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.
Tuesday, February 24, 2009
Monday, February 23, 2009
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.
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.
Sunday, February 22, 2009
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.
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.
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