer wastage of resources. What needs to happen is deleveraging to reach equilibrium point. Till then we have two things that will play. One is uncertainity and second is dead cat bounces.
By end of June S&p 500 should stay around 900 or trend lower.

Macro=Algo

Financial markets and Real economy interoperate to create prosperity in the world. Financial economy acts as a barometer to provide instant feel of the state of the economy. Ted spread is an indicator of stress in the financial economy. High Ted spread suggests markets are experiencing deep stress and low ted spread will tell us converse is true. Real economy indicators like ISM report, Housing sector indicators gives us an indication of actual picture of what is happening in the real economy. Ultimately growth rate, unemployment and inflation are three indicators that will form the base of the economy and base of the financial and real economy pyramid.
Humanity around the world is always in need of goods and services for its survival. In ancient times people lived in isolated corners of the world by living with whatever is available in their surroundings. Once humans evolved from hunting societies to civilized societies where food and other goods are secured tug of war has took place between different societies. In the words of Darwin fittest society survived. Today, we witness similar fight for survival among various countries happening all around us. Countries are scouring across the world for energy resources, cheaper services and production of goods. Technological advancements have helped accelerate this process that started to make the world look more tightly integrated and known as globalization.
Although societies across the world today have global bodies like UN, IMF and other associations to resolve and safeguard rights we still witness extreme poverty, rise and fall of societies. This can be attributed to fact that individual societies operate on policies that can make or break them. For instance, African countries were given aid by western countries are not seeing the light of prosperity mainly because of lack of proper governance policy. These things have main implications for differential growth rates, inflation and unemployment levels in these countries. This differential will become base for the FX market, interest rates and commodity markets. Together these markets will become base for the equity markets locally.
Macro Trading is identifying opportunities in FX, IR and commodity sectors that are arising due to dislocations caused by governance policy. These policies can be like, Quantitative easing policy followed by central banks to fight credit crisis, Chinese and Japanese purchasing of US treasury bonds to keep recycling their dollars obtained by selling their goods to world, famous Mugabe’s printing money to buy grocery items. These brute force acts comes with lot of side effects and macro traders are after these kind of opportunities. Along with macro trading, systematic trading can be pursued where markets follow certain rules.
I call trading style that includes Macro themes with systematic trading strategies macro-Algo trading and if this style is based on mathematical themes, quant-macro-algo trading. Futures, futures options and spot contracts provide suitable vehicles to monetize the themes.

Fisher says economy has long way to go to recover

Review of comments from Dallas Fed:
A very slow recovery
Economy has a long way to go before a clear recovery starts kicking.
Fisher says “A sudden new set of circumstances, easy money seemingly heaven-sent and the short-sighted suspension of time-tested, prudent financial practice led us on the road, not to salvation, but to economic perdition.” To aid this argument fable about a man visiting Episcopal church after getting aid from a presbyterian pastor describes the current economic situation very aptly.
Geo Political factors and Technological factors
End of cold war and commercial reorientation of Asian and eastern European countries has unleashed enormous new capacity for production of goods and services and capped the costs. Technological advancements have created new forces that connected remote corners of the world to trading centers and became source for new place to invest and speculate.
Fed is trying to prevent past errors and of course it acted as pastor earlier and has not stopped from being so.
The Green Shoots (Financial Economy)
Revival of Commercial paper Market
Decline of Mortgage rates significantly
Robust corporate bond issuance market
Invest grade corps premium over treasury has fallen
All measures compared to last fall have improved.
The Green Shoots (Main Street)
New orders index shows rise
Moderations in decline of activity (Fed survey)
Job losses are reduced
Monetary policy initiatives have given rise to these green shoots. Side effects are inflation. But fed is very aware of these facts and taking every measure not unleash the ugly monster of inflation.
So far financial markets have taken these green shoots and have risen from last week. From here where are we headed next week? Next we have GM bankruptcy filing and unemployment report.

WU long straddle

Exploiting volatility spread between Implied volatility and historical volatility. Western union Implied vols falling down once the rally picked up in the equity market. Current implied vols of 40 for aug 09 contracts is at its historical lows. This gives an opportunity to buy some volatility at this level.

WU aug 09 strike: 17, underlying: 16.51, straddle costing 3.1 debit. trade date: 5/24/09. for 10 contracts, net debit will be 3100.

this position will loose if underlying moves nowhere. Time decay will be eating into the premium. Best case for this trade is underlying moving above 20 or below 14. rising volatility will add some more to our profits.

Since this is a long position, this will needs no initial margin requirements.

best trading

regards
Chandra khandrika

IBM condor Option Trade

On april 21st i have decided to play a iron condor option on IBM. I have observed few things. IBM is trading at 100. 10 IBM May options 90/95/105/110 iron condor with a premium intake of 2400 and a risk of loss of 2600 if IBM is above 110 or below 90. So far IBM never breached these levels. looks like a decent trade with minimum risk.

Only one factor creating itch in my back is the trending market. Since March markets entered into a Bull market. No one is able to believe in this market. But market is rallying. Market has moved from the bottoms of 6500 to 8500 today.

Some observations on the trade. This trade is a 5 point Bear call spread and 5 point Bull put spread. This has a width of 10 point range. Implied volatility fell down and benefited the trade.

Now i am on to next trade.

Bye for now

Chandra Khandrika

Option Trader.

Forecasting markets-perspective

Whenever I see a fit personality, I conclude that person should be exercising well. In the same manner if I see a person doing exercise and his schedule then I should be able to tell how fit and unfit his body turns out to be. This needs keen observation and sense of understanding of exercise and human body. Also how these relations existed historically.
How this relates to economy and trading. To undertake trading as a serious business it needs understanding of how various movements can happen. What scenarios can prevail? Strong economies are symbols for stronger factors leading to growth. So what factors contribute towards growth can be inferred by looking at economic indicators. If that is the case then why we make so many poor judgments with regards to understanding economy. Markets (people) are collectively blind and individually wise. They swing from one side to other when cool breeze pass by them. In other words as Benjamin Graham said in the short term markets are like voting machine, but over the long term they are weighing machine.
When looking at individual economic indicators we can tell what is happening in that sector. But we fail to predict what will happen to economy as a whole. Economic indicators are a snapshot of the economy at a particular point of time. Extrapolating the economic potential from scattered economic indicators with some empirical reasoning might be akin to predicting stock markets with number of sun spots. No doubt, economic indicators play a role in measuring the economy. There is one aspect which we might be missing. People adjust their activities according to market environment. A classic example is cut back (adjusting) in personal consumption with a gloomy outlook of economy. Sophisticated predicting models may be adaptive and also they can factor most of the changes and kinks in economic growth but they cannot assimilate the human nature. Human nature can be detected by human alone. There are plenty of human actions that can be automated but to predict a human you need a human. Similarly to predict markets you need humans. Therefore trading remained as a human activity since the dawn of civilization. To predict the markets we need, flair to understand and relate the past. A good understanding of economic indicators and their functional relations to traded instruments. On top of this it requires a human touch of understanding human behavior. By blending all these insights properly we can come up with a good forecast. So for instance to predict gold prices, we need to understand the nature of this commodity, its historical performance under various environments (inflation-deflation). From here we need to understand forces that will drive the price of gold. Towards the end market madness need to be included to come up with a genuine forecast.
This tells me clearly to trade an instrument, I need to know its past, present and market madness.

Generic Execution Algo-definitions

Generic algorithms: Systematic execution of securities in the market can be performed in various ways. Each of these ways will serve one particular purpose. These Algorithms can belong to categories of Iceberg, TWAP, VWAP, Participation and Seek and Destroy.

Each algorithm has certain basic features that it shares commonly with all other algorithms. Limit price, Maximum or minimum price at which the algorithm will send orders to the market. Order quantity, the amount of quantity to trade.

ICE Berg: This algorithm sends out limited quantities of order at certain fixed price and continues to do so till the order is completed. Good thing about this algorithm is it will execute trades at desired price but on negative side some times order gets unfilled.

TWAP: Time weighted average Price algorithm is used to trade a fixed quantity in set time period. Order is broken down into discrete time intervals (waves) with an equal quantity to be traded in each wave.

VWAP: Volume weighted average price algorithm executes orders proportional to average historical market volume over the same period.

Participation (% Volume): This algorithm is used to trade up to the order quantity using a rate of execution that is proportional to the actual volume trading in the market.

Seek and destroy: This algorithm is designed to hide on the passive side of the order book until there is sufficient liquidity available on the aggressive side.

Limit on Close: The limit on close algorithm aims to trade the target quantity during the closing auction of the exchange. If no limit price is set it will trade at a limit of 2.5% of the last traded price before the auction.

option trading -Basics

In this article, short summary of Black, Scholes and Merton model, ways to measure and forecast volatility and dynamics of implied volatility surface are discussed.

BSM Model: Delta hedged portfolio consists of a call option and ∆ units of underlying short stock or future. With passage of time this portfolio will be rebalanced to make it delta neutral.

Option prices change due to passage of time, change in underlying and change in volatility. Of three components, change in underlying impacts the option price most.

From Taylor’s rule, we get a relation between volatility, theta and gamma.

Option trading using quoted prices and estimate of option volatility can have P/L effects in the following fashion.

GAMMA profits:

(½)*S2*Γ*(σ2- σ2implied)

Vega Profits:

Vega*(σ- σimplied)

Assumptions:

1) Underlying is a trade able asset
2) Underlying pays no dividends
3) Can short the underlying in any size
4) Interest rates are constant
5) Volatility is constant
6) Underlying changes continuously


Defining and measuring volatility

Volatility is defined as square root of variance. Variance is measured as


Unbiased estimate

To get unbiased estimate of volatility needs correction factor. This correction factor depends on the assumption of the underlying process follows particular distribution (Normal distribution).



There are other estimators that can be used to measure volatility. But due to simplicity and well understood sampling properties make this estimator most desirable.


Forecasting volatility:

Volatility is a mean reverting process
Volatility of volatility is positively related to level.

In making an estimate of volatility, we need to understand primarily what events are being included and what are getting excluded. Exponentially weighted moving average model does a good job in giving higher weights to recent events and lower weighting to past events.


In the above equation most recent return values are given weightings. Λ values used generally range between 0.9 and 0.99. One draw back of exponential moving averages is that they do not address the mean reversion nature of volatility. High volatility regimes follow calm and low volatility ranges.

GARCH (generalized auto-regressive conditional heteroskedasticity) models address the above issue of mean reversion. These models are developed by Engle-Bollerslev. But this model is not Holy Grail for forecasting volatility.
This equation is specification for GARCH (1,1) Model.



This model does good job in some situations. One undesirable feature for this model is that it needs estimation of calibration parameters. These estimates are not persistent and some times they tend to be highly unstable.

Volatility cones: Forecasting volatility involves in coming up with point estimates for the volatility. When we need a range of volatilities then volatility cones will come in aid for such analysis. This analysis was initially developed by Bughardt. In this analysis, what we try to find is chart a series of 10, 20, 40, 100, 300 days volatility for securities for non-overlapping periods. This will give a context to today’s volatility.

Implied volatility dynamics: Implied volatilities for a particular stock at different strikes and maturities form a 3D surface. This volatility surface will have different shapes and contours. From time to time market changes cause the shape to undergo changes. PCA (principal component analysis) when applied to yield curve data it provides insights to level, slope and curvature changes in the yield curve. Similarly when applied to implied volatilities as a deviation from ATM (at the money volatilities) we get similar factors that explain variation.

Level Dynamics: VIX Index published by CBOE.



Level of VIX has 3 regimes, less than 20, above 20 and below 40 and above 40.
Volatility of the index is positively related to the level.
There are more large ups compared to downs.
It is mean reverting and settles with new level at each regime.

ATM volatility level for contracts maturing from front month to last month will have embedded event volatility. In other words contract maturing after event will see a sharp drop in volatility.

Smile dynamics: Good understanding of volatility smile will give us a handle to spot best strike to trade. Volatility smile is a phenomena where OTM/ITM strikes trade at different volatilities compared to ATM. These volatilities can be higher or lower compared to ATM vol subjected to market conditions.

1) retail investors buy OTM strike options (akin to lottery ticket)
2) Large funds who buy downside protection and writing covered calls


Skewness and kurtosis are 3rd and 4th moments for a distribution. These two elements additionally required to specify a particular distribution. Jarrow and Rudd (1982) have made first attempt to include these two elements into option pricing. Corrado and Su (1996) have provided a better solution to estimate these parameters.

The European call price is given by



This equation will be solved for ATMVOL, SKEW and Kurtosis.

Market perspectives- March - 09

A friend of mine asked me how low markets will go from here. If I knew that I would be playing GOD. But I can provide a rational basis for predictably irrational markets. To able to see end of tunnel we need some lights to at least start glowing in terms of stabilizing housing prices, resumption in credit markets functioning, improvements in consumer and business confidence and most importantly the new stimulus package should put some sort of damper around growing unemployment rate. If these events happen then we can say signs of life coming to economy.

Treasury is working jointly with Federal Reserve and created various plans under the umbrella of financial stabilization plan to bring life into economy. It is tackling various problems in the economy through its bailout programs. Housing sector is being supported by treasury’s purchase of agency debt and mortgage backed securities. These two activities were part of Fannie and Freddie’s activities. Treasury is ensuring that mortgage rates remain lower and bring more buyers into the market. Also it is plugging the pressure on housing markets coming from foreclosures. Will these actions bear some fruits? Only time will decide but at least we can say it will not deteriorate drastically. Treasury is doing everything possible to bailout financial sectors. Treasury is pumping money into the recapitalization programs, working plans for removal of toxic securities on banks balance sheets. These actions will start showing slow improvements in the economy. Treasury’s new TALF program will start aiding credit starved nation and jump start securitization industry. Recent stimulus package is aimed at providing state and local governments to start new projects and reduce the rise of unemployment. These factors jointly shall improve consumer and business confidence and leads to increased consumption expenditure and industrial activity.

Risks to above scenario is coming from further weakness in banking sector, ineffective stimulus and further deterioration in real estate sector coming in the form of commercial real estate sector. Also some macro themes that can work against broad based recovery are rise of global protectionism measures.

From here what can be said about individual financial markets

FX markets

USD has become safe haven currency. It will strengthen during this despite domestic weakness

Interest rates markets

Short term libor rates are totally anchored to lower levels.
Long term treasury rates will be rising due to supply of treasury. But international investors purchases will keep a cap on this from going too high.

Equity markets:

Stock markets will weaken further but rally on small good news events.

Commodity sector:

Oil will live for rest of the year under 50. Reason being global unwinding and lack of industrial activity. Even If dollar weakens, gold will benefit but not oil.

Few steps to restore confidence in the markets

It is very normal to hear that today’s economic woes have started with sub prime defaults. Last one week we have witnessed falling markets all around the world. Blame game is going all around. In this game we have heard financial sector wizards as drunkards. East Asian govt blame their loss of employment to lack of western consumer demand. US auto industry blames its woes on economy. Lucky few who succeeded by predicting economic gloom has blamed everybody. Recently, an IMF economist vaguely described necessary action for government is to restore confidence in the markets. One thing is clear from all this people who are governing do not understand if we are stuck in pot hole or a deep ditch. Ok so what is the point here? What is that I exactly want to convey?

To restore confidence we need bold steps and decisions. No one knows clearly what are we going to do?

1) Make banks mark down the books. No more optimistic thoughts that prices will come back up and I will be still solvent.
2) Create a process to bring all the derivative securities out of OTC domain. This way market will know the cost of unwinding and we can at least avoid market freezes after Lehman bankruptcy.
3) Loan modifications are disastrous. It will be less beneficial short term and more harmful in the long term. Investors who were supporting this market will never visit this side.
4) Auto bailout is a sham. I don’t say the 3 companies are waste asset. These companies are loaded with UAW. UAW has stifled the growth of the companies. So govt should take over the retiree benefit plans offered to the workers and in return big 3 companies should pay themselves from profits arising out of operations.
5) Last 10 years have created lot is new resource utilizing technologies and lots and lots of wastage of resources. So Govt should spend money in kick starting the production of resource utilizing technologies.

Option Spread strategy Analysis:

By combination in terms of calls and puts

1) Calls + puts
2) Calls
3) Puts

Above combinations will enable us to develop a wide variety of option strategies. These strategies can meet the needs of different market expectations and situations.
Every strategy has its own strengths and weakness. Some are expensive with low sensitivity to market movements. Some are very cheap but highly sensitive to markets. A strategy has to be devised depending upon market expectations and sound reasoning. Also never sit on losing position like a stubborn person. Markets have changed so it is better to cut the position by reducing loss. As famously John Maynard Keynes is reported to have said, "When the facts change, I change my mind. What do you do, sir?" So based on cost benefit analysis the position should be repaired or liquidated. Trading opportunities come every day. Only thing one can do is to stay solvent.
Option volatility trading is both art and science. For a particular situation there are multiple strategies that can serve the purpose. But option Greeks will tell more precisely which strategy fits the situation. Option strategies, Straddles, Verticals, Butterflies, Condors, Iron spreads, Box and synthetics have unique risk reward profiles. Each of these strategies is loaded with risk sensitivities uniquely. Some are high in Gamma and some are high in Vega.

A strategy should be created by considering a lot of factors. These factors include

1) Technical analysis of underlying
2) Historical and implied volatility analysis
3) Greek sensitivity analysis
4) Scenario analysis
5) Expected market reports
6) Mathematical analysis

Technical analysis of underlying: Technical analysis indicators, specifically, momentum indicators provide a view of overly sold or bought situations. Stochastic and MACD indicators serve this kind of purpose. Moving averages provide a bird’s eye view of market trends. Donchanian’s two trend lines provide a crossover system that provide the signal of buy and sell. Most importantly, all these indicators need to be analyzed along with volume and open interest.

Historical and implied volatility analysis: Implied volatility defined as market expectation of uncertainty in the market. This will help us develop range of underlying price movements like one, two and three standard deviations. Also this will help us to understand the probabilities of market movements. Most importantly, it can be compared with market experience of historical volatility to form a view about it. As volatility is mean reverting so this comparison helps in identifying this relationship.

Greek sensitivity analysis: Greeks are response of option value to movements in markets and time. Most important are, Delta, Vega, Gamma and theta. Greeks provide a way to look at various strategies that cost same. Two strategies can cost same but one has high Vega and other has high gamma. Depending on our view we select a trading strategy.

Scenario Analysis: For every trading strategy that is devised, scenario analysis is most important element. In this we get a clear perspective on the strategy with regards to what can happen if certain market conditions prevail. This will also shows us what we can loose or make in different conditions.

Expected market reports: Expected market reports will set the tone to the movements in the market. Economic indicator reports will define the path of the market movements. Unemployment report, Personal consumption expenditure reports and geopolitical events will drive the markets up or down.

Mathematical analysis: Markets behave mostly like herds. These herds are governed by certain loosely set rules. Quantitative analysis is used to understand these rules and implement strategies that can benefit.

Every Strategy should be viewed through these lenses. Then the strategy has to be executed.

Various kinds of option strategies can be devised for these market situations.

• High Volatility and Direction Neutral.
• High volatility and Direction Bullish.
• High volatility and Direction Bearish.
• Low Volatility and Direction Neutral.
• Low volatility and Direction Bullish.
• Low volatility and Direction Bearish.
• Sideway market with range bound volatility.

30 year treasury bond future has moved from its December highs of 140 handles to around 130 levels. Yields have increased almost 75bp in last 2 months. Last 3 months we had considerable uncertainty in market direction. But treasury market has shown determination towards higher yields. Last week we have seen inflation report suggesting smack of inflation. Unemployment claims suggested labor market is worsening. Treasury investors across the world are still anchored to theme of safe haven buying. But impending treasury supply scale is showing markets are here for higher yields. Stock markets have already dropped below November lows last week. This is clear sign of markets slowly digesting fact that worse is yet to come. Last week talks of nationalizing banks have intensified. Treasury has mentioned that it is going to conduct stress tests with banks to determine their capital requirements. Since Citi bank and Bank of America (Merrill+Country wide) are serious holders of these securities and they will need deep treasury capital. This capitalization is tantamount to nationalizing banks. Markets needed this rumor to go into selloffs.

This week will be a volatile week. We have some indicators coming from housing sector, consumer sector and Bernanke’s testimony to market. Market will be looking for state of housing sector through these indicators and Bernanke;s speech to understand his view of how monetary policy is working to mitigate current crisis. This week, I would like to position for a bullish bond prices and may be further lower levels in equity index markets.


Dow Jones index is below its November low. RSI is at 30%. Indicating market is near over sold region. This week we can expect a pullback from current levels to higher side. But economic indicators might drive market to new lows. I will position for a low of 7100.

What’s going on with Gold? Gold is really on a rising tide. What factor is driving its rise. Equity markets are tanking, treasury market is in bubble state (this is what experts have concluded about it). Gold has attained a clear safehaven status as investors have figured out US treasury is going to flood the market. In this situation, gold has a near term target atleast close to 1100 before a pullback occurs.

Nationalize BenchMarks

Nationalize Benchmarks not Banks.
Car company’s own cars building and selling but not roads on which cars ply or the traffic signals that control flow. If this is not true then when a car manufacturing company is shuttered down due to its inefficiency it can bring entire system to grinding halt. I think current credit crisis is classic analogy to this point. Banks are intermediaries and risk takers. They are intermediaries with respect to credit flow. This way they help match savers to borrowers effectively. They are also risk takers. In this regard they are leveraging on their knowledge to bring value to their shareholders. In this process they are creating benchmarks and these benchmarks are becoming benchmarks for their credit business activity.
Common people need money to borrow for a house, car and to pay for collage. They do so because it will take a life time to save all the money needed to perform these activities. If there is a credible way they can pay back the amounts in small monthly installments then they are willing to borrow. Now these loans are made by banks using various benchmark indices like prime rate, 10 yr Treasury note and some are directly related to libor instruments. Federal Reserve can impact prime rate by cutting or hiking fed funds rate. But they cannot regulate rates like libor. These rates are set by banks.
Now, last few years as technology has evolved finance engineering also grew to the occasion. This created novel way to price the products and securities. This allowed bankers to create wide array of products. Its like if you walk in an aisle in a supermarket you will see 10 different selections for simple milk. Depending upon your palate and tolerance you buy a particular kind of milk. Similarly there are tons of different products to make a choice. So people go to bank and get the kind of loan they need based on their credibility.
Currently, we are in the midst of big recession. Credit flows are all but stopped. When common people are still paying their loan commitments and plenty of new people want to get loans to start on their own creative activities. This activity is stalled completely. Government is creating TARP, TALF, rate cuts, and mortgage security buying, Quantitative easing and also planning to legislate to put a cap on mortgage rates. On the other hand, people are getting laid off; companies are winding down and thus creating a vicious circle of traffic jams.
So what went wrong? Banks have taken risks without impunity? No, banks did their job. Only one thing they have done correctly so that they will be bailed out in the event of mishap is tying credit activities to bench marks of their own creation. Government should help get into the business of maintaining these high speed lanes of credit benchmarks. This way no single bank can be labeled as too big to fail. If a bank has failed in discharging its obligations then let it close. But it should not be allowed to take the system down. Now question is the leverage taken by banks. For instance, Lehman bankruptcy created a situation where unwinding of the contracts traded by them created market dislocations. Market dislocations are like battle scars or minor injuries in the long life of the active economic life. But today, media fills the people’s ears with fear and greed and directing people to act like herds at their beck and call. Mortgages, car loans and student loan activity should be tied to benchmarks and securitization should be tied to again benchmark rates only. It’s the interbank spreads that unleashed havoc on the credit flow activity. Therefore we need not nationalize banks, nationalize the benchmarks. Nationalize the LIBOR rate setting activity. Like roads and traffic lights govt should own indices for loan creation. Banks should innovate their ways to create new structures. Govt should own the indices that allow the structures to thrive.