Monday, January 18, 2016

Hedging The World With Eurodollar Calls

From ZeroHedge:

Here Is The Stealthy Way Some Are Betting On A Market Crash
Credit markets have been warning of a looming crisis for months...

And as the cost of protecting against credit collapse has soared so the cost of protecting against equity downside (VIX) has started to awaken:
However, as we detailed previously, more than a few market participants have turned to deep out-of-the-money options to protect themselves against drastic downside (pushing the skew - the relative cost of crisis protection over 'normal' protection - to record highs).
And so, with the cost of protection so high, traders are looking for cheaper alternatives.
Since the Fed folded in September (under the same conditions that are playing out now), basically admitting it is terrified to raise rates and willing to backtrack due to market fragility, IceFarm Capital's Michael Green explains, it appears many market participants are piling into par Eurodollar calls:
[the chart shows the cumulative open interest in par calls on eurodollar futures contracts that expire in 2016 and 2017 - basically options on short-term interest rates with a strike price of zero, such that they pay out if the Fed takes rates negative]
When queried whether this is indeed a trade to bet on a market drop, Michael Green responded as follows:
[A reader] thought  this might be an attempt by hedge funds to hedge out their exposure to rising interest rates very cheaply.

My initial idea was that it actually could be a bet on negative rates (if for some reason the Fed had to come back into the picture with QE4).

The bottom line: "Deep OTM puts on the S&P are very expensive while par ED calls are relatively cheap.  In my view, we are that inflection point where the Fed is going to start to waffle…the bear market beckons and they will not be able to stick with their interest rate guidance. Of course, markets tend to frown on Central Bankers revealed as less than omniscient..."...

So, what if the Fed chickens out?
The dollar weakens.
Oil trades more on supply/demand rather than currency so...stable to up?