Update – $UUP: Calendar Spreading

by Dan January 26, 2016 12:18 pm • Trade Updates

In late November, heading into what was a near certainty that the U.S. Fed would put an end to their zero interest rate policy in their December FOMC meeting, we decided to put on a trade that helped us finance the purchase of longer dated calls in the UUP, the PowerShares US Dollar etf, in an effort to position for a breakout of the U.S. dollar in the new year.  To refresh, here was the the original trade and the rationale from November 20th:

*Trade: UUP ($25.90) Buy the Dec31st 26.5/ March 26 vertical call calendar for .35
  • Sell 1 Dec 31st 26.50 call at .12
  • Buy 1 March 26 call for .47

Rationale – Consensus is that the dollar continues higher but there are a lot of moving parts here as no one really expects to see an aggressive FOMC beyond 1 or 2 symbolic rate hikes. And UUP already reflects a lot of the news. So as with any breakout play you want to be careful, define your risk and look to finance as best you can. This won’t lose money on any serious move above the 26.50 strike (although the profits are capped if that move happens before year end). Ideally we want UUP to creep up near 26.50 by year end and then we have a few options how to roll and further reduce premium risk in March.

The Fed did in fact raise the Fed Funds rate by 25 basis points in December, their first increase since June 2006 and investors immediately started pricing in further cuts throughout 2016. But then the upheaval in global financial markets might have thrown a monkey wrench in that plan, and the Fed Fund futures are pricing a zero % change that the Fed raises tomorrow at their meeting, and only a 23.5% chance that they do so at the next meeting on March 16th, per Bloomberg:


And while rhetoric was heating up in the Fall on the heels of hot U.S. jobs data that the Fed needed to end ZIRP, there are loud voices now that feel the Fed has made a very bad mistake. See Jeff Gundlach of Doubleline Capital’s comments yesterday:

It’s been my view that the U.S. Fed has little interest in being the spark that ignites a massive global growth scare by too aggressively raising rates here, thus diverging in monetary policy with China, Europe and Japan, causing the U.S. dollar to further strengthen and wreak havoc on a fragile global economy.

But the Fed can’t do an about face entirely, they only raised rates in Dec because of the fear of losing credibility on prior comments, if they turn tail now that could send a sort of panic among global investors.  I won’t pretend to know what the Fed will do, but the chances of them saying something that causes the US dollar to surge in the near term is not great in my opinion. The most likely path for them is stating a desire to continue rate rises, but with extreme caution.

So we are going to manage this trade, buy ourselves some more time, and further finance the March 26 calls that we are long in the UUP. I expect the UUP to remain range-bound, and now we want to better position for the March 16th FOMC meeting which will be the next, after tomorrow, by reducing our premium exposure in the near term.

ACTION: UUP ($25.76) Sell to Open 1 Feb 19th $26 call at 11 cents
New position: UUP ($25.76) long Feb 19th / March 18th $26 call calendar for 24 cents

To Be clear, the initial trade cost 35 cents, the short Dec 31st call strike expired worthless leaving us long the March 26 call. So the original price, less the sale of the Feb calls now, leaves us with a cost of 24 cents. The markets don’t expect a massive move higher in the dollar on tomorrow’s meeting because the Fed Fund Futures are saying the chance of a rate raise tomorrow is zero. This has always been a consensus trade that the Fed would be gradual in rate hikes while the rest of the world was going in the other way. We will manage the premium risk alongside the consensus that the Fed will not raise tomorrow. The position is still playing for a move to 26 in UUP, but we’re positioned that it won;t break too much higher in the near term before February expiration. 26 is still the near term target.