Earlier this week, I laid out a perfect example of what most people refer to as a “Black Swan” trade.
Now, I intend to give you my original thought process behind it all, along with an update on the trade itself.
Finding Black Swans
People often ask me what it is that we’re trying to accomplish when we talk about Black Swan trades. Making money? Sure. But at its core we’re really focusing on tail-risks or third standard deviations, and beyond probability analysis.
Here’s what I mean…
Step One: Find a low volatility trade that the bulk of the market doesn’t think is possible.
On Monday, I highlighted that short-term options on the Invesco DB US Dollar Index Bullish Fund (NYSEARCA: UUP) had an implied volatility of just 7.5. This signaled that the market didn’t anticipate any significant move on the dollar in the weeks ahead.
That was puzzling. After all, we are in the middle of a pandemic. Momentum in the S&P 500 had gone negative, and we had a recognizable downward trend in the index. There has been a selloff in tech stocks, with Facebook, Alphabet, Apple, Netflix, and Microsoft all having their worst week in months.
The implied volatility here just simply did not match up with reality.
Step Two: Recognize the market’s bias by locating the underlying reason – typically that the overwhelming majority of people expect something to happen and have put an ungodly amount of money behind that conviction.
This was the easy part. Tim Melvin and I looked at the CFTC’s Commitment of Traders Report and realized that we had a pretty stunning opportunity on our hands. There was a reason why no one expected that the U.S. dollar would rally. At the end of August, hedge funds were net short the U.S. dollar futures by a staggering -$33.93 billion. That was the largest net short position in nine years, and a signal that people continued to expect a slide.
While we’re certainly bearish on the dollar over the long term, we’re not worried about the nominal value. We’re only focused on the relative value to other currencies given the current state of the global economy. If the dollar is still the reserve currency, and if a market selloff is once again the means of settlement for outflows right now… the dollar will benefit in the short term.
More on that in a minute.
Step Three: Recognize what quantitative and qualitative events would need to happen before we saw a pendulum swing back against the herd’s trade.
The natural answer to this path is the understanding that the U.S. only needs to be the cleanest shirt in the laundry for a little while. I mentioned this in yesterday’s update (Part II), but what do I mean?
I mean that, out of the basket of currencies in the Bullish Fund, the greenback appears to be in the best position. The currencies matched up against the dollar are the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc.
In fact, we are wagering that the world is going to turn to the dollar in the short term. Even if we follow the bearish case for the dollar over the next year, I’m wagering that the dollar will be what people want to hold over the next 25 days.
With momentum going negative in the S&P 500 on Monday, a rush to cash appears to be underway. That was evident in yesterday’s selloff and this morning’s continued outflows.
Now, I don’t anticipate that we’re going to see any level of forced selling like we did in March, which fueled a massive uptick in the dollar. But I do think it’s fair to focus on relative value against the other basket of currencies around the world.
Europe is in far worse shape than the United States, and it can’t keep going lower with interest rates… until it does. Christine Lagarde has signaled that the recovery will take longer than expected, and I would say that things are far more problematic there given that the European Union project remains a hot mess. The EU has been flawed from the beginning and having one monetary policy for 28 different nations with 28 different fiscal policies was a bad idea. COVID-19 has exposed this weakness, and further stimulus will weigh on the currency.
The United Kingdom is locking down once again, and it could see 50,000 new cases a day by mid-October. That’s only three weeks away, but a lot can happen in three weeks. Just look at the time frame from when momentum last went negative in late February up to the massive dollar run that we saw in mid-March.
Australia and New Zealand are facing new weakness due to interest rates, their reliance on the Chinese economy, and their currencies’ ties to commodities.
But at the core of this, hedge funds have been shorting the dollar into the ground for the last five months since we got a clear picture of the Fed’s policies and expectations for unlimited easing. At some point, the speculation goes too far, and people need to start covering their asses.
The covering has picked up over the last three weeks, and I anticipate it will be very significant in this week’s Commitment of Traders Report – set for release tomorrow.
Step Four: Ensure we have positioned ourselves in a low volatility trade that reduces downside but can provide asymmetric payoffs when the herd panics.
Again, we purposefully selected the October 23, $25.50 calls at a limit of up to $0.15 after the bell on Monday.
This call option had an implied vol of 7.5 (which is incredibly low and a signals that no one was expecting a move on the dollar). When it opened at $0.13 on Tuesday morning, we locked in at our limit order.
Step Five: Profit immensely.
At the time, it was one tick above the In-The-Money contract, but on Wednesday it has crossed that magic line, and it is now, in the money.
This could just be the beginning of a larger run over the next few weeks. As I said, investors who are willing to take the risk should be willing to lose $15 per contract if the potential upside in the next few weeks is 5:1, 7:1, or even more.
So far, the contract closed on Wednesday at $0.22, good for a 46.6% return in two days. And with the UUP heading higher on Thursday morning, we’re going to continue to ride this out.
We’ll continue to follow this trade and start to look for others like it on the other side of the election.