Traders’ Attention Spans Get Shorter – 0DTE Options

/0 Comments/in /by

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

May 15, 2023 – DJIA = 33,300 – S&P 500 = 4,124 – Nasdaq = 12,284

“Traders’ Attention Spans Get Shorter – 0DTE Options”

 

There are many days where the financial markets seem to be light-years apart from economic reality.  We have all scratched our heads on days when stocks rally after a terrible news report.  Similarly, an upbeat report hits the wire and there is widespread turmoil across the markets.  While this has been a common occurrence over the years, it has become more common because of new derivative and option trading strategies.

Daily options on the SPY and QQQ ETFs began trading in the second half of 2022 and have quickly grown to have a large role in the stock market.  Before exploring this trading strategy, let’s provide some definitions.  Put and call options can be a little confusing but basically buying a call option is bullish while buying a put option is bearish.

A call option offers the right but not obligation to buy an underlying security at a specific price any time before the call’s expiration.  A put option is the right but not obligation to sell the underlying security at a specific price before the put’s expiration.

Here is a specific example using Apple (symbol = AAPL).  The AAPL options expire every week.  Looking at a call option that expires on June 16 with a strike price (the exercise price) of $180 per share.  This means that the owner of the call option can buy Apple at $180 any time before June 16.

Obviously when Apple’s share price is trading around the current level of $172, the owner of the call will not exercise (buy at $180).  But if Apple trades above $180 before June 16, the call owner can buy AAPL at $180.

Turning to the put side, the buyer of a $165 AAPL put option with the same expiration date (June 16th) provides the right to sell AAPL shares at $165 before Jun 16.  It wouldn’t make sense if Apple is trading in the $170’s, but if AAPL has fallen to the low $160’s, then put holders will gladly sell Apple shares at the higher price ($165).

To complicate the situation further, the price of these options trade and move up and down according to the stock price relative to the exercise price and the amount of time left before expiration.

With this Introduction, we move the focus to the recent development of daily expiring options.  While many large stocks and the major indexes began offering options that expired each week, the SPY and QQQ started trading options in 2022 that expire every day.  The SPY and QQQ are ETFs that mirror the S&P 500 and Nasdaq 100 indexes, and these are the securities on which the daily options trade.

These daily options are referred to as “0DTE” which stands for Zero Days to Expiration.  In other words, these options expire at the end of the current trading day.  The pricing of these options is entirely based on the S&P 500 and Nasdaq 100’s intraday price movements.  Obviously, given the limited shelf life, this is for nimble traders who can react and adjust quickly.

The growth of 0DTE trading has been massive and led to some unexpected market influences.  From a high-level view, when 0DTE options are bought (a bullish strategy), the dealer who sells these options now has added risk.  The dealer had essentially sold short the options which means they are at risk of rising prices (they will lose money if stock rally).

Logically, dealers hedge their risk from the selling of call options by buying the underlying stocks of the index or they buy futures options on the index.  This buying of stocks and futures pushes prices higher which then encourages more 0DTE call buying which forces more stock and futures buying.  This can easily turn into a circular exercise which can move stock prices regardless of the news flow.

There is evidence that this was a big part of the stock market’s trading in the 1st quarter of 2023.  The S&P 500 was up over 7% in the first quarter and the Nasdaq Composite rose almost 17%.  This happened within an environment where banks failed, inflation remained high, the Federal Reserve raised interest rates, and the economic data weakened.

0DTE trading is being used as a short-term trading tactic and has very little correlation to the fundamental economic data.  Traders, who are undoubtedly aware of the problems that are challenging the economy, believe they can rapidly adapt their positions to a changing stock market through this strategy.

The trading of 0DTE options has changed the way the stock markets move in the short term.  To be sure, the circular machinations have helped stock prices in 2023.  However, this can work in reverse if stock prices begin to drop.  It could cause a rapid and steep drop if put option buying starts to outweigh the call buying.  Dealers would have to hedge against declining prices and a dive could accelerate.

This is a complicated subject which can be confusing.  Please feel free to call or email me and I’ll try to answer and explain further.  One of the main conclusions from the growth of 0DTE is that underlying risks get masked in the short term.  Ignoring risks doesn’t mean that they are reduced or eliminated.  In fact, it could result in greater risks as financial asset prices move further away from reality.  This could be the story of 2023.

Wall Street Asks If The Glass Is Half Full

/0 Comments/in /by

 

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

April 28, 2023 – DJIA = 33,826 – S&P 500 = 4,135 – Nasdaq = 12,142

Wall Street Asks If The Glass Is Half Full

 

To some the glass is half full and to others it’s half empty.  This quarrel between optimism and pessimism arises throughout our world.  These mindset differences are growing wider and deeper in many areas of our culture.

The financial markets have long been a battleground of opposing opinions.  In fact, Wall Street has assigned each side a mascot – the bull and bear.  And while the fight is never ending, the 2023 episode is exceptional.

This year is unique on countless levels with economics and finance having their share of distinctive issues.  For example, the bulls and bears disagree about the impact and longevity of the Federal Reserve’s policy of raising interest rates.  There is broad optimism that the Fed will stop raising interest rates soon and then pivot to reducing rates and loosening monetary conditions.

The pessimists in the financial community believe the Fed will continue raising rates and then will be patient before any shift.  They point to multiple speeches by Fed leaders and Chairman Powell that emphasize the need to reduce inflation.

Another related and critical topic dividing the bulls and bears is the economy.  The bulls, counting on the tailwinds from a Fed swinging to interest rate cuts, are predicting an economic rebound and growth starting in the second half of 2023.  Additionally, the recent stock market declines, they believe, have priced in all bad news and it’s time to click the “buy” button.

The ursin view is much different.  Inverted yield curves have historically led to recessions.  The record level of the current inversion suggests that the recession will be deep and long. Layoff announcements have become a regular occurrence and their impact has not been fully felt.

We’re in the middle of the 1st quarter earnings reports and the numbers, so far, are troubling.  258 companies within the S&P 500 have released results.  The summation of these reports shows revenue growth of 4.9% year-over-year.  Earnings have fallen 2.6% for this same period.  Looking at the industry sectors, technology reported a 1.2% decline in revenues with a 12.8% drop in profits.  The same data for the Nasdaq 100 index (46 companies reported) is worse.  Sales have increased 4.4% while net income is down 6.9%.

The banking crisis is another glass half full-empty development.  Wall Street bulls are confident that the failures of Silicon Valley Bank and Signature Bank are isolated events and that the Fed and other regulators have addressed the problems.  With the system stabilized, banks will start financing housing and businesses.

The bears contend that the crisis is starting and that it will continue to grow.  The increase in interest rates during the past 12 months has impaired the loans that banks have on their books.  The value of a low interest rate mortgage that was done years ago has plunged given the current level of rates.

This is a large problem for many lenders and their balance sheets have been devastated.  Of course, the Fed has initiated a new program that basically allows a bank to pretend that an underwater asset is worth its original value.  They are lending to all banks based on fabricated numbers.  This might work in the short term, but it doesn’t address the problem of the loss of value.

Opposing viewpoints drive the markets.  A buyer sees value while a seller sees an opportunity for liquidity.  The willingness of each party to transact at an agreed price is what makes markets.  The capital markets of 2023 are facing widely differing views.  Economic developments as well as geo-political and international problems will drive the markets.  Ultimately the views of the bulls and bears will determine the path forward.

Ides of March 2023, Banks Beware

/0 Comments/in /by

“Bad News is Good News”

/0 Comments/in /by

 

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

February 3, 2023 – DJIA = 34,053 – S&P 500 = 4,179 – Nasdaq = 11,816

“Bad News is Good News”

 

Bad news is good news.  This has become the rally cry of a lot of Wall Street bulls.  The logic is that economic bad news will mean that the Federal Reserve will stop raising interest rates, reducing their balance sheet and other restrictive monetary machinations sooner.

Fortunately for the bulls, when it comes to bad news, they have had plenty of ammunition. Recessionary economic statistics, falling consumer confidence, widespread layoffs, and tumbling corporate profits are some examples.  While many would apply common sense and conclude that these signals are a negative for the financial markets, the current investor attitude is that this will force the Fed to back off and then it is back to party time.

This mentality has helped stabilize the stock market in recent months after a horrible first half of 2022.  It further assisted a strong stock market rally in January 2023.  The Nasdaq Composite jumped 11% in January which is the best start to a year in over 20 years.  The S&P 500 climbed 6.2% in the month.

At risk of raining on the bull’s parade, it might be useful to look past the intense emotional state of the capital markets.  Taking a glance at the financial fundamentals, it shows an extremely overvalued condition.  This may not matter in the short term, but it will likely be a headwind if it continues.

At the end of December 2022, the S&P 500 P/E (price to earnings ratio) stood at 28.7.  To put this in perspective, the 50-year average of this number is 21.  So, if there is any type of reversion to the mean, it is a bad binary outcome.  The S&P 500’s price has to tumble while the earnings stay the same.  Or the earnings number does a rocket launch which will reduce the multiple.

Unfortunately, recent earnings reports and the guidance for 2023 does not foretell any material increase in earnings.  But if things like 0 days-to-expiration options (0DTE) and similar trading strategies continue to squeeze prices higher, maybe it buys enough time for the Fed to back off.  This seems like a low probably outcome but so did an 11% monthly increase for the Nasdaq.

 

 

“New Year, New Me”

/0 Comments/in /by

Copy of the 3rd Quarter Review Letter

/0 Comments/in /by

KERR FINANCIAL GROUP

KILDARE ASSET MANAGEMENT

45 Lewis Street, Lackawanna RR Station

Binghamton, NY  13901

Phone: 607-231-6330                                              email: jkerr@kerrfinancial.com

 

The following is a copy of the 2022 3rd quarter letter sent to clients. It reviews the markets and the client account’s activity and performance for the 3rd quarter of 2022.

 

The Federal Reserve (the U.S.’s central bank) was formed in late 1913.  The main purpose was to strengthen the banking and monetary systems after some damaging financial crises.  The Panic of 1907 was an especially deep and destructive recession (perhaps depression) which included bank runs and closures.

 

Despite their efforts at reinforcing the financial system and smoothing out the business cycle, our central bank’s report card is far from honor roll material during its 110 years.  In addition to numerous recessions, the U.S. economy was ravaged by the Great Depression, suffered through widespread inflation and recession in the 1970’s and early 1980’s, the Dot.Com stock market bubble, and the mortgage and financial crisis of 2008-2009.  And there are many critics who believe that the Fed had a hand in each of these or, at a minimum, made them worse. 

 

Regardless of this mediocre performance, the Fed’s influence in the capital markets has grown.    Over the past 40 years, the Fed’s role has mutated past strict monetary policy to become intertwined with the capital markets.  Consider that before 1994, monetary policy decisions were not formally announced.  In the 21st century, the investing world stops whenever our central bank finishes their FOMC meetings and release the accompanying statement.     

 

One of the important components of the Federal Reserve’s operations is controlling short term interest rates.  The Fed has raised this rate (the federal funds rate) six times in 2022 and it has become one of the biggest news stories of the year.  Our central bank tells us higher interest rates are needed to battle inflation which has jumped to 40-year highs. 

 

Rising interest rates and higher inflation signal a new and different environment for investors.  For the past 15 years the Fed have been supportive of the economy and financial assets through low interest rates and easy monetary conditions.  This is changing and it is upsetting the markets. 

 

Stocks are having their worst year since the financial crisis of 2008 – 2009.  Bond investments have also fallen with losses in many fixed income indexes in the mid-teens for the first nine months of 2022.  This double whammy has been especially painful as bonds and stocks have hedged (moved in different directions) for each other in recent years.  With rising inflation, higher interest rates, and a restrictive Federal Reserve, the markets are facing headwinds that have not been seen in decades.

 

Here are the major indexes’ performance numbers for the 3rd quarter and year-to-date ending September 30th.

 

Using a size weighted average, here is how the average Kildare Asset Management – Kerr Financial Group client’s account performed. This is calculated after all fees and expenses.

 

There were some notable market developments during the 3rd quarter.  Stocks bottomed in July and rallied into the middle of August.  It began to look like a significant turning point had happened and Wall Street become more optimistic.

But interest rates, which had drifted lower, reversed, and started climbing again.  These interest rates were the longer-term ones that the Fed can’t directly control.  At that time a growing crowd was pushing the belief that the Fed could soon be done rising rates.  When the long-term interest rates, led by treasury bond yields, began to rise, it rippled through the capital markets and the turmoil continued.

The stock market gave back the 3rd quarter gains and continued to slide into the end of September, finishing that month at year-to-date lows.  The inflation and interest rates challenges that were facing the economy began supporting worries about an upcoming recession.  Also, corporations started to present lower sales and earnings guidance.

Your accounts weathered this turbulence reasonably well.  The hedging that we’ve used your accounts throughout 2022 has been effective.  This hedging has been in the form of inverse mutual funds, put options (for those accounts who allow that) and some selective short sales.  These strategies attempt to balance portfolios and manage risks.

As I stated in the 2nd quarter client review letter, I am cautious and will continue to position defensively.  I believe that a recession is a very large possibility.  Further, I expect the Fed to keep raising rates as they fight inflation.  Unfortunately, I worry that they will lose that battle as inflation is now deeply embedded throughout the economy.  This is a terrible situation and could result in a deep recession that our government and bureaucratic leaders will not be able to fix.

Despite my expectations, there will be opportunities in the long term.  At some point I will be active in unwinding the defensive strategies and changing to the bullish approaches.

Please contact me with questions or comments.  I’m happy to explain what I think is going on within these volatile conditions.  As always, thank you for your support and confidence in Kerr Financial Group

 

“Operation Break Stuff”

/0 Comments/in /by

 

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

October 17, 2022 – DJIA = 29,634 – S&P 500 = 3,583– Nasdaq = 10,321

“Operation Break Stuff”

 

The economy has a large influence on the financial markets.  This “joined at the hip” relationship makes sense as economic growth helps increase corporate earnings which then leads to higher stock prices.  Looking at the upper part of this food chain, there are countless influences on the direction and breadth of economic activity.  Such things as fiscal policy, inflation, foreign competition, the regulatory environment, labor conditions, and monetary policy affect the economy.

The degrees of impact of these and other factors vary over time.  There have been times where things like foreign currency levels and international trade conditions have an outsized influence on the economy.  But fiscal and monetary policy are probably two of the biggest things that affect the economy, and, during the past 15 years, monetary policy has been a huge boost to the economy and the markets.

The monetary policy tailwinds have been a significant support of the capital markets since the financial crisis of 2008 – 2009.  The Fed chopped short term interest rates to zero and pumped money into the banking system.  The interest rate cuts are easy to understand.  The Fed controls the overnight inter-bank lending rate which impacts other interest rates in the bond market.  By reducing the Fed Funds rate to 0%, interest rates across the spectrum also went down.  It was hoped that these lower rates would spur increased business activity.

The liquidity injection was a different operation.  The Fed would buy bonds and fixed income securities from Wall Street banks.  While this is a simple straight forward transaction, there was some nuanced components to this operation.  First, the Fed would magically create money.  Most of us get money via getting paid for our labor or selling a something that we own.  In this quantitative easing policy, they would hit a button and create dollars and electronically send them to the financial institution for the bonds or mortgages.

While the Fed has this limitless ability print money, it does record its activities on a balance sheet.  It reflects the totals of their purchases and sales.  To offer some perspective, prior to the 2008 – 2009 financial crisis, the Federal Reserves balance sheet totaled around $800 billion.  In early October 2022, it exceeded $8 trillion.  That’s a lot of money created out nothing and sent into the financial system.  Unquestionably, it helped the stock and bond prices for the past decade.

The Fed has not been the only host at this party.  The Bank of England, the European Central Bank, and the Bank of Japan have all participated in quantitative easing through their operations.  Here is a chart from Torsten Slok, Ph.D. the Chief Economist at Apollo Global Management.  It shows the total central bank asset purchases since 2008 and estimates the future reductions.  Keep in mind that this is purchases at different times and doesn’t reflect the summation of entire period.  That is shown in the Federal Reserve’s balance expanding from $800 billion to $8 trillion.

This has been a chaotic year in the financial markets and many historical indicators and correlations are changing.  The Fed has been raising interest rates which has significantly harmed the bond market.  For the past couple of decades fixed income securities offered some diversification from stock market risk.  This year both markets have been battered.

On top of raising interest rates, the Fed has announced that they will be reducing its balance sheet.  This is taking the form of not reinvesting the proceeds from the maturing securities that they own.  The guidance from the Fed is that starting in September $90 billion per month will run off from their balance sheet.

Here is a chart from the Fed’s website showing the progress so far.  The blue line represents the total assets held by the Fed.  It clearly peaked earlier this year.  The red line is the S&P 500’s price which peaked on January 4th.  Also of note, the S&P 500 has declined much faster which is a function of many things but certainly the interest rate hikes as well as the prospects of a reduction of the Fed buying bonds are playing a role.

 

While the Fed has decided that higher interest rates and reduced stimulus are necessary to fight inflation, there are many who question that they can navigate the journey without inflecting systemic damage. A common phrase being used is Operation Break Stuff. Some are replacing “Stuff” with another word that begins with “S”.

The combination of higher interest rates and the removal of the markets punch bowl into an economic recession can easily lead to widespread complications across the markets and the global economy. We recently saw upheaval in the British government bond market as the market plunged and many overextended financial institutions were impaired. The Bank of England scrambled to rescue the markets. They have calmed down – for now.

While the U.S. stock markets are experiencing a historically bad year, it could get worse if the Fed keeps going and does break something. Here is the year-to-date performance for the major averages as of last Friday, October 14th.

 

 

 

Higher interest rates have been in the headlines throughout 2022.  Everyone is aware that rates have moved higher.  Quantitative tightening in the form of Federal Reserve balance sheet reduction was announced in May.  It has gone unnoticed.  If it continues and accelerates, more people will become aware of “Operation Break Stuff” as it as it will inflict widespread pain.

Many on Wall Street are calling for the Fed to stop the rate hikes as well as stop quantitative tightening.  This policy switch is referred to as the “Powell Pivot”.  Our central bank is facing difficult paths.  If they pivot, inflation will continue and perhaps increase.  If they stay their course, they may break things.  Many are looking for a bottom in stock market decline.  Instead, it might not be too late to “pivot” to a more defensive approach.