Trade Analysis of: “Hedging a Dour Janet w/ Utilities”
Today, Janet stuck to her dovish guns and reiterated the Fed’s intention to remain cautious on raising the Fed Funds Rate (FFR) while it continues to monitor data from China – whoops, I mean the US! As predicted, the dollar took it on the chin with oil, gold and even US equities rallying hard from 12:20:01pm into the 4pm close. I suggested hedging my gold short with long calls on utilities. My analysis suggested Dominion Resources [$D] was the best alternative for an immediate term hedge.
From the release of Janet’s prepared remarks until market close, $D saw a gain of 126 bps. That was slightly less than $AEP at 127 bps and $EIX at 132 bps.
However, looking at the returns on the APR calls, $D was far and away, the outperformer. As a side note, I was a bit surprised by the outperformance of $XLU’s calls. $XLU’s equity only saw a 106 bps gain following Yellen’s speech. This was barely – by 1 bp, the fourth strongest move, yet the options were the second best performer, doubling in value by the close.
Intraday decreases in implied volatility (IV) partly explain the outperformance of $D and $XLU, which had the second and third smallest declines. A smaller decline in IV would have helped bolster options prices through higher embedded premiums. $XLU’s greater “front-of-mind” association with the “utility trade” likely elevated demand and boosted bids, further contributing to the ETF’s outperformance, versus my model. In addition to $D’s limited intraday IV decline, the magnitude of $D’s move relative to option-implied expectations, pre-Yellen is the most likely explanation of $D’s outperformance.
The 1-sigma or 68% option-implied (OI) bound is a useful metric to evaluate the market’s expectation of the speed of a stock’s price action. In the simplest of terms, the “68% OI bound” represents the price at which the market – at that instant, believes there is a 68% “chance” of the stock touching, at or before a certain date. The larger the distance between the “68% OI Bound” and the current price, the faster the market believes the stock will move. The smaller the distance, the slower the market believes the stock will move.
Prior to the release of Yellen’s comments, options markets were expecting – with 68% probability, $D to move higher by 2.5%, to 74.98 by APR expiry. Post-Yellen, at the close, $D had moved 204.6 bps closer to the Pre-Yellen “68% OI Bound.” The average alternative stock only moved 143 bps towards its “68% OI bound.” That’s a 43% relative outperformance by $D versus the average of what options markets were expecting. Simply put, $D options markets underpriced the probability of the magnitude of $D’s move by quite a bit.
It’s easy to observe this mispricing in hindsight, but nearly impossible to do so contemporaneously. That said, comparing beta-implied targets versus “68% OI Bounds” can be a rough guide, early on in the analysis. When beta-implied targets exceed “68% OI Bounds,” options markets can be viewed as discounting historical correlations. Depending on your views, this can present an easily identifiable opportunity to exploit a mispricing.
While this trade was intended as a hedge, I loath closing winning trades too soon! To that end, I performed a brief open interest (OI) analysis for some guidance on what to do next. Analyzing changes in “Daily OI” seeks to answer the question: “are market participants expanding their conviction, and to what degree?” Large positive changes in daily OI are supportive of the recent price action trend, while flat to modest declines can signal consolidation/reversals.
“Conviction” – the percentage of trading volume that results in new open interest units, attempts to reveal to what degree existing holders have “conviction that further upside is still to be had” or instead, are closing their positions – aka “taking profits.” Extreme values – positive or negative, indicate unidirectional sentiment. +100% means every trade resulted in the creation of new open interest units, while -100% means every trade resulted in closure of existing open interest units. Values near 0% indicate weak “conviction,” where the majority of trades involved existing holders selling their positions to new buyers. While weak conviction readings don’t outright invalidate a trend, they can help to identify when those “late to the party” begin to arrive.
Keep in mind that OI data is released by the exchanges with a one-day lag. As such, “today’s” level of open interest reflects the number of contracts in existence at the close of trading yesterday. However, “today’s” level of volume reflects the number of contracts traded during today’s session. This misalignment makes prospective OI analysis a bit more opaque. Nonetheless, there’s still merit in analyzing its trends.
Leading up to Janet’s speech, we see that all alternatives – with the exception of $DUK and $AEP, saw large increases in open interest accompanied by very high conviction. Whereas, $DUK and $AEP saw tiny changes in OI and weak conviction. The narrative here is that traders seeking increased exposure to the “Utilities Trade” – ahead of a dovish Yellen, caused a surge in demand where new buyers were forced to open new contracts because existing holders refused to sell. These same traders also found some reason to avoid using $DUK and $AEP as speculative vehicles.
Post-Yellen, we see OI declines and >50% conviction in $DUK and $AEP – both of the vehicles avoided by speculators ahead of Yellen’s speech. All of the pre-Yellen speculative vehicles saw further OI increases and reduced conviction post-Yellen, with the exception of $EIX. The declines in conviction reveal that a good deal of profit-taking occurred across the board and that existing holders are less certain about the likelihood for additional gains. $EIX is the exception. Post-Yellen, it saw OI more than double with 99.9% conviction! That’s incredibly, uber-bullish for the stock, especially when all of its peers are seeing conviction fall contemporaneously!
Moving forward one more day, we see some pretty boring numbers. While $SO did see a 1% increase in OI with 100% conviction, it’s really only a <$500 trade. In the grand scheme of things, that’s a very tiny rounding error. Otherwise, across the board we see minimal increases/decreases in OI and marginal conviction. This isn’t a bad thing, it just means traders have made their moves and are in wait and see mode.
In summary, my OI analysis has shown persistent increases in OI with declining conviction for $D as well as most of the alternative utilities. This isn’t a ringing endorsement to sell or to hold, but it does suggest it might be time to consider moving on. That said, the OI analysis does scream buy $EIX! I’ll need to spend some additional time figuring out why $EIX, but I’m strongly considering closing out my $D calls for a 138% profit and rolling into some $EIX calls.