SPX fly, July 2017

It’s a bit late in coming, but I’ve been busy. July’s SPX trade was profitable, but not as hoped. The play-by-play is described in the image at the link below. In this post, I wanted to put down some thoughts about the model in general and why the immediate outlook for performance is not very positive.

Link: SPX July 2017 Afteraction

When the markets are in free-fall, the decision is easy. I simply exit. The model ensures losses are not catastrophic to the account. The initial t+0 line is flatter on either side of price, and degrades more gradually out to -10% than most similar models–an important reason for trading the model.

The hard decisions are made when markets are moving strongly higher, as in the current regime. In normal market conditions, the objective is to exit with no less than 21 days to expiration. You may already have seen the recent statistics for the S&P: n days with <1% declines, etc., where ‘n’ is ridiculously large between >1% days, and with many instances being larger than the normal life-cycle of these trades. Exits for the last two flys were executed with about one week to expiration! August may be the same.

There is no end to this in sight… the markets continue to push higher, with pullbacks of less than 1% for months on end… with SPX/VIX options trading being impacted by HFTs and algos, and the related effect of relentlessly inflated put skews… with the Fed engaging in financial and social engineering experiments that are at best quasi-dependent on questionable data, as a matter of monetary policy (let this sink in for a moment)… in the midst of significant, unquantifiable systemic and event risks (perhaps unprecedented)… and with what is definitely unprecedented financial engineering on the corporate side adding fuel to the fire… I haven’t even mentioned the internals, like margin debt/investor credit, liquidity and volume… this list goes on. Have I missed anything? There is no reason to think this regime will change anytime soon, even with a rapidly deteriorating US fiscal (and political) context.

Under these conditions, the decision to exit is more difficult because low volatility forces me to hold the position longer, which in theory increases the risk as the trade moves toward expiration and the Greeks start to lose their collective minds. But low volatility also creates the impression that holding the trade is safer… key word here being impression. The effect is that I’m “stuck” with the trade in the most dangerous part of the expiration cycle (gamma week). While the returns are smaller, the losses should also be smaller in this type of regime–in theory. However, the probability of a smallish loss is also greater in such a relentless, late-stage bull market. To make matters worse, more adjustments are required, which can double or triple the cost of the trade.

Some adjustments can also significantly change the risk profile, particularly when adding call flys. These adjustments increase risk to a level equivalent with a major market sell-off (>-10%, e.g.). And when volatility is so low, there are fewer options available when adjusting with calls to the upside. When necessary, call flys can protect a mature put position, but can also create traps in which losses mount very quickly when markets take off later in the expiration cycle… the losses in such circumstances can be equivalent to what one would expect during a market sell off. (August may be a case in point. Fingers crossed that it isn’t.)

All of this means that the model expectations are probably useless in the current market regime. It is probably the *wrong* model! The challenge is knowing. How many of us have experienced or heard about situations where, after losing confidence in a historically robust model, the regime changes and the equity curve returns to normal?

Having said all that, the returns have not been entirely bad.


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