Executive summary

Rich Excell discusses upcoming market events like the FOMC meeting, housing market data, Empire Manufacturing, and Treasury auction and describes various scenarios one could position themselves.

Image 1: Implied volatility term structure

Often, I sit down to write the Excell with Options and there may be a compelling story already unfolding. Perhaps this is in the news, events, or catalysts on the horizon. Maybe it is in the price action of the underlying itself. This time as I sit down, I think the most compelling ideas that are coming from the 10-year futures and options market revolve around the implied volatility term structure itself. I can see just in the front part of the curve going out a few weeks, there are a wide variety of prices ranging from 5.75 up to 7.31. Of course, these are often driven by economic events and by the influence of weekend days on the short times to expiration. For a trader, understanding how to navigate, and perhaps profit, from this term structure can be very useful.

Image 2: Snapshot of the economic data releases

When I see such a wide spread of implied volatility, the first stop I usually make is to the Dashboard within QuikStrike. From here, I can look at the economic releases for the given period to determine what the market is trying to price in and whether I agree with that differential in pricing. Once on this page, I can choose the filter at the top to see what I want to see. In this example, I have chosen the entire month of December (not shown here because it would be too large). As I scan the month of December, there are several well-known events that traders are most likely bracing for: nonfarm payrolls data on Friday, December 8, and the FOMC meeting on Wednesday, December 13. However, there are several other catalysts that the market may not be as focused on that may be of consideration as well: Empire Manufacturing, which is thought to lead the economy, on December 15; housing market data from NAHB, MBA and building permits December 18-20; and Treasury auctions every Monday and Thursday throughout the month. Sometimes, it is these other events that the market is not initially focusing on that could prove to be the bigger movers of a market. For example, if the debate is about hard vs. soft vs. no landing, that housing market data and Empire Manufacturing may prove to be the most important news of the month. If the market is worried about the U.S. government’s ability to successfully fund, each Treasury auction is a potential catalyst.

Image 3: CME FedWatch Tool probabilities for December FOMC meeting

If you look at the high point of the implied volatility term structure, it is on Friday, December 15 – the expiration that will capture the next FOMC meeting. The market is presumably saying that the decision by the FOMC is the most important event of the month. However, is it? After all, the FOMC has been on pause already for a few meetings. In addition, as I can see from the CME FedWatch Tool, while it has changed a bit over the last week or so, there is still a pretty strong consensus that the FOMC will remain on hold at the next FOMC meeting. Is that the event to be aiming for?

Image 4: Forward volatility calculation

It is important to understand what is being priced into the market. For this, we need to know the formula for the forward volatility calculation when we look at the term structure. In the image above, I have given you the formula for the forward volatility. In addition, I know that many people may feel a bit put off by mathematics so I have shown you how you can use ChatGPT to get to the answer that you want to get. I was interested initially from three data points from the implied volatility term structure: TY2Z3 (December 8) at 6.89, TY3Z3 (December 15) at 7.31 and TYF4 (December 22) at 7.06. In the example above, I am looking at what is the forward volatility between the December 8 and December 22 expirations that the market is pricing in, given there is a move higher in volatility from 6.89 to 7.06. The formula shows us this is 7.22. This indicates that the market is expecting that daily implied volatility will be lower until December 8 (nonfarm payroll day). It will then move to 7.22 for the period of December 8 to the 22 which captures the FOMC. I can compare this to the December 15 expiration being priced at 7.31 which is much higher. In fact, if I use this same formula for the forward volatility from December 15 (priced at 7.31) to December 22 (7.06), I can impute that the market is saying that after December 15, the implied volatility will fall to 6.61 (not shown here). I can see from these calculations that there is much lower expectation for volatility before December 8 or after December 15, with all expected volatility to come from the FOMC week. When I see the market leaning heavily toward one catalyst, I naturally start to expect that it is something else all together that could cause a move. I am very intrigued by the housing data in December 18 — 20. I know that housing leads the economy into and out of recession. It has been a better-than-expected housing market that has carried the economy in 2023. However, with mortgage rates recently climbing toward 8%, we have started to see strains in housing. The NAHB number last month plunged to a pre-Covid low. What if that trend continues? Will the discourse around a soft landing continue regardless of what the FOMC does? If I am effectively able to buy volatility for both the FOMC even on December 13 and for the housing data December 18 — 20 at a lower implied volatility (7.22 vs. 7.31) than the December 15 expiration, isn’t this a better trade for me?

Image 5: Commitment of Traders for 10-Year futures

Next, I want to look at the CoT tool to get a sense for how leveraged money is positioned in the futures. Here I look at the 10-Year futures, but if I look at the aggregated data, I can see leveraged money is short futures across the entire complex, though the biggest positions are in the benchmark 10-Year product. Could these futures need to be reduced if the data starts to turn bad enough that it looks like the FOMC has already gone too far? Maybe or maybe not, but the very large short position which has persisted since the summer could prove to be kindling for a fire that some are not anticipating. We may never know when a real fire will start; however, we can anticipate when the conditions are such that if it did, it could be worse than normal. A big short base suggests to me that if the economic data takes a turn for the worse, even if the FOMC is on pause, we could see a sharp move higher in futures.

Image 6: Futures chart for generic 10-Year futures

Technically, we can see that the futures have recently moved about the 50-day moving average. The next resistance will not come in until the 200-day moving average at 111.18. This should prove to be resistance at least on the first test of it. Thus, I may feel comfortable selling calls near the 200-day moving average for December 8 expiration. However, if on the second or third test of it the 200-day breaks, there is no resistance until we go back to the highs seen in March and April of this year. Not only do I see a potential calendar spread, but the technical picture suggests to me that I may want to consider executing on the call side of the market.

Image 7: CVOL tools for the Treasury complex with a time series for the 10-Year options CVOL

I now look at the CVOL tool to get a sense of where volatility, skew and convexity are relative to other products and relative to their own history. I can see in the Treasury market, 10-Year options CVOL is near the lowest levels we have seen this year. Therefore, I do not feel concerned if I am net long volatility on any spread I execute. In the bottom chart, I can see two other things. First, the last time CVOL was much higher was when we were at the highs of the year in futures in March and April. A return to those levels may not see CVOL return all the way to that high, but directionally I would expect a move higher. Second, I look at the skew and see that there is little to no preference for calls vs. puts. Thus, even though I think CVOL could move higher on a move higher in futures, the market is not pricing this into the volatility surface.

Image 8: Volatility surface for TY options

With all of that information at hand, I now turn to the volatility surface in QuikStrike in order to select the strikes I want to use. Remember, I want to sell calls for TY2Z3 expiration and buy calls for TYF4 expiration. The at-the-money volatility shows a premium for December 22 over December 8. However, if I move to the 110 strikes for each expiration, given the relative convexity in each expiration, I can actually buy that calendar for no implied volatility premium since the implied volatility is 7.05 for each option. This suggests that I am therefore buying a forward volatility around 7.05 vs. the 7.22 calculation previously.

Image 9: Expected return for TY2Z3 110 calls vs. TYF4 110 calls calendar spread

This is a chart of the expected return of the 110 call calendar between those expirations. You can see from the Greeks above, the spread is slightly long delta at inception, and it is long gamma and vega. However, since I am short an option that is closer to expiration, the theta is in my favor. You can also see that by buying the calendar instead of the outright December 22 110 calls, I have roughly cut my cost in half. It is important to point out that a calendar spread is not a set-it-and-forget-it trade. It is one that a trader needs to monitor and trade around in order to optimize performance. Simply looking at the breakeven before December 8, you can see that as we move to strike, the PNL is maximized. However, a continuation of the move through the strike can cause that PNL to go away and actually go negative. Why is this? If for instance we move up to 112 right away, the calls I am short are 100 delta as are the calls I am long. Both options are exercised and there is no resulting futures position. In this case, I lose the extra premium I paid out at inception. Similarly, if we move to 107 right away so that both calls are 0 delta, there is also no resulting position with both options expired and I lose the premium. The maximum PNL occurs if futures move higher but stay below 110 by December 8. In this case, my December 22 calls have gained in value, but if we stay below 110, the December 8 calls will not be exercised but will expire worthless. This would be the best-case situation for me. 

The trader must also have a view at inception of how they would want to risk manage any residual delta from the expiration or assignment on December 8. If we are below strike, you will now own an at-the-money 110 call for two weeks in the future. Do you like this position? Are you still bullish on futures as we may be moving above the 200-day moving average? If not, you may choose to sell some futures and turn the at-the-money calls into a synthetic straddle to trade the realized volatility around the FOMC meeting. The same is true if we move above 110 by expiration. In this case, the trader is short futures and long December 22 calls. The resulting position is a synthetic at-the-money put option. Is this the direction view the trader wants? If not, should they reduce the delta to turn it into a synthetic straddle instead? These are decisions the trader needs to make on or around December 8 depending on where the futures are and what the trader’s view is

Image 10: Risk view from QuikStrike Spread Builder

In order to help with these decisions and anticipate where risks are and how the Greeks change, QuikStrike has a risk feature within Spread Builder. You can see from this table how the PNL and Greeks change for each option and how the resulting total PNL and Greeks change over a wide range of futures prices. I believe this tool is invaluable in anticipating risks so traders can make quicker decisions when the time comes. 

This week, we looked at how to calculate forward volatility so traders can understand more what is priced in the options market.Given that I think the housing data may be more important than the FOMC decision that everyone is focused on, I am happy to buy the calendar to gain this exposure. I want to sell options in front of that to reduce my upfront cost and potentially give me the opportunity to win two ways if the first move higher in futures is met at resistance and the break doesn’t happen until later. By being flexible and understanding my Greeks, I am also able to turn directional trades into volatility trades again based on how my view evolves over the life of the calendar. Additionally, since there are Monday, Wednesday, and Friday expirations each week, a similar strategy could be executed around a variety of events.

As always, I like to see what the market is pricing in and what I disagree with. By doing so, I can potentially earn much better risk-adjusted returns on my trades.

Good luck trading!

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