10 days ago we initiated a short trade in the banking etf XLF (below). Since then the etf is up about 40c as the market has continued its post Fed meeting rebound. Here was the initial trade and rationale:
Trade: XLF ($24.40) Buy Feb 24/21 Put Spread for .55
-Buy to open Feb 24 put for .65
-Sell to open Feb 21 put for .10
Rationale: If you have the sense that we’re just beginning to figure out who has all the exposure in this commodity collapse and that the risk could spread, the U.S. financial stocks, having just made multi year highs,, seem like a good fade. This structure goes out a few expirations and captures several other events as well like Fed moves and earnings.
In hindsight we maybe could have looked a little harder at some calendars like we have in other recent trades like the QQQ structure from Friday. The calendars represent our view that the market is likely to go sideways or drift higher into the year end, but we could see some pressure on the markets in early 2015. This XLF trade was a straight directional trade and would have continued losses if the market continues to drift higher.
We’re not worried yet but if the 24 strike starts to look too far out of the money we’ll have to think about maybe taking a loss rather than waiting around. The good thing is the expiration on this trade is in February so we have plenty of time. Here are the current greeks that are important is assessing this trade:
Delta: -26
Theta: -01
Vega: +.03
Obviously the vol and delta have hurt the trade so far. We paid .55 and it’s currently worth about .30. The vol collapse could continue a little into the Holidays but mainly this is a delta trade at this point. If it gets too far away from the $24 strike those deltas start looking really soft and we run the risk of having a lotto ticket. That’s our main concern at this point. If this goes sideways over the next few weeks we’ll probably stick around, down slightly and we’ll feel alot better, but up towards or above $25 and we’ll probably have to take it off and look for a better entry.
New Trade – $XLF: Exposure To the Elements
There is no shortage of explanations for oil’s more than 45% collapse since the 52 week highs in June. Many have focused on oversupply, while some (of late) are placing a greater emphasis on the lack of demand from what appears to be a weakening global economy. It is my view that yes, it’s a deadly combination of oversupply and under-demand, but it could also be an unintended consequence of the Fed’s completion of quantitative easing. Commodities like crude oil were one of the primary beneficiaries of the global stimulus.
A Fed induced bubble is popping before our eyes and you can make up whatever reason you want for the price action, but there are likely to be further unintended consequences.
The chart below dating back to 2007 shows the price of crude oil plotted against that of the S&P500 (SPX). What’s clear is that the SPX had already topped out in ’07 prior to the top in crude. In fact, while the SPX topped in October 2007, Crude went up another 30% before reversing and then losing 75% of its value from July 2008 to December 2008:
Equities led the way in 2007/2008 but this time around they don’t seem too bothered. Despite crude and the other industrial commodities’ collapses. But as I mentioned earlier in the MorningWord, other asset classes / instruments are clearly showing stress:
In the past week, since the better than expected jobs data, the VIX has risen 70%. Yesterday it closed above 20 for the first time since October 20th (when the SPX was more than 100 points lower than where it is today.) There is a growing angst amongst investors that has not exactly manifested so far in equity prices (at least here in the U.S), but is very visible in safe haven assets like U.S. Treasuries, the U.S. dollar. Conversely you see it in some increased volatility in the high yield debt markets and obviously with equity volatility products. Crude Oil is the main event and all discussions of price movements in other risk assets us start and stop with what’s happening in black gold.
So if you agree that part of the oil decline is a function of a Fed assisted asset bubble popping, while part is reflecting weakening global growth, then you have to ask yourself what comes next?
Yes the U.S. has been the place for relative strength. And yes the world we live in today does not have the leverage issues that we had in 2007/2008. But we have seen a reflation of risk assets in the past few years that has been in direct response to crisis stimulus measures that turned into monetary policy. And some of that is about to end. And when bubbles bursts we know that there can be reverberations. From the MorningWord:
The worry here is that the oil collapse causes all sorts of cuts in economic activity, including job cuts, with the potential of causing some sort of credit event. Oil and related companies will start slashing dividends, risk defaulting on debt followed by some bankruptcies.
What will the knock-on effect be? Will we also see sovereign debt defaults in places like Russia, Brazil and Venezuela where their economies are so tied to the demand for crude?
Which leads me to bank stocks. These stocks are always right in the middle of every economic crisis, no matter what the origination. They just can’t help themselves. European Banks stocks (Euro Stoxx Bank Index – SX7E) already reflect strain, down 5% on the year, and now just a few points from the 52 week closing lows:
But in contrast to Europe the XLF (Spyder Financial Select etf) is up 14% on the year. Although it was just rejected at a massive long term resistance level:
If you follow the oil slick from Feb Bubble bursting, to corporate defaults, to the possibly of sovereign defaults, even the banks of the most de-levered nation will not be immune to some sort of credit event.
XLF options prices have seen an uptick in the last couple weeks, with 30 day at the money implied vol nearly doubling, despite a mere 3% decline from 8 year highs in the ETF:
This tells me there are those who think the downward volatility in commodities and the stress in the high yield market can find their way into the banking sector. Additionally, traders are bracing for the Fed to remove the language that they will keep rates low for a “considerable time” at Wednesday’s FOMC meeting.
A break below the recent consolidation at $24, and the Sept high of $23.88 could see a quick move back to $23 and if a little bit of hell starts to break loose, $22:
So XLF vol is NOT cheap, and the rise in vol with the muted price action in the underlying suggests that there are those who are getting a tad worried about the commodity collapse spreading. Despite the rise in XLF options prices I want to have exposure with defined risk of a re-test of the October lows:
Trade: XLF ($24.40) Buy Feb 24/21 Put Spread for .55
-Buy to open Feb 24 put for .65
-Sell to open Feb 21 put for .10
Break-Even on Feb Expiration:
Profits: between 23.45 and 21 make up to 2.45, max gain of 2.45 at 21 or lower.,
Losses: between 23.45 and 24 lose up to .55 with max loss of .55 above 24
Rationale: If you have the sense that we’re just beginning to figure out who has all the exposure in this commodity collapse and that the risk could spread, the U.S. financial stocks, having just made multi year highs,, seem like a good fade. This structure goes out a few expirations and captures several other events as well like Fed moves and earnings.