G3 Recap 3-2-11

Main Items:

  • US ADP improved to 217k in Feb vs 180k expected and 187k previously. Small and Medium business again put up strong improvements.

Overseas Data:

  • EU PPI rose 6.1% YoY in Jan vs 5.7% expected and 5.3% previously
  • South Korea CPI rose 4.5% YoY in Feb vs 4.3% YoY vs 4.1% previously
  • UK PMI Construction improved to 56.6 in Feb vs 52.8 expected and 53.7 previously
  • Australia GDP rose 0.7% QoQ in 4Q as expected and 0.2% previously

Commentary:

  • As a follow up to yesterday’s comment – note how the S&P has only sold off on days when Oil (in orange, inverted) made new highs, and it rallied as long as oil was stable, a trend that continued today:
     

    This suggests that the balance of risks for stocks over the intermediate term remains positive. This suggests that a trade opportunity is available:
    The idea is that given 1) the positive bias for equities, 2) the fact that implied vol for oil is much higher than for stocks, 3) the relationship between stocks and oil has been fairly stable over the past two years, (chart in lower panel is 11 * 2nd WTI contract – SPX Index) we can buy S&P calls financed by selling Oil puts.

    The Trade:
    Buy 1 June S&P 1325 Call for 32 pts, or $1600, expiry 5/17
    Sell 8 June WTI 95 puts for $2.5, or $20,000, expiry 5/20
    WTI to SPX notional ratio of 11.5
    Net premium of ~$18k. If both options expire at the money, the implied spread would be 11*95-1325 = -280, vs a Median of -250 (meaning Oil prices are usually a bit higher)  Selling 90 or 85 strike puts are lower risk versions of this trade, and if you do the 80 strike it will be roughly premium neutral .   Selling a smaller number of  higher strike options is of course also a possibility.

    Basically, this trade bets that if the oil price goes back to levels prevailing at the end of January, the S&P will make new highs. It is more likely that oil prices stabilize somewhere, hopefully not too far from here, as the political risk is likely to recede only slowly, and the S&P makes new highs anyway. This would result in the highest payoff scenario. And if oil prices spike AND the S&P sells off, we still make money by keeping the premium.

    Obviously, this trade is subject to conditional correlation risk, so you probably should not put it on in size, but it allows a way to make money in most conceivable scenarios.

    Comments welcome!

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7 thoughts on “G3 Recap 3-2-11

  1. looks like oil was cheap relative to stocks and now fair. the 11* i suppose comes from making the total face values equal at current market prices, yet still uncanny how correlated both series are with about the same drift over the observed period.

    given the above, the real juice of the trade comes from the vol differential rather than trading the delta (spread). so keep it simple and trade the strikes you feel comfortable managing the gap risk within if need be. all this implies the oil puts are 80% of your trade which is implicit in your analysis.

    focusing on downside scenarios, you are selling the tail risk of the drift mentioned about reversing … i don’t see any G3 monetary tightening before the maturity of the trade so should be ok vis-s-vis payoff. you also have event risk to aggregate demand shock but i suppose that could only come from a fiscal/bond market blow up. as for geopolitical/supply i have a feeling this marks the beginning of a period of prolonged instability.

    in a round about way, you are short the US$ with the above trade but that’s probably not worth hedging as would introduce too many variables and add even more conditionality. overall, gut ya.

  2. Just a wild thought — what about this trade via a basket of oil producers, such as BRL, CAD, NOK, and RUB? It could be vs the EUR, doesn’t have to be vs the USD …

    Carry would pull the ccy’s from your put strike. If the vanillas/vanilla spreads aren’t appealing, you could do a best-of put exotic to push things in your favor, or maybe use individual digitals / no touch options to limit your risk.

  3. shorting JUN95 puts WTI for $2,5 without downside protection is too risky in my view.
    A simple SPR release note from the White House would make this short very exposed
    plus the political premium now in the oil price makes the downside very risky to headlines.
    At least make it a put spread ( -JUN95/+JUN88 maybe?). Also margin calls if the WTI comes off can kill your position before its expiry.

  4. I agree with PPK, you’re taking huge and hard to manage risks with such exposure to WTI. The premium-neutral position with short JUN80 puts seems to be ok, if you’re willing to live with a tail risk of oil falling sharply (I wouldn’t, frankly). Though I would change the long SPX call for a bunch of call spreads, that way you’ll do well even if market just keeps up near current highs or starts falling after making new highs.

  5. and also: if you wish to short oil puts, go for Brent puts rather than WTI puts for simple reason that WTI front 3 months contract r in contango ( apr =101 , jun = 103) whereas Brent front 3 r in backw : apr = 115, jun = 114.70.

    With oil in Cushing pretty much constantly in over supply, the WTI contango will contunue while the Brent backw is strong at moment.

    Libyan + N.African crude is big supplier to EU refiners , who now must buy more N.Sea
    crude. Brent is similar in quality as the Libyan crude.

    In that environment, if you want to short puts , go for the stronger + backw contract !

  6. Thanks for your comments, everyone.

    Bert -I think the point on geo-stability is right on, which was the reason I initially looked at a high strike for WTI. Good point to the correlation to short USD too.

    qeqe – good thought, but I feel like that assumes so many additional correlations that the payoff may be very different from expectations. I like to keep it simple, so I’d probably trade such a basket on its own merits. Not sure what the implied correlations are for the exotic, but certainly sounds interesting.

    PPK – You are right, but Brent options aren’t very liquid, unfortunately. Otherwise, you’re right, the WTI risk definitely needs to be considered.

    Sid – Oil’s definitely a choppy asset, but a decline to 80 in 2 months would be a 23% move, or -140% annualized. Certainly possible, but probably a tail risk.

    One more point to add is that part of the appeal of this trade is that the option market implicitly prices S&P and Oil independently. While that may be true over the long run, over the short run, I think we can all agree that there is a fairly strong correlation, so this is kind of a way to monetize that.

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