Why Options are best way to play "Central Banks" dominated markets.....

Central Banks can change drivers of markets but they can't change emotions driving the market....
O Ashuji...

If the biggest asset market (fixed income market) is the most intervened market by the central banks, then rest of the market will be anything but natural. Correlations will break, conventional way of looking markets will be obsolete and only constant in asset market moves will be lack of permanence. Under current scenario, I will believe trading markets through options can be profitable. Large Section of the blog is sourced from Jamie Mai's (Cornwall Capital) interview in the book "Hedge Fund Market Wizards" by Jack D Schwager. 

"Options are priced lowest when recent volatility has been very low. In my experience, however, the single best predictor of future increases of volatility is low historical volatility. When volatility gets very low in a market, we consider that a very interesting time to start looking for ways to get long volatility, both because volatility is very cheap in absolute sense and because the market certainty and complacency reflected by low volatility often implies an above-average probability of increased future volatility." - Jamie Mai's (Cornwall Capital), "Hedge Fund Market Wizards" by Jack D Schwager.
Current situation should sound very similar to above situation. Though, beneath the surface certain very big markets have had big moves namely Gold/Silver during April 2013, Nikkei since November 2012 & JGBs since April 2013, equity markets so far remains relatively calm. Again, Idea here is not get the direction right (getting direction right in a world where natural course of action for market is constantly deferred with massive intervention by central banks, will be very difficult) but playing on bigger moves in the market. Options are best way to express that view with limited downside.

Variable within option pricing itself can help one play current environment in a better way. Variable includes - time, interest rates, volatility, etc

"Often, the longer the duration of option, the lower the implied volatility (IVs), which makes absolutely no sense. We recently bought far out of the money 10 year call options on Dow as an inflation hedge. Implied Volatility on the index is very low. The Dow companies would be in the best position to pass along higher prices. There is also an interest rate bet implicit in buying long-term options that can be quite interesting when interest rates are very low, as they are now. By being long 10-Year call options, we are taking exposure on the risk-free rate implicit in the option pricing models. If interest rates go up, the value of the options can go up dramatically." Jamie Mai's (Cornwall Capital), "Hedge Fund Market Wizards" by Jack D Schwager.

Smooth trending market often tends to understate the volatility. 

"One of our strategies is called cheap sigma and is predicated on the idea that markets sometimes trend and that volatility will dramatically understate the potential price move of markets that trend. For example, in 2007, Charlie noticed that the Canadian dollar was trending very smoothly as it broke the dollar mark for the first time in decades. Spot went from about 1.1 (CAD/USD) to about 0.92 - a very large price move. The market volatility, however, was very low. Based on the volatility, a nonsensically improbable event had just occurred. If the 3 month IV says that the price move that just occured was a three and half standard deviation event, we are going to like the odds of buying deep out of the money options for a price move back in the opposite direction." Jamie Mai's (Cornwall Capital), "Hedge Fund Market Wizards" by Jack D Schwager.
Since 4th June, 2012, most of the world markets were smoothly trending. However, since 2013 moves have become bigger and there is marked divergence among various equity markets and inter-assets (Precious Metals, Bonds, Stocks).

Assumptions that goes into option pricing can help identify profitable opportunities. 

"There is another type of option mispricing. The broader principle is that explicit and implicit assumptions that go into option pricing models often diverge from the underlying reality. Looking for those divergences can be very profitable exercise because you can wait and do nothing until you see a probability that is wildly mispriced. Option math works a lot better over short intervals. Once you extend the time horizon, all sorts of exogenous variables are introduced that can throw a wrench into the option pricing model. Another, example of distortion is introduced when the time interval is extended relates to the fact that the option-pricing models assume that volatility increases with the square root of time. This assumption may provide reasonable approximations for shorter time intervals, say one year or under, but if you have a very low standard deviation, and you extend it for a very long time, it doesn't scale properly. For example, if a one year standard deviation is 5%, assuming that the 9 year standard deviation will only be 15% is probably an understatement. Jamie Mai's (Cornwall Capital), "Hedge Fund Market Wizards" by Jack D Schwager.
Long Term Options, thus make very good sense.

Entire Chapter (SEEKING ASYMMETRY) on Jamie Mai contains far better examples and explaination and how options can be used for excellent asymmetric pay offs. 

Nifty is Binary Option Trade......

Big moves in market begins slowly and then clusters....
O Ashuji...


Nifty Compression reached extreme during December 2012 and January 2013 (Both months had just one day each of move greater than 1% move). This was extreme market compression.
Blog on Market Compression (Dated - 26th Dec, 2012)
http://speculationanart.blogspot.in/2012/12/market-compression-reaches-extreme.html
Post January 2013, Nifty has been experiencing bigger market moves.

Nifty Daily Move (>3%)

1) Nifty hasn't experienced >3% move since December 2011. 

2) 2012 was the only year in Nifty's history, which didn't have single day of move >3%.

3) Since 2009 end, Nifty had only 8 trading days of move >3% (that is 41 months)

4) Since 1995-2009, Nifty's yearly average of daily move >3% has been 18 days, while excluding 2008-09, average is 14 days. Thus, 2010-till date has been very compressed in terms of big moves in Nifty. 

Nifty Daily Move (>2%)

VIX Monthly Average

1) VIX Monthly average has been highly compressed since 4th June, 2012 low. 

2) May 2013 average of 17.2 is highest since July 2012. This is reflection of bigger moves in Nifty. 


Nifty as Binary Option Trade....

Indian Market (Nifty) has been extremely compressed since 2009 end and broadly ranged (up 17% and High Low Range of 38.91%). I am not getting into broader market because that has been major under performer. To understand how ranged market has been, lets look at the table below...

Since 2009 end, 87% of time Nifty has spent in 25% range, while 9% time has been spent on upper side of range i.e 6000+ and 4% time has been spent on lower side of range (<4800). 

Such long period of ranged market brings tiredness and frustration among traders. Market typically prices in recent past and Nifty past has been anything but extremely ranged. Big move out of this range should come very soon and my sense is it could be on upside. India has always been "beta" trade which does well when liquidity flow is ample globally and undershoots on downside when liquidity is tight. "India Growth Story", "High Growth", "Corruption",etc are good cover page stories with no cause effect relationship with Nifty Movement Whatsoever. Bull Market Thrives on Corruption and India's Lack of Tolerance for Corruption has been affecting start of Bull Market. Given the massive injection of liquidity by Global Central Banks and Powerful Force of Deflation (resulting from lower growth coupled with huge debt levels) assures one thing - Overshooting of Inflation or Deflation. Such Binary Outcome will make India come out of the range. Volatility in Nikkei and JGBs (Epicenter of Massive Monetary Experiment) is just early signs of volatility which will spread across global markets. One thing is given - MOVES ACROSS MARKETS WILL BE BIG (UP OR DOWN) AND ANYONE TRYING TO MAKE SENSE OF IT WILL BE SCRATCHING....

Vastly Different Mood For Nifty @ 6000+ in Jan 2013 and Now !!!

When Financial "Comedians" on TV don't believe in something, then one must blindly believe....
O Ashuji....

I must say, I have been surprised by the strength of rally across global markets. Indian market strength has been surprising after Feb 2013 carnage. However, rally has been driven purely by large caps and broader market (Mid/Small Cap) continues to under perform large caps. Before we get into the mood of "Financial Comedians" on POGO (CNBC), I would like to compare how broad market performs during early stage of bull market.

Broad Market Performance During Early Stage of Bull Market....

2003 Bull Market 

1) Broader Market out performed benchmark in 7 out 12 months and under performance in remaining months was marginal. 

2) At the end of 2003, Nifty was up 59%, while broader market was up 95%.

1) Classic out performance of broader market. 

Markets bottomed in June 2012 at 4800 and since has rallied 25%. In the same time-frame, NSE Mid Cap is up 9% and small cap is up 5%. This is huge under-performance in broader market and hardly bullish. 

Idea to put above data point is to show massive under performance of broader market both during June-Dec 2012 and in 2013. Bull market typically dont begin with such massive under performance of broader market. BUT IT CAN ALWAYS BE ..."THIS TIME IS DIFFERENT"

Now, coming to the main theme...How Mood among "Financial Comedians" is vastly different now compared to January 2013..

Mood among Comedians now...

Clients should be cautious in this rally: Motilal Oswal Sec  (16th May, 2013)

Nifty heading 6200, don't short now: Aditya Birla Money   (16th May, 2013)

Nifty will take long to decisively break 6100: Edelweiss (15th May, 2013)

Nifty rally valuation-driven; profit booking seen: Religare   (15th May, 2013)

Market trend choppy; sell Nifty on rallies: Sukhani   (14th May, 2013)

See flat Nifty; be stock specific now: Angel Broking (7th May, 2013)

Nifty to hit 6100 soon; bet on pharma; shun IT: Dimensions   (8th May, 2013)

Rally almost over, stay clear of PSU banks: Dalton's Bhat   (10th May, 2013)

Midcaps set for huge rally in May: Dron Capital   (8th May, 2013)

Mood can broadly be summed up as cautiously optimistic...

Mood among Comedians during Jan 2013...

Nifty may touch 6700 by year end: Prabhudas Lilladher (9th Jan, 2013)

Sensex to see 21,700 in 2013; bullish on ONGC, ITC: HSBC   (10th Jan, 2013)

Market downside capped; Infosys Q3 to be flat: PN Vijay   (10th Jan, 2013)

Don't see signs of weakness in Nifty yet: Anil Manghnani   (11th Jan, 2013)

'13 to be good for stocks; wary of infra: Raamdeo   (11th Jan, 2013)

Nifty over 6,350 on rate-cut; sell Infy on weakness: Baliga (14th Jan, 2013)

Momentum favouring bulls: Nifty may head to 6350: Sukhani   (15th Jan, 2013)

Liquidity strong, Nifty heading towards 6150-6200: Bhamre  (15th Jan, 2013)

Nifty may touch 6150; bet on large caps, pharma: Edelweiss   (16th Jan, 2013)

ICICI Sec eyes 6550 on Nifty by Dec; bullish on IT, cement   (16th Jan, 2013)

Market may touch 25,300 by end-December: Karvy Private  (18th Jan, 2013)

Mood was broadly very optimistic since most comedians had VISION 2020 in Jan 2013.Market obliged mood among comedians then by correcting 5.7% in following month (Feb 2013)

Thus, at similar Nifty levels and close to all time highs...Mood is vastly different now compared to Jan 2013. Current Mood is relatively subdued. Same can't be said about global markets which close to euphoric.

Ben Bernanke's Magic & Fund Managers Frustration

When market believes in magician, it will be a tricky market....

O Ashuji







Ben The Magician....

 

Just like creating money out of thin air...Central Bankers have been able to create stunning rally across equity markets out of thin air. Its been a market melt up within worse set of economic data points. Its been one of the most hated rally and investors/traders are being forced to participate. "Search for yield", "Rotation out of bonds", "Valuation Benchmarks Relative to Bond Market" (which is the most intervened market), etc are being used to justify the move and participation in the equity rally. Too Many "This Time is Different" has been created since last couple of months. (Please refer Previous Post)

Most of the veterans in the market believes that this will end badly and price action is certainly confirming that (melt up never ends with consolidating markets). I will quote few veteran Hedge Fund Managers who have been at the forefront of bashing "The Great Magician" Ben Bernanke, partly due to, not able to participate in the up move of equity markets and partly due to awareness of ultimate outcome of such tricks of Central Bankers.

Notes from Ira Sohn Conference 2013, New York (Source - www.marketfolly.com) 

Stanley Druckenmiller - Duquesne Family Office (previously of hedge funds Duquesne Capital and Soros Fund)

US Market & Quantitative Easing

Druckenmiller noted everyone is saying, "love the market long term, looking for a correction." He believes the opposite, loves market short-term, but hates it long term. Strongly disagrees with quantitative easing by Bernanke now. Only agreed with the first QE.

"His bond buying is controlling the most important price in the US economy." Says it will end badly, despite money-printing being beneficial to financial assets currently. When Fed slightly tightens, that will hurt things he says. Bernanke completely ignored strong economic data in January and February, but with slightly soft data later, he printed even more money. Expects a "melt-up" in the short-term, due to Fed's current policy.

 Paul Singer of Elliott Management ($ 20bn Hedge Fund)

Financial Overview & History of Markets

Singer gave a “history of financial markets since WWII.” There was less debt back then. Sound financial institutions. "Long term entitlement programs are the effective equivalent to debt." Countries are unwilling to even do non-threatening changes to these entitlement programs.

In Japan, it is 800% of GDP. In US, 500% of GDP. "Obligations that cannot possibly be met, no matter what the tax rate, or the growth rate." Financial institutions are now doing not just loans, but they are doing a lot of principal trading. Typical bank now: 200B equity, 2- 3T of assets, and 50-80T of notional value of derivatives. He claims it is hard or impossible to know what those derivatives actually are. Still completely opaque, and their risks are not understandable. VAR totally misstates risks. Also highly levered.

"Central Banks have revealed in their role, flooding the market with money, they think printing money is 'free' and they don't see the cost- since there is no inflation." We have modest growth, and build-up of risk. "The world needs growth; from innovation." Quantitative easing has caused a distorted recovery. People owning bonds, stocks, is doing fine. Ordinary citizens are not feeling the effective equivalent of Dow 15,000. Causing class warfare.

Other Noted Comments Recently

Bill Gross on Twitter

Gross: Never have investors reached so high in price for so low a return. Never have investors stooped so low for so much risk.

 Marc Faber

“In the 40 years I’ve been working as an economist and investor, I have never seen such a disconnect between the asset market and the economic reality ... Asset markets are in the sky and the economy of the ordinary people is in the dumps, where their real incomes adjusted for inflation are going down and asset markets are going up.

“Something will break very bad.”

When it is.... "This Time is Different"

When market move goes beyond comprehension...."This time is Different"
O Ashuji

When it is....."This Time is Different"

1) Its "This Time is Different", if Barron's Cover page targets are met within months. 

October 2012

February 2013

Now April 2013....

2) Its "This Time is Different"...When "new" bull market begins after four years of gain with markets rising 240%+...!!

3) Its "This Time is Different"...When historic low yield on "HIGH YIELD/JUNK BONDS" happens during worst growth environment (unlike during 2005-07 when world growth was booming)

4) Its "This Time is Different"...When only correlation that works with stock market is size of Central banks balance sheet

5) Its "This Time is Different"...When NYSE Margin Debt approaches all time highs with S&P at all time highs

6) Its "This Time is Different"...When deteriorating macro data is associated with all time S&P      500 highs....

7) Its "This Time is Different"...When Most Countries are running negative real interest rates and still requires more easing....

8) Its "This Time is Different"....When one of the Sentiment Indicator (AAII Survey) is at lows while S&P 500 is at all time highs !!!

9) Its "This Time is Different"....When Stock Market are at all time highs, 4 years into the "recovery" and "Economy" continues to require more and more easing.....


When Creating and/or Injecting more and more money to every problem, results in "confused" capital moving in and out of various asset class resulting in wild swings and lack of permanence in those swings. Gold Collapses when Huge Money Printing exercise is undertaken by Japan, Stock market rallies with significant deterioration in economic data points......Investors/Traders/Speculators/Politicians continued  reliance on Central Bankers as panacea for everything is reminiscent of continued faith in AAA rated securities during 2003-2007 boom, irrespective of their underlying.  Given the linearity of price move in stock markets, shows it will NOT HAVE NORMAL CORRECTION....but then it can always be "THIS TIME IS DIFFERENT"