Is The Crazy Over? Is This it?

by CC December 22, 2011 11:16 am • Commentary

As we head into the end of the year, volatility is down, the market is up, volume is light. There’s not a ton we can deduce from this type of light volume year end action, and typically volatility does get crushed in the Christmas through New Years period as so many traders are on vacation and there are so many more days when the market is closed than in a normal fortnight (nailed that!) But what if this volatility we’ve been seeing since August is over? How will we know and what do we do?

I don’t think the situation in Europe is solved for the long-term yet as they never really addressed some of the structural problems that have lead to the massive debt imbalances that occurred within the Eurozone over that past few years. This will take time and one can only hope that being brought to the brink of collapse the past few months will get the powers that be thinking hard about how to address these structural issues going forward. Who knows if they will? For now it may not matter.

Think back to 2007-2009 here in the United States.  Some (most? all?) would argue that we never really addressed the long term issues that lead to the housing bubble and subsequent banking collapse. But then look at the stock market since. The fact is the Fed, Treasury, the White House and Congress through tons of money at the problem, the incredible size of which we are still now learning… and at least in the short term, it has paid off for the stock market. Corporate profits are at record highs, unemployment, while still way too high, is way lower than it would have been had we entered a Great Depression 2.0. Yeah, we’re still in a sort of liquidity trap, banks aren’t lending, corporations are sitting on boatloads of cash etc. But at the depths of the crisis, the market reached a low and bottomed and made an epic run that lasted more than 2 years.

Which brings us back to Europe. The news that the ECB started a lending program to Eurozone banks at a fairly massive scale is one of those moves that alot of people were starting to think would never happen. People are still trying to digest the story, but my thinking is it could be one of those things in hindsight that we’ll all be kicking ourselves for not recognizing the significance of at the time.

As we’ve had our eyes focused on Europe the past few months a funny thing has been happening stateside. If you look at some of the data in the U.S. over the past few months it’s been overwhelmingly surprising to the upside. Granted, these numbers haven’t been spectacular on their own, and “beating low expectations” is a weird sort of thing to hang your hat on, and some would argue they are meaningless. But the fact is, the worries that the Eurozone would infect U.S. growth and send us into a double dip recession just haven’t played out.

So what does this mean for trading? Dan and I had a great deal of success the past few months playing a couple of theses over and over again. The first thing was focusing on the bank stocks, like MS, BAC, JPM, C, GS and DB. We put a ton of bearish trades out in bank stocks on market rallies. We’d then trim, take off, or in one case went long in the banks at the various times when the market seemed like it was near a capitulation point. This strategy worked out great. The other one we had success with was going short alot of the cultish high PE stocks like GMCR, LULU, NFLX etc. as they headed into some sort of event like earnings. We also had alot of success in stocks that we have a good feel for like AAPL and AMZN. The places where we didn’t have as much success, and a couple have been recent unfortunately, was playing binary events in stocks without a larger thesis as to why we were playing. We’ve learned our lesson on this.

As far as things you may be trading outside of the Risk Reversal universe, I would be very careful into year end and in the first few months of the year assuming that the volatility that we’ve seen will carry over. The VIX is back to historically reasonable levels, and the assumption that we’ll see it back in the high 30’s anytime soon could be a dangerous bet if things in Europe have cooled down for the time being. This could change of course, but I’ve been on the receiving end of a vol crush too many times and it is massively painful. So if you are on the long end of alot of premium, don’t be afraid to trim or sell some options against it. Better to be safe than sorry. Also, if you are long some of these VIX etn’s BE VERY CAREFUL. The VIX has been in backwardation the past few months, it is now in contango. This means the futures roll of long VIX etn’s will be bleeding money every day for the time being. If vol is truly in a new phase, it could last for a long time.

So be careful out there heading into the year end and let that caution carry over at least for the first few weeks of the New Year. It’s tough to read the market here, is this volatility really over or is it just the holiday season. We don’t know yet but the market that we saw since August and the wild swings never last forever. Once they do end you need to change your trading accordingly. New strategies for a lower volatility environment? We certainly will be watching out. Stay tuned.