Friday, January 30, 2009

Micro vs Macro

It's been a bit of a weird month, hasn't it?

For Macro Man, the last couple of weeks have really dragged by (including the always-crushing error of mistaking Wednesday for Thursday)....and yet he is shocked that we're at the end of January already. Talk of loving risk and a the five-day rule seem like a long, long time ago.

Such is the difference between micro and macro....quite often, when focusing on the one, it's easy to lose sight of the other. Macro Man, as the name implies, typically focuses more on the macro side of the equation; as the saying goes, the name does exactly what it says on the tin.

But if it seems as if his macro musings are less interesting than usual- and judging from the relatively low number of comments this month, you have- he is not surprised to hear it. While Macro Man has focused a bit on macro issues this month- the collapse in global trade and the potential onset of protectionism (a long-held theme for him), in his real world book he has become much more of a micro man this month.

To be sure, he has allocated capital to his favourite thematic trades and done OK by them. But there has been quite a bit of noise in these trades, relative to the net directional signal. And there have been good, fairly directional macro trades that he either missed (long the front end of Europe early in the month) or got wrong (the equity dump into the inauguration.) So Macro Man has found imself doing an unusually large amount of shorter-term trading to pay the bills, so to speak, while his longer-term macro bets percolate on the stove. It's not his core methodology, but if markets are going to be noisy than it behooves him to try and trade the noise.

One of the other reasons for his stronger emphasis on micro, rather than macro, is the relatively unattractive pricing of options. Macro Man typically likes to articulate his views via options becasue a) they offer significant leverage, b) the strategies that he employs allow him to articulate a defined loss parameter, and c) they allow him to play for the signal rather than getting shaken out by the noise.

So in the current environment, they should be ideal, given how noisy things are; in the past week, for example, AUD/USD has traded from 0.6425 to 0.6725 and then back again. And on the face of it, options on "risky assets" might look cheap. A simple overlay of the SPX and VIX, for example, would suggest that implied index vol should be closer to 70 than 40.

However, this ignores the fact that options decay, and the longer you remain in the same range, the more unprofitable owning options ata given volatility will become. Given that the SPX first traded at yesterday's closing level on the 10th of October, it's not surprising that implied vols have come lower.

Digging deeper confirms Macro Man's suspicions that options have been expensive, not cheap. Plotting the VIX against realized 20-day annualized vol in the SPX yields some pretty interesting results. If we look at the gap between realized vol and VIX, we can see that implied vols were actually lower than historical vol throughout the teeth of the crisis in September-November. This year, despite the lower level of VIX, implieds have still traded at a premium to the actual volatility in the market. So Macro Man's intuitive sense that optins have seemed expensive looks to have been correct; small wonder he's found difficulty in structuring attractive looking trades, in contrast to Q3 and Q4.
A similar development is evident in the currency space, where AUD/USD vols, for example, now trade above the level of historical vol after trading at a substantial discount late last year. While it is of course future, rather than historical, vol that is the real basis of comparison to implieds, it's difficult to extrapolate an uptick in realized vol while so many asset prices remain within the ranges established over the past few months.
An obvious alternative strategy is to sell vol. However, Macro Man has found that bid/ask spreads on bounded-risk short vol strategies (butterflies, barrrier ptions) have rendered those unattractive as well. There's no point buying a barrier option if you are effectively selling vol at 19% rather than the 24% mid-market vanilla implied.

Given his gloomy worldview, Macro Man has little interest in unbounded-risk strategies like selling straddles and strangles. So he's left keeping some risk in his favourite macro trades (while remaining poised and ready to add aggressively when they come into play)....but for the most part, spending his time on the micro, trying to use the noise to his advantage.

19 comments:

Anonymous said...

Interesting thoughts - do you think outright risk reversals look better value (e.g. in usdjpy)?

Anonymous said...

Do forgive my ignorance but on the chart of SPX against vol on a reversed scale....why would the disparity lead you to ask if vol is cheap and not whether equities are undervalued?

Anonymous said...

Good post MM, I think that's the theme for most at the moment - trading the range. Rogers verbally beating GBP, Soros on €, EURGBP retraced to support from Oct08 now and could break (skiing might be more affordable, woohoo). Cheers for vol insight too, tgif, JL

Anonymous said...

the inverted relationship between equity indices and S&P is something i enjoyed following from a market timing perspective as much as anything. with regard to the reader comment that equities could be undervalued its a very valid point. At some stage we get convergence....what i would add however is there is one index you need to add to this 4 in 1 graph. Itraxx crossover or investment grade protection. We all know that equity markets have been behind the credit markets in understanding the magnitude of this mess for the last 2 years. When credit and equity vol have diverged it has been equities that have come out with the black eye to date.

Anonymous said...

typo. the inverted relationship between equity indices and volatility is something i enjoyed following from a market timing perspective as much as anything. with regard to the reader comment that equities could be undervalued its a very valid point. At some stage we get convergence....what i would add however is there is one index you need to add to this 4 in 1 graph. Itraxx crossover or investment grade protection. We all know that equity markets have been behind the credit markets in understanding the magnitude of this mess for the last 2 years. When credit and equity vol have diverged it has been equities that have come out with the black eye to date.

Macro Man said...

Well, I take it as almost axiomatic that equities are still over-priced, so I know which way I am betting. The real issue, of course, is that options have a negative cost of carry, and stocks don't...so it's not an apples to apples comparison over long periods of time.

And good point re crossover...THAT....indicator is saying we're right where we should be.

Anonymous said...

http://www.ft.com/cms/s/0/efe1a910-ed98-11dd-bd60-0000779fd2ac.html?nclick_check=1

N N said...

"and judging from the relatively low number of comments this month"

Well if your looking to something to keep you busy, I have sent you emails that you have not responded to yet....lol

Anonymous said...

buying index options you are betting against the house. selling options is a strategy that is stacked in your favour provided you have enough capital to withstand the bulldozer coming around every so often. saying that i don't mind paying up for index puts the odd time VIX tanks and we all know that all the dominoes have not fallen in the funky finance world. Leveraged loans, private equity deals, high yield default rates, commercial property prices, sovereign risk all ahead. I think the final clear out takes us to the 600's on SPX. we can then move on. we will have purged ourselves of all the excesses that started in the 1990s!!!! and spend years on higher band income taxes paying for the clean up.

Macro Man said...

N N, touche! I typically answr comments at work but email exclusively from home...and Mrs. M and the Macro Boys has kept me busy recently. Will eneavour to catch up soon, I promise...

Bruce Chadwick said...

MM, I'm curious, you talk a lot about your macro bets, and I understand most of them, but how do you approach the micro-decisions. What things do you look most at when you "trade the noise"?

Macro Man said...

For me at least, noise trading is a lot more about technicals, positioning/flow, and instant reaction to news events. It requires a lot more full-time engagement with the screens, which I frankly don't particularly enjoy, but in this market is a worthwhile endeavour. When the price tells me that ky longer term themes are in play, the I can focus more of my energy there and dial down the punting.

matthew said...

when looking at realised is that close to close or e.g. 4 hourly...as daily ranges have been monstorus (enabling you to capture gamma) whilst directional moves have tended to reverse, which means close to close vol (BBG realised) underestimates actual volatility. In this choppy but ranging market, wings are what you want to own, so maybe consider selling straddles buying strangles, or selling callspreads in directions you like (alternatively with overpriced skew usdjpy usdasia etc, you can get 5:1 type leverage with simple 1:2 month 40:15D call spreads)

Anonymous said...

macroman. how are you seeing EM rates shaping out from this point? mpm

Macro Man said...

Matthew, I have been able to structure some trades that have a short vol component- flies, condors, spreads. The problem, of course, is that these strategies involve pinning the tail on the donkey (at least the first two do).

mpm, I have a small residual position in Brazil. I'd love to add on a deeper pullback; alternatively, a front end rally sub 11% will probably see me cash in.

I am struggling to find really high reward opportunities elsewhere, to be honest, though perhaps that is because I remain (too?) sceptical that countries like the Latams will slash rates to as much as they perhaps should, given global circumstances.

Anonymous said...

re: 'slashing as much as they should?'

EM countries cannot have deflation - bc they dont have a desirable currency in that global envir. If they continue to slash, the fronts shall hold, but i think the backs get rocked. do you agree w this?
mpm

Anonymous said...

Deflation can be occuring in a global sense (in dollar terms)... but in mxn, brl, zar, aud, etc etc its inflationary. Dropping rates in those specific countries will only excetuate the relative domestic inflation pressure. Mex for example printed higher cpi last report.
You have 2 forces pushing and pulling... this will result in high risk premium. best case would be fed buys the 30yr to slam all global spreads down.

this fit your logic? or am i completely off base mpm

Anonymous said...

looks to me like the best trade out there in the FX space is short USDCNY 1yr....who would have thought you get paid to be long the CNY!?

Anonymous said...

mpm,
Imo, you make no sense. Also, I believe you mean "accentuate". Sorry for the redundant post (that makes two now).
Thanks for the interesting entry, as usual, MM.