Traders are becoming increasingly jittery about a potential risk spike in the coming days.
One day after Nomura’s Charlie McElligott timed the potential day of max pain for longs as Jan 31, when some $7.5BN in MBS will roll off the Fed’s balance sheet, an event which historically been accompanied by acute drops in the market…
… an unexpected new member has joined the bear brigade.
In an overnight note from Goldman’s derivatives team, John Marshall and Rocky Fishman tell the bank’s clients that they “recommend buying short-term options to benefit from an increase in equity volatility this week.”
Specifically, Goldman lists a number of macro and micro catalysts which the bank believes has the potential to move the market more in any one day than the 1.6% that is priced into SPX straddles for the next four days, as shown in the chart below.
To justify their bearish thesis, Goldman’s strategists note that over the past three months, the S&P has moved more than 1.6% intraday in 90% of rolling four-day periods, and has moved more than 3.2% in 51% of four-day periods.
Further, Goldman believes that options prices are far too low in the context of elevated realized volatility, as shown in the chart below…
… coupled with challenging liquidity and continued global growth uncertainty, all of which will be accentuated by 6 key developments in the coming days:
- Biggest week of the quarter for Earnings: This week is the biggest week of earnings for S&P 500 companies with 37% of the market cap of S&P 500 companies reporting earnings with a particularly large focus on Energy (56% of mkt cap, XLE), Communications (53%, XLC), Industrials (52%, XLI) and Technology (52%, XLK). Earnings day moves have been a bigger source of volatility than normal this quarter as the average S&P 500 stock has moved 4.6% on its earnings day vs its historical average of 3.1%.
- Macro data delayed by shutdown will be released: Goldman economists note that the Census Bureau and Bureau of Economic Analysis will likely begin to release backlogged data this week as the government resumes normal operations. This data may include New Home Sales, Retail Sales and Wholesale Inventories which traditionally are significant drivers of volatility in macro markets over time. This data could provide increased confidence to bulls or bears as the debate regarding US economic growth continues. Further, the end of the shutdown could allow for an increase in equity and credit issuance; while good for corporate liquidity, an increase in issuance may have mixed implications for secondary markets.
- China-US trade talks (Jan 30-31): Trade talks will continue this week in Washington. Our economists believe that trade policy risks have receded somewhat overall and US-China negotiations look likely to result in a continued pause of tariff escalation. In Friday’s note they provided an update on the trade war’s impact on trade flows, US economic activity, and global equity markets
- FOMC statement and press conference (Jan 30): Our economists expect the FOMC to emphasize its intent to be patient and data dependent. Given the large moves in December and January on comments from Chairman Powell, we expect investors to be focused on the press conference.
- Payrolls and Unemployment (Feb 1): The SPX was up 3.4% on last month’s big Payrolls surprise, although the unemployment rate ticked up on a higher participation rate. Given last month’s report was the largest beat since May 2009, we expect there to be increased focus on this data point from macro investors. We acknowledge that last month’s Payrolls release coincided with the Powell/Yellen/Bernanke press conference, but we believe the Payrolls impact was significant given the market had risen 1.7% prior to the start of the press conference.
- ISM manufacturing (Feb 1): The SPX was down 2.4% on the ISM release in early January which showed the largest drop in new orders in years. Given the importance of the ISM as a leading indicator of industrial activity and in the context of fewer macro data releases this month (due to shutdown), we believe this data point will be a more important indicator for macro tactical traders than normal. We acknowledge that half of the Jan 2nd 2.4% SPX decline occurred prior to the 10am ISM release (likely driven by AAPL preannouncement), but believe that quantitative models that estimate the importance of last month’s catalyst will find it difficult to disentangle this factor.
Yet despite this barrage of potential risk events, Goldman notes that 1-week implied volatility in the SPY has been cut in half over the past month, showing that investor fears have relaxed significantly, and largely for just one reason: an increasingly dovish sentiment from central banks and increased stimulus by China.
And while Goldman notes that it is not taking “a strong directional view this week”, it believes options prices are too low in the context of the recent moves on macro catalysts. To wit, the abovementioned SPY 1-Feb straddles cost 1.6%, below the 1-day moves on the most recent ISM (2.4%), Payrolls (3.4%) and only slightly higher than some other 1-day moves over the past few months.
For perspective, Goldman also looked back over the past three months at each of the rolling 4-day periods, and concludes that if an investor bought SPY straddles for 1.6% on each night’s close, the intraday volatility on the subsequent 4 days would have been enough for the premium to more than double in 51% of the periods.
Meanwhile, the bank also points out that one of the key reasons for sticky high vol, namely low liquidity, persists and remains challenged for macro products. While the “top-of-book depth” in S&P futures has improved modestly over the past week, it remains below its 25th percentile relative to the past year; it is this low liquidity that has been a factor in the increased volatility of the past few months, Marshall and Fishman warn, and the decline in liquidity “has not yet reversed.”
Goldman also expects options prices to rise as investors focus on the upcoming ISM and Payrolls catalysts, and beyond the S&P 500, the bank’s derivatives team sees options on XLK, XLI, and FXI as particularly attractive in the context of the catalysts this week and recommends buying options to implement views.