The most memorable events in the career of a trader are due to surprise events. Especially for an options trader. I have many trading days etched into my mind because of a surprise after-hours announcement about a merger or acquisition, or an unexpected fraud or loss.
With QE3 and OMT by the ECB at the forefront of everyone’s minds, and with implied volatility near 5 year lows, I wanted to bring up the idea of unknown unknowns. It will likely be relevant in the months to come. The market is most surprised when an event occurs that has not even been considered. Uncertainties that are well telegraphed are rarely uncertainties on arrival. The fiscal cliff, the Spanish bailout, or Chinese growth slowing are of this nature. Certainly impactful events, but known unknowns, to use the popular euphemism.
With implied volatility so low, my favorite strategies during my trading career have usually involved setting up for unknown unknowns, but with structures that don’t cost me too much premium. One example of an unexpected event not in the public discourse at the moment: the Greek army declared a coup, and shut down the banks and government over the course of a weekend, announcing the country’s exit from the Euro and a newly denominated Drachma. That’s a truly surprising event.
We should not place trades that only profit off such events. But I bring the topic up today because FDX implied vol in Oct yesterday reminded me of unknown unknowns. Since FDX had already pre-announced, market makers had priced in basically no move for earnings. FDX is only down 1.75% as I type, so market makers were likely right in doing so. But selling FDX Oct implied volatility at 20 (near 5 year lows) only makes sense by ignoring the tail risk of the unknown unknowns. In the long run, it’s a loser’s game.
Markets overnight:
- First thing I’ve noticed over the past couple days is that the overnight weakness is starting in Europe, for the first time in a couple months. Asia closed mostly in the red, but most markets were only down small, less than 1%. Europe showed weakness on the open, and like yesterday, has been in the red the whole session, most markets down 0.5-1%
- SPX futures down 0.2% in sympathy with Europe. FDX down 1.75% after cutting its earnings outlook once again
- Commodities are broadly lower and the dollar is broadly higher. The Aussie Dollar has given back its post QE gains, another illustration of special weakness in China
- Treasury bonds are slightly higher. Spanish yields have started to tick up again this week as the Spanish govt delays on asking for aid.