Relationships…….

Posted on 12/16/2011

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….are arguably the lynchpin to a happy life.

The ones we develop with our parents, siblings, significant others, peers, coworkers, etc.

They share in our victories and bolster us in defeat.

Unimaginable attention has been and will continue to be paid to relationships and for good reason. The entire fields of psychology and music/television/film (among others) are pretty much dependent upon the constant analysis of relationships.

I have neither the skill set, nor the audacity to dissect relationships in general. I do however, care to address what I genuinely believe can be a key to long term successful trading, which are……. an understanding, appreciation, and willingness to position capital based on RELATIONSHIPS.

The risk manager at the first trading firm I worked for was incredible. At the time, he completely intimidated me (and at one drunken outing I believe I told him that explicitly-if you need other career advice, just ask). Over the years, I’ve come to realize how much I learned from him and the other more experienced guys in the group.

In the 12 plus years since I was a clerk, technology has turned the trading I was introduced to in the late 90’s on it’s head. The risk management tools that were advanced for floor traders in the early 2000’s wouldn’t be compelling to a 1 and 2 lot guy in Fargo, ND these days.

I digress, but my point is, no matter how dramatically the landscape is altered some things don’t change. I vividly recall being told that “something (an option/stock/commodity/anything of value) is only cheap relative to itself or something else”, and it’s  a mantra that continues to inform my trading decisions. The magnitude of that statement wasn’t apparent to me for years.

(Isn’t that often the case with seemingly simple maxims?)

For example, I would argue that the VIX is too cheap right now (at 25ish) given the cataclysmic potential impact of further Euro Sovereign/Too Big To Fail US institutional downgrades. Remember AIG – that started with a downgrade. MF Global – same thing.

However, 10 day historical vol on the S&Ps is below 19. 30 day historical vol is 25 1/2. We’re in the middle of December, often some of the slowest trade sessions of the year. Perhaps vol is priced perfectly.

Taken one step further – until March and then August of this year, 25 would have been the high end for implied vols.

So, is vol cheap in relation to historical vol? No, not really.

Is vol cheap relative to the past year? Depends.

However, maybe I’m asking the wrong questions. Should we look at the S&P 500 v. the S&P 100? Is 1/5 cheap? expensive? Are the SPUs cheap in relation to Gold? I WISH I could answer that one. Is S&P option vol expensive relative to Gold option vol – I think that’s often the case.

My point is you can make Brendan Fraser or Keanu Reeves look like a good actor if you compare them to the “star” of a car commercial, but they both would be better off bringing Daniel Day Lewis or Robert DeNiro coffee than sullying up any movie screen I’m in front of.

There are a variety of relationships I’ve followed through the years. That same risk manager taught me the things to look for in a viable “pairs trade”. Years ago we would trade AMD v. INTC or SMH. FNM v. FRE (insert joke here) MSFT v. ORCL. That trade still goes on all the time – it’s just done by an incredibly fast computer with a good program.

In recent years, my attention has been more focused on the correlation between various commodities.

I could probably tell you the “important long term levels” for:

Wheat v. Corn; Cattle v. Hogs; Kansas City Wheat v. CBOT Wheat (or Minneapolis); Crude v. Gasoline – the gas crack; Crude v. Heating Oil – the heat crack; Gasoline v. Heating Oil – a psuedo product crack spread otherwise known as the spread that worked until it didn’t; Platinum v. Gold; Silver v. Gold (proxy/fear spreads or industrial v. precious metals); WTI v. Brent Crude (or any sulfur content spread); Crude in Copper terms (an interesting/outside the box spread); the 2 year v. the 5 year; the 2 year v. 10 year; etc.

Over the next couple of weeks, I hope to have the time to elaborate a bit on some of these relationships and areas where the risk/reward can be skewed in your favor as well as creative ways to express your market sentiment without necessarily just being long/short.

As a side note, any spread v. Gold likely reached an extreme in the past few months. The Platinum v. Gold spread is VERY stretched by historical standards, but history may not give a proper indication of how the ultimate reserve currency should be priced in a genuine sovereign debt/fiat panic.

Finally: yesterday I caught the second half of the House Oversight Committee’s hearing on a potential impact of Eurozone Panic on the US. It was riveting in the “slow-motion, multi-car pileup” type of way.

If you’re inclined, you can watch it here:

http://www.c-spanvideo.org/program/UnionDeb

 

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