Todd Harrison: The Other Side of Compression

By Todd Harrison  JUL 10, 2014 10:15 AM

The structural implications of recent market activity.

 


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It's been an active week, albeit one that required more handshakes and meetings vs. trading and writing. As my market exposure is on a tight risk leash of late -- I punted Twitter (NYSE:TWTR) late last week and kept a spec in the cannabis space -- that's okay.  I don't know if this is the beginning of the comeuppance that nobody saw coming, but I wouldn't fall off my seat if it were.

The conditional elements of a downdraft lower are seemingly in place. Fear, as measured by the VXO (INDEXCBOE:VXO), recently registered an all-time low while sentiment, as measured by Investors Intelligence percentage of bulls, notched the second highest level on record. 

Through a structural lens, we are seeing the same compression that John Succo wrote about 10 years ago (!!).  And while we understand that volatility levels are under pressure, what most people don't see is the aggressive selling of premium in an attempt to squeeze out incremental performance. 

I saw this strategy firsthand over 20 years ago -- massive selling of out-of-the-money puts for one-eighths and teenies -- while I was on the Morgan Stanley (NYSE:MS) derivative desk, and it worked incredibly well, until it didn't, and folks got carried out.

My peeps on the Street tell me that funds across the land have been overwriting their underlying stock positions -- selling calls against them -- in a reach for yield.  That is, of course, the exact same risk profile as selling a naked put.  When you factor in the bevy of accelerated share repurchases (I can't help but think of another buyback strategy 20 years ago), you start to piece together a mosaic of latent risk waiting to exhale.

Portugal is that catalyst du jour -- there are concerns surrounding missed debt payments by a company linked to the nation's second largest bank -- but it remains to be seen if it's Cyprus 2012 or Thailand circa 1998, as these things go. 

What we do know is that if there is any semblance of reality left in this market -- if there are still booms and busts, expansions and recessions -- nobody in their right mind should be surprised to see the "other side" of this market trade through. 



Timing, of course, is everything, but this is one instance when investors would rather be early than late.

Random Thoughts

R.P.

Twitter: @todd_harrison

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No positions in stocks mentioned.

Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at todd@minyanville.com.

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