Macro Wrap – Why I’ve Been Nibbling on the Short Side

by Enis February 6, 2013 7:46 am • Commentary

Since Friday, I’ve initiated a couple bearish bets (here and here), and moved my trading from more neutral (focused on short volatility), to more directionally focused.  It’s certainly not a gimme strategy, as shorting the market at 5 year highs is a high risk game, and in my experience, it’s generally easier to play on the short side after the market has shown its hand and displayed some initial weakness.  But I only nibbled.  I didn’t bite off more than I could chew.   And volatility is cheap enough across the market that my risk/reward for buying options is better than usual.

There is more to my thinking though.  Looking across asset classes, geographies, and sectors, I see some clear warning signs for risks.  First off, in the currency market, which is the largest single market in the world, classic “risk-on” currencies have been underperforming.  The Aussie Dollar is touching its 200 day ma for the first time since mid-Nov, when the SPX was 150 points lower:

1 year chart of AUD, Courtesy of Bloomberg
1 year chart of AUD, Courtesy of Bloomberg

Other emerging market currencies like the Mexican Peso and Turkish Lira are showing signs of topping as well.

In global markets, both the Euro Stoxx and Hang Seng topped last week, and are actually down 4 of the last 6 days, another sign of reduced risk appetite globally.

In corporate credit markets, investment grade and high yield credit spreads are wider than than the level they closed at on Jan 2nd, indicating a (slightly) reduced appetite for risk in the corporate bond market.

Perhaps most importantly for the timing of my trades, realized volatility picked up in the broader market.  I initiated the first trade on Friday, when the SPX was up close to 1%.  If you’re going to buy options, you want to see increased volatility overall.  Even if the market eventually moves higher, if there are a couple big down days, I will have a greater chance to get out for a winner.  The chart of 5 day realized volatility in the SPX over the last 6 months:

6 month chart of 5 day realized volatility in the SPX
6 month chart of 5 day realized volatility in the SPX

Clearly, the volatility over the past few days is much higher than it’s been for most of the past month.

None of this evidence guarantees that I will be right, and that my trades will be winners.  But all of it together stacks the odds in my favor.  And in the end, trading, especially options trading, is all about the odds.

Markets overnight:

  • The Nikkei surged almost 4% overnight, as Japan trades in its own world.  The rest of Asia was mixed around the unchanged level.
  • European markets initially moved green, but the Euro Stoxx is now down 1%, as the DAX in Germany is now unchanged on the year.  Silvio Berlusconi continues to gain in Italian election polls, and Italy is the worst performing market in Europe today.
  • SPX futures are down 0.1%, after spending the overnight session in the green.
  • Dollar is stronger, Treasuries up small, and commodities weaker across the board.
  • V, ORLY, AKAM, PRU, TSO, GMCR, NWSA, ALL, and YELP report after the close