Much of the buzz in the market of late has been the waning risk appetite. There may be no better measure of risk appetite in the market than the price of Bitcoin. In fact, when you plot the price of Bitcoin versus the Nasdaq price, you see a remarkable co-movement. In fact, you may be able to tell that the price of Bitcoin leads the price of Nasdaq, even if by a small amount. As a result, it is particularly interesting that Bitcoin prices have fallen substantially, down over 25% in a little over a month, yet the price of Nasdaq has little changed over this period. There are certainly other drivers of equity prices, as we are nearing the end of earnings season. However, the large loss in risk appetite apparent in the market is worth noting for those who are invested in stock indices.

Turning to the idiosyncratic news within the Nasdaq, the big story is the amount of debt taken on by the “hyperscalers” or the large tech firms that are investing in capex in order to ensure they are one of the top providers of AI to institutions. The problem, as the market sees it, is the previous cash-rich companies are not only spending all of their cash but are also borrowing to seize this once-in-a-lifetime type of opportunity. The credit market is responding by raising the cost of the credit default swap, insurance against a default on these bonds. While these CDS levels are not signaling a red flag or even a yellow flag, at the moment, they have also almost tripled in the last two months. The stocks are starting to take notice and have come off the all-time high levels at which they had traded.  Thus, it may not only be risk sentiment, but also the fundamentals of the largest companies in the index, that are calling the rally this year into question.

Despite the negative news that could weigh on prices, Nasdaq-100 futures prices still look to be in a strong uptrend. The moving averages are still pointing up and to the right. However, there are some signs of concern even in this chart. For instance, if you look closely, the uptrend that has existed since May of this year has seen any price pullback in futures hold the 50-day moving average, even if it breached the shorter term 20-day moving average. However, recent prices have the futures sitting directly on top of the 50-day moving average. Thus, futures are at a pretty critical juncture. A sustained break and close below the 50-day moving average would certainly bring into focus the 200-day moving average at 22,386, almost 3000 points lower. This could wipe out all of the gains for the year, something that Bitcoin, coincidentally, has already done.

Looking at how the faster money in the futures – managed money – is positioned does not indicate that traders are particularly bullish or bearish. While the net positioning is currently short, it is roughly near the average position of the last 3 years. Managed money has not been long since April of this year and has not been materially short since February of this year. This light positioning may suggest that traders will be responsive on the back of any large catalyst, such as a technical breakdown. Traders were right to be short ahead of the breakdown in Q1 and got long ahead of the rally at the start of Q2. If we see a big move in positioning, it may be a coincidence with a sharp move, exacerbating the magnitude of the move.

Looking at the implied volatility markets, we can compare the level of implied volatility to both the historical or realized volatility, as well as to the direction of price. First, the level of implied volatility in blue stands at a premium to historical volatility, however, this premium amount is relatively compressed if we compare it to the last 2 years. Second, the amount of realized volatility in the underlying hit a 2-year low in the summer of this year but has been rising ahead of the fall and the earnings season. Finally, we see that when futures prices rise, volatility tends to compress but when futures fall, volatility rises, sometimes sharply. This is consistent with the relationship between futures prices and volatility in equity indices that traders have come to expect. Overall, implied volatility is not priced at onerous levels relative to its two-year history or versus historical volatility. In addition, if there is an expected all-in futures prices, it is likely to correlate with a rise in implied and realized volatility.

Post earnings, the next major catalyst that traders may focus on is the potential FOMC rate cut in December. While odds have reduced for a cut, they still stand at roughly 50-50. Please refer to the FedWatch tool (not shown) for real-time updated odds. It is worth highlighting because if there is concern over debt levels in tech, a reduction in interest rates as well as a commitment to further cuts could help soften some of that concern. That catalyst comes December 10, which falls between the QN1Z5 and QN2Z5 expirations. You can see a small uptick in implied volatility from 22.73 to 23.19 between those two expirations, indicating that traders are aware this catalyst could matter. Looking at the full implied volatility surface, it is also apparent that the typical levels of skew in prices are present, with 25 delta put implied volatility trading about 8 vol points above the 25 delta call implied volatility. Looking at short-term expirations like NEX5, we see the same skew is closer to 7 vol points, so slightly lower.

Putting these ideas together, the trade that stands out as a possibility is a put diagonal. A put diagonal is similar to a put calendar spread, where a trader buys a put option in one expiration and sells a put option in another expiration. The calendar is typically done at the same strike. If a trader chooses different strikes, the trade is called a diagonal. Why would a trader choose different strikes? In this example, the trader might choose different strikes because they are deciding to buy the shorter-dated option, where the option premium is lower. Instead of collecting premium in selling a calendar, a trader can choose to move the strike they buy to a higher strike so the premium is neutral, but where profitability will kick in sooner on the strike they are long.

In this example, we look to buy a November month-end (NEX5) 24,750 put and fund that by selling a QN2Z5 expiration 24,000 put. The latter expiration comes after the December FOMC meeting where there is not only a slight premium to implied volatility, but where if there is any sell-off in tech stocks, the odds of a rate cut might go higher.

This trade benefits if futures prices move lower in the short term but fund a bottom from rate cuts and consolidate or rally post December FOMC. That is the best-case scenario. Even if futures simply trade lower, all the way to the 200 day moving average at 22,386, the trader is effectively long a 24,750-24,000 put spread. The trader would have to exercise their short dated puts and run short futures vs. the short puts in December on a continued sell-off.

Conversely, if futures prices go straight up from here, there is no risk because it is done as a premium neutral trade. The trader would neither gain nor lose on a sustained rally from current levels. The major risk for this trade would be if nothing happens until the end of November, and then there is material market weakness after November and before the QN2Z5 expiration. This is a risk the trader needs to consider when putting this trade on.

Diagonal trades can be a useful tool in the trader’s toolkit to take advantage of relative market pricing of options around definable catalysts.

Good luck trading!

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