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Meta Strategy Derivatives Portfolio – Probability Map Update

The dashboard shows my current data-driven estimate of the probabilities for future returns of the S&P 500 over the short term (1 – 8 weeks), medium term (3 – 6 months), and long term (6 – 18 months), followed by a detailed probability map table. It is updated each Monday  and is followed by key market drivers, relevant studies, price targets, model portfolios, and trading ideas. Please check back here for updates around key price levels during the week.

For background information, please read this article.

Probability Dashboard

Current Research and Analysis

OpEx and Seasonality
We are at an interesting juncture in the markets, as the last 5 weeks of a manic year 2020 are beginning.

The large rally coming off the US presidential election was driven by an exceptionally strong flow of liquidity from the options market. But despite additional inflows into equities, the stock market hit a ceiling last week, as mechanical hedging unwinds from options dealers lost their force, to finally ebb to a low on Friday’s monthly option expiration (OpEx). 

This weakness may persist through the shortened Thanksgiving week while a new magnet is building up attraction: the December 18th OpEx. Traditionally, the December OpEx (through annual portfolio hedges) holds the highest put option open interest — a setup that has a tendency to play out in either black or white:

1. Rising prices and falling volatility create a feedback loop (Vanna, Charm & Gamma), pulling the market up to create the classic Santa Claus rally and January effect that often carries over well into the new year. 

2. Price breaks down below key levels (watch out for Zero Gamma and VIX futures term structure inversion) and the opposite effect takes place: the price drop accelerates as volatility spikes, because market makers must short equity futures to increase the hedge on their short put positions as prices move toward their strike prices.

Seasonality and strong market breadth support a positive outcome: on average any weakness during the end of November is followed by a rally into the year end. But, remembering December 2018 as an example, the opposite scenario can lead to significant downside, even if the chance for that to happen is significantly lower.

• Equity Exposure: no changes last week, but we are getting close to a long entry zone around the 3510 area to add exposure on post-OpEx weakness. The basic idea is to buy dips in year-end strength, take partial profits at long targets, and keep the risk of the derivatives position controlled with a break-even stop loss.
  Update Wednesday: A current phase of weakness may have ended with the breakout above 3580 – 3610. I am moving my long entry order up to add on a retest of the breakout area. Should we be able to take partial profits at the main long target area first (3670 – 3690), I would add an additional buy order at the recent intermediate high (3640).

Probability ≠ Certainty: All that I state here are my personal ideas and best guesses, which I use to make my own investment decisions. (I may hold positions discussed here.) It is not investment advice. Everyone is responsible for their own investment decisions and potential losses.

Key Insights

(only change gradually and at major inflection points)

Current Market Environment (defined by Meta Strategy Indicators): Volatile Bull Market Regime

• Basic Premise: Market Environments tend to stick around, so adjusting strategies to the current regime and trading with the trend have the best odds for success over the long term.
• Market Regime: We can now wait for signs of a new regime change from the Meta Strategy model rather than try to predict highly uncertain long-term developments.
• Big Picture Bullish Scenario: The coronavirus impact is strong, but temporary. Enormous stimulus acts like rocket fuel to propel economic growth and asset prices. (This scenario remains in place as our main investment blueprint until the Meta Strategy signals a Bear Market Regime.)
• Volatility is falling, and the VIX dropping below 20 would be a very positive sign for the development of the bull market — changing the classification to a stable Quiet Bull Market Regime.

Current Influential Market Drivers

(details change frequently as new information is included continually)

• The trend is your friend: In a rare alignments of uptrends across all time frames, 85% of S&P 500 stocks are trading above their 10-, 50-, and 200-day moving averages — a highly positive, pristine momentum signal.
  Over the short term, however, this strength across a majority of sectors may prove to be too much of a good thing.

• Russell 2000 at a new 3-year high: When the Russell has done this for the first time in a year, it has never lost ground over the next month. Large caps also performed better than average.
• Equity Exposure: Some conflicting data is coming in. While NAAIM surveys show that active investment managers are leveraged long stocks with the 4th-highest reading on record, equity futures traders seem to have cut exposure aggressively (the 3-week positioning change is one of the most negative in history). Interestingly, both data points have not led to negative future returns, but in fact, quite the opposite (chart).
  Very low S&P 500 short interest is another negative aspect making the rounds (no more shorts to be bought back to support the market). But my wider NYSE data (via SentimenTrader) shows it to be in the middle of the range since 2008. There is a strong tendency for shorts to be reduced after spiking during a crash, which is a healthy development, and is not a negative for the market going forward.

• Sentiment is bullish: The AIM Model of sentiment surveys is showing extreme optimism for the first time in more than 9 months, while SentimenTrader’s Smart Money – Dumb Money Confidence spread reached extreme overconfidence levels of -69%. 
  Pure sentiment is a fickle indicator, as positive emotions can last for a considerable period of time, and actual buying often lags bullish sentiment. I’m inclined to see this as a worrisome development, but as yet likely to be too fresh to overcome strong end-of-year tendencies. If it persists, it may matter more in the new year, especially if we see coincident, increasing speculation in the options market.
• Seasonality: As many characteristics of financial markets, seasonal tendencies change over time. But a 40-year comparison shows that the year-end rally pattern has held over long periods. The fact that the S&P 500 currently trades at a year-to-date return above 10% adds to the basic bullish bias: over the last 92 years such momentum led to positive returns over the next couple of months between 74% and 82% of the time.

• OpEx Friday: Vanna flows have ceased post-OpEx, which could lead to continued short-term weakness. As long as we trade above zero Gamma exposure, a new buildup of Vanna and Charm effects over the next 1 – 2 weeks will provide a stable tailwind all the way to the December 18th option expiration. Traditionally, the highest put open interest of the year sits here, and dealer hedges are continuously unwound with the passing of time and falling of IVol.
• 11/20 Gamma Exposure: @ 3560 = Long; Zero Gamma trigger = 3515; Call Wall/Top Gamma Strike = 3600; Put Wall 3200; Absolut Gamma 3600 (details about gamma exposure). 
  The zero gamma level provides support and price dips into that region can be bought with well defined risk (stop loss at close below 3500).

Conclusion and most probable scenario

We are in a bull market regime, which is the most profitable, “normal“ environment, seen about 75% of the time. Falling volatility may change my classification to the most stable designation “Quiet Bull Market Regime” soon.

Weakness around the option expiration date (last Friday) creates a buyable dip.

As we are starting to see large flows into equities, my primary scenario is that many market participants have been waiting for a resolution to the US elections to position themselves in stocks. This could continue to provide a solid tailwind for equities going into the year end. 

The ensuing rally should continue more slowly and look more natural: the typical 2-steps-forward-1-step-back bull market staircase.

On the other hand, a quick drop below important support areas (3510), paired with an inversion of the VIX futures term structure, could be a tell-tale sign for the opposite scenario — an accelerated drop.

Main Fundamental market drivers

• Central banks and fiscal stimulus: Renewed US stimulus would be a major force driving the index higher, but the US Senate’s stimulus block is now likely to continue after we failed to see a “blue wave” in the election, and positive vaccine news may prove to be a hindrance.
• Economic recovery is slowing: New global lockdown measures to combat rising Coronavirus infections make the possibility of a contracting GDP in Q4 a real danger.
• US Housing is still going strong: Historical cases of the housing market rebounding this strongly usually occurred after a recession.
• Stock valuations: are high, capping prospects for a new, long bull market – specifically in big tech stocks. Unprecedented monetary and fiscal stimulus, however, may create the “Mother of All Meltups (MAMU)”.
• Coronavirus: After a full stop, the world economy is restarting, with economic data improving from Great Depression levels. But the winter wave is causing a new slowdown.
  • New cases and infections are spinning out of control globally, and the pandemic narrative is likely to be back on the “most important news” agenda.
  • Vaccine optimism: Recent news about a viable vaccine is very positive. This is the one thing everyone is looking for to get us out of this mess.
  • Current Corona data

Further Outlook

• Bull Market Environment: signaled by the systematic Meta Strategy. This is the best trading environment because a bullish medium/long term outlook is aligned with the stock market’s basic upwards tendency for high conviction setups.
• Exogenous Shock Bear Market: has ended in record time and we now see the fundamental picture slowly turn positive (a switch from red to a moderate yellow warning signal). We can wait for signs of the next regime change from our Meta Strategy model rather than try to predict highly uncertain long-term developments.

Target Areas for the Meta Strategy Derivatives Portfolio

Please check back during the week for new updates at key levels.

Long Targets	target reached	comment	target probability	derivatives exposure change*
3670 – 3690		strong resistance	main target	reduce long
3830 – 3880			max. target	reduce long

*size of planned exposure changes = max. position / number of targets (details in planned portfolio adjustments)

Short Targets	target reached	comment	target probability	derivatives exposure change*
3580 – 3610		breakout area	min. target	long entry
3510 – 3540		major support, zero gamma	main target	long entry
3410 – 3460		major support
3230 – 3270		correction low, lower trend-line

*size of planned exposure changes = position / number of targets (details below)

CURRENT TRADE SETUPS

Check back for updated tables during the week when indicated key levels are reached.

Buy The Gamma Dip: (High probability short-term trade – trade setup & rules)

Enter long S&P 500 at any random 1-2 ATR (30-day average true range = average daily market move) dip in an uptrend. Trade setup activates with long gamma exposure and a new S&P 500 intermediate high.

I add these short-term positions independently of the portfolio exposure indicated in the target areas above or use the setup to add long positions coinciding with my trading portfolio – be careful not to overshoot maximum exposure levels.

Trade Idea: At long gamma exposure, option market makers are forced to buy market dips to adjust hedges, often causing a quick snap-back rally. The Zero Gamma Exposure level is an important support area.

Preferred Instruments: ES/MES Futures (table shows futures pricing approx. 5 points below SPX), options or CFD; probability for success = 70%

High S&P (ES)	Entry 1 H-(ATR+10)	Entry 2 H-E1-0,5xATR	ATR (30)	Avrg Entry	Stop Loss	Profit Target 1	Profit Target 2	Zero Gamma
3670	3590 √	3555 √	70	3572,5	3480	3665	3690	3515

The Meta Strategy Derivatives Model Portfolio

Please check back during the week for new updates at key levels.

Full disclosure: These are the current positions and instruments I am invested in with the capital dedicated to the Meta Strategy Derivatives Portfolio.
A balanced exposure to the current probability estimate is achieved by combining long-term ETF positions with derivatives that are held short term.

Positions may change at any time – roughly according to the target tables above, but exact entry and exit points may vary. Instruments are not a recommendation as there are many equally valid ways to express current probabilities; e.g. ETFs, volatility products, CFDs, futures and many more. Also the decision of how to set maximum leverage and risk levels fits me personally and every trader has to be mindful of their own risk tolerance.

Investment Portfolio: the Meta Strategy Aggressive ETF Portfolio 
(with 80% of the capital dedicated to the Meta Strategy Derivatives Portfolio)

• Meta Strategy long-term exposure: 50% S&P 500 2x leveraged ETF & 50% Gold ETF according to the monthly Meta Strategy newsletter.
  • planned portfolio adjustments: none, unless regime change is signaled.
  • maximum risk (approximate distance to exit): S&P 500 2x leveraged ETF: 15% – 25%; Gold ETF: exit above entry
  • positions: a hypothetical 100k portfolio would hold 40k in SSO and 40k in GLD

Trading Portfolio: derivatives sleeve
(20% of capital – the size of this is the decisive factor for the maximum level of portfolio leverage)

• 50% Cash (or up to 20% in asymmetric alternative trade ideas)
• 50% S&P 500 call options (ES/SPY April 3600/360 Call Options); mental break-even stop loss 
• recent trades: no changes last week.
  • planned portfolio adjustments: take advantage of rallies and pullbacks to roll options further up and out in expiration.
    Add long (25% ES/SPY June 3800/380 Call Options) on retest of major resistance areas (3510 – 3540).
    Take partial profits at main target (below 3700).
  • maximum risk: break even stop loss
  • positions: a hypothetical 100k portfolio would hold 10k in Cash and 10k in S&P 500 Call Options

Current Portfolio Leverage Level (approximately, stocks only): 3x long (this can be adjusted by dedicating a different percentage of available capital to the trading portfolio which will influence maximum leverage levels strongly)

Have a safe trading week!

David

Disclaimer

This report is a description of my own investment approach and ideas, and I personally invest in the Meta Strategy Derivatives Portfolio. The content of this letter is for entertainment purposes only and not meant to be investment advice to others.

I am not an investment advisor and I do not provide individual investment advice. None of the ideas in this letter are meant to be construed as professional financial advice.

Your investment decisions are solely your own responsibility, and I am not legally or financially responsible for any losses you may incur from reading or using the content of this letter.

© 2020 David Steets, all rights reserved – please be fair and do not distribute without my permission