In this report, Rich explores how to use equity options to manage the risks that may still exist even after the debt ceiling deal was reached.
Image 1: Yields on short-term Treasury bills were influenced by the expected “drop dead date,” which refers to the point when the Treasury General Account was projected to exhaust its funds, both for bills expiring before and after that date.
Much of the recent discussion on market risk has related to the debt ceiling and the upcoming “drop dead date,” which Secretary Janet Yellen indicated was June 5. With the agreement between President Biden and Speaker McCarthy being reached, there are some people that probably feel as if the market is now passed this risk.
One way traders could see the magnitude of the risk priced into the market was to look at very short-term Treasury Bill yields before and after this drop dead date. The date was initially thought to be June 1 but was later pushed back to June 5. However, there has been a market preference to hold cash in bills expiring before the end of May, and not to be invested in bills expiring in early June in case no deal was made. At one point, the spread between these days widened to as much as 5%, with the yield on bills in early June (past the drop dead date) reaching 7%.
Image 2: Performance of various asset classes around the 2011 debt-ceiling debate
Traders have few data points to consider when trying to ascertain how events may unfold. The most obvious analogue to consider is the 2011 debt ceiling crisis, when the U.S. was put on watch for a rating downgrade and where a deal did not look likely. The timeline for this event started after July 4, which is a U.S. holiday, and got worse as the month of July continued. A deal was finally reached, and the bill was passed in early August.
We can see from this period, traders and investors have favored the ultimate safe-haven, which is considered gold. We also saw 30-year yields move higher over this time. Finally, money was repatriated to Japan, which has historically been one of the largest holders of Treasuries.
Equity prices at this time struggled mightily. The current debt ceiling discussion never saw equity prices struggle as they did in this period. Perhaps this was due to the perception a deal would always be reached. The second or third time we move through a crisis, it is common to not see the same magnitude of a move. Using this analogue, traders and investors may feel we are well past the worst of this crisis, even if we did not see the same drama.
Image 3: Comparison of Treasury General Account increase and decrease vs. the SPX return
State Street recently put out an interesting chart showing the performance of the SPX when the TGA was being drained versus when it was being refilled. When it is drained, this adds incremental liquidity to the market, which could go into reverse repo facilities, bank reserves, or money market accounts held by households. This incremental liquidity has meant strong and positive equity returns.
The converse is also true. When the account is being replenished, this takes liquidity out of the market. As this happened in late 2021, the SPX had a -23% return in a fairly short period of time. Are traders considering this risk as they climb the wall of worry?
Image 4: Treasury General Account balance at the Federal Reserve
Just when the market feels we are passed the worst possible news or biggest risk, we might in fact just be facing it. Once a bill is signed, the Treasury will need to replenish the money within the Treasury General Account (TGA), which has fallen from almost $1 trillion to a lot of $38 billion in the past year. This account may not go all the way back to $1 trillion. Most estimates suggest the account will be replenished closer to $500 billion, which is approximately the average over the past year. This number is much higher than the TGA has historically run at; however, post Covid-19, government spending is quite higher than pre-Covid-19, which is requiring a larger number to be considered.
Now, if we combine the amount that is needed to refill the TGA with the bills that are maturing and need to be re-issued in the coming weeks/months, the amount needed to be raised could approach $1 trillion. Senator Everett McKinley once remarked, “A billion here, a billion there, and pretty soon you're talking real money." Those billions are adding up to real money now, and this could be a liquidity event and a real risk to the markets in the coming weeks, just as the market thought we were passed the real risk.
Image 5: Change in SPX vs. change in bank reserves over one month
It isn’t entirely clear where this liquidity may come from. The primary sources of this liquidity to buy Treasury bills or bonds is thought to be reverse repo facilities, bank reserves, household money market accounts, or foreign buyers.
There are reasons to suggest any one of these may be more or less aggressive. Of these potential buyers, we have seen big changes in bank reserves--both positive and negative-- in recent years. First, it was money flooding into bank deposits. Recently, it was the opposite. If we use this time series as a case study to approximate the potential market move, we may surmise that bank reserves will reduce by about $500 billion. This may suggest a market move lower of 10% if recent history holds. While it may not all come from bank reserves, the amount needed may actually be larger. Thus, we shouldn’t rule out the possibility of a move this large.
Image 6: NDX Index vs. the Goldman Sachs Financial Conditions Index
Of the equity markets in question, the index that might be at most risk is the Nasdaq-100 (NDX). The NDX is considered a “long duration” asset. By this I mean the majority of its value comes from the terminal value in a valuation analysis, and not from current earnings and cash flow. As such, this index may be more susceptible to change in financial conditions.
In the chart above, I have plotted the GS Financial Conditions Index (inverted) versus the NDX. When this index moves higher (lower in the chart), this means financial conditions are getting tighter, or liquidity is coming out. When it moves lower (higher on the chart) the opposite is true. I can see that easier and easier financial conditions helped lead the strong rally in NDX in 2020 and 2021. Then came 2022 and the tightening of financial conditions.
Since last Fall, conditions have eased a small amount and stocks have responded. However, in the last couple of months, financial conditions have gotten tighter, yet the NDX continues to march higher. Is there a macro headwind to the technology/AI story that the market is not focused on?
Image 7: Forward Price to Earnings ratio for major equity indices
Looking through the various equity indices to see where investor exuberance is most pronounced, I compare the forward price to earnings ratio of the NDX, SPX, and RTY. Forward P/E can be a great measure of investor sentiment. I can see through time that sentiment across these indices moves largely together, though at various times, one index may be more preferred than others.
In the early 2000s, the NDX was more preferred to RTY and SPX. Post the Great Financial Crisis, small-caps were preferred to large-caps and tech. In late 2021, the NDX P/E once again climbed above the other two indices, something it had not done since 2008. We have recently seen a similar divergence, with the NDX forward P/E being at its widest level to the RTY since 2007. Investors have clearly shown a preference for the NDX. Is this where positioning is most at risk? Is this the positioning that at least needs to be hedged?
Image 8: NDX Index Daily Ichimoku Chart
Now I want to look at the NDX chart. I know the powerful AI story that has been driving the volumes, interest, and flow. However, as they say, trees don’t grow to the sky. Over the last year, I can see that there have been two other times when the daily RSI has gotten as similarly overbought as the NDX is right now. While simply being overbought was not enough of a catalyst, when this combined with the MACD rolling over and cross lower, a strong sell signal developed. In mid-2022, this meant a move lower in excess of 20%. In early 2023, this meant a move lower of about 8%. If we see the MACD cross lower, could we be ripe for a move lower at least similar to that of early 2023?
Image 9: QuikDNA of equity index options
I like to look at the options market to see what is being priced in. One of the best and quickest ways for me to do this is to use the Quik DNA that QuikStrike puts out. From this I can see where at-the-money vol is relative to other indices and its own history. I can also see the same for risk reversals, put skew, and call skew. I can see all of this for the 1-year and 2-year horizon.
Looking specifically at the Nasdaq-100, the thing that stands out the most to me is the -5 Z-score on 25 delta put skew for both 1-year and 2-year. While investors have shown a preference for NDX index and futures, they have also been looking to hedge with puts. At first blush, this can seem frustrating because it feels like the opportunity to hedge a long position may be gone. However, when I look to build an options strategy, I like to sell the market what it wants the most, use other options as a spread to deliver the desired overall structure that makes sense for my portfolio. I try to sell the relatively expensive insurance and buy the relatively inexpensive insurance.
Image 10: E-mini Nasdaq-100 skew for June and July expirations
I look at both June and July expirations. I looked across all expirations but the ones I show here for the sake of comparison are the June 16 and July 21 expirations. June 16 is a little too nearby to capture the events I am talking about. July 21 is far enough away to hedge the time as well as direction that I need.
Fortunately for me, when comparing the two expirations here, we can see put skew is more pronounced for July expirations than for June. Not only are investors bidding up puts, but the calls far out of the money are being suppressed. This is a somewhat natural position for equity index skew, but the low delta calls do look a little unusual. A good thing for me is that this is not the case for close to the at-the-money call options.
Image 11: Expected return for a July 21, short 140-136 put spread and short a 148 call, hedged
Most people think of the jade lizard as a short put and short call spread. However, I think the same name can be applied when I long the underlying and sell a call and a put spread.
The idea here is that I am a strangle to take in some premium that will create some protection for my underlying long position if we have a move lower. I buy the further downside put to limit any loss from the short strangle. The distance between the put strikes is less than the premium I take in, so for moves lower that are not large in magnitude, I am protected somewhat against the big move and do the best on a small move.
I am still wedded to wanting to be long the underlying position, otherwise I would consider simply closing it. If I am able, I could also consider stock replacement, selling the underlying and buying a call, to maintain upside exposure but provide more protection on the downside. That is not my core view. I feel that any tech exposure might be at risk and long in the tooth, but on any meaningful pullback there will be good support given the investor enthusiasm around AI and technology disruption. Thus, the short strangle with a long put is the preferred expression to hedge the position.
I can see the maximum gains to this total structure are when the NDX futures are currently between 140 and 148 versus 147. On moves below 137 or above 154, the trader will have to considered trading more futures against the aggregate position. Thus, the position is not without risk and is not a “set it and forget it” idea. For active traders willing to take this risk, the idea could be one that provides protection on a move lower, even when that protection has been priced higher by the market.
There still may be risks in the market around the debt ceiling that the market is not focused on. Traders should consider hedging portfolios. This may seem difficult to do with put skew at a -5 Z score, however, with some creativity and some willingness to take risk, there may be ideas that can provide the protection traders need within a desired range.
Stay vigilant and good luck trading!
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