European Vacation – $FEZ

by Dan June 23, 2016 2:11 pm • Commentary• Trade Ideas

No matter what you think global stocks should do on Brexit referendum results, European stocks have already factored in a higher likelihood of a Remain vote. The rally in the past week has them nearly back to the one month highs, with the Euro Stoxx 50 (SX5E) up 9% since last Thursday’s lows:

From Bloomberg
From Bloomberg

While the year to date action looks fairly range-bound in the SX5E, a longer term view shows the well defined downtrend the index has been in since making 7 year highs last April, way before anyone was talking about Brexit votes. The index is now down about 20% from those levels, having just bounced off of key technical support at 2800:

From Bloomberg
From Bloomberg

It’s been my view that Brexit mania has been more about doomsday easy click-bait by the media, while not properly reflecting the much higher likelihood of of Bremain  (read from this am:  Cause I Don’t Want to Be… Anarchy). And it seems like most financial market volatility would take place prior as opposed to after the resolution.  It’s also been my view that the the bigger issue facing Europe is the ECB’s push into negative interest rates. That effort to stimulate growth has created a unique and uncertain environment for risk assets. Any demonstrable lack of effectiveness of NIRP to achieve its goal will cause downward volatility spikes in the back half of the year, Brexit or not.  

I want to use the recent bounce in European stocks to get in front of what I feel will be a “sell the news” reaction for a Bremain vote. I may be a day early but I think after Bremain we’ll cycle back to the negative feedback loop for European stocks that existed prior to the run up to today’s vote.

FEZ (the EuroStoxx 50 etf) is very near important technical resistance, just below its 200 day moving average (yellow) and its early January breakdown level of $34. It’s lining up for a good short entry:

[caption id="attachment_64574" align="aligncenter" width="600"]From Bloomberg From Bloomberg[/caption]

Short dated options prices in the FEZ have exploded as one would expect, with 30 day at the money implied volatility rising very near levels from last Summer’s global risk asset implosion. I suspect options prices will come in hard after the event, with implied vol likely back in the low 20s, making short term long premium directional trades a difficult way to make money:

[caption id="attachment_64575" align="aligncenter" width="600"]From Bloomberg From Bloomberg[/caption]

Therefore I want to use near dated elevated options premium to finance the purchase of longer dated puts.

So what’s the trade?

*FEZ ($33.58) Buy the June 24th (tomorrow) / Aug 33 Put Calendar for 70 cents
  • Sell to open 1 June 24th weekly 33 put at 40 cents
  • Buy to open 1 Aug 33 put for 1.10

Break-Even On Tomorrow’s close:

The max profit would come at 33 as the short put would expire worthless, while the long Aug put would have the pick up of deltas offset the decline in value from iv coming in. Ideally, the weekly puts expire worthless tomorrow and then I’m able to roll that short put leg farther out to July or August. This trade will experience losses on a large move higher tomorrow (or a Brexit and an even larger move lower). But the likelihood is that the June weekly put expires worthless and we’re able to roll that portion.

Rationale – Weekly vol in FEZ is off the charts at around 90 pricing in the hedges of those worried about Brexit. August vol is also inflated at 24 and will likely come in as well after the votes are tallied. But selling the weeklies should cover the vol collapse in Aug, and if we get a slight pullback in the next few weeks the calendar trade is a good way to play short deltas without getting smoked on inflated volatility in the options.