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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). It is updated each Monday and is followed by a detailed probability table, a review of key market drivers, relevant studies, price targets, model portfolios, and trading ideas.
Please check back for updates around key price levels during the week in the “Current Trades” section below.

For intra-week commentary, follow me on Twitter: @indievesting.
For background information, please read this article.

Probability Dashboard

Research and Analysis

Mean Reversion
Last week’s tight trading range oscillated around the SPX 3900 level, where the largest concentration of options dealers’ gamma exposure sits. This is most likely to continue until next Wednesday (Vix futures expiration) or next Friday (SPX monthly options expiration), after which we are left with two weeks of considerably less support to protect against the growing signs of instability in the market.

Vix closed below 20 for the first time in a year on Friday, which is the strongest argument for a sustained breakout to new highs, as volatility-controlled market participants (e.g. risk parity funds or trend following strategies) systematically increase their allocation to stocks. Up to now, they are among the few remaining big players that are only moderately exposed to equities. Monday’s close will give us a directional hint in that regard: Are we going to see a sustained breakout, or do options dynamics pull the market back, continuing the pronounced tendency for mean reversion during OpEx weeks?

Short-term probabilities are beginning to tilt in favor of negative returns, because extreme sentiment and excessive speculation continue to build up market fragility. This has been the case for several months now, but last week saw several new indicators flash a warning signal. A strong correction in the beginning of 2021 is still my highest probability scenario, as many signals point to a likely reset of these extremes in the coming weeks or months. OpEx Friday in the middle of February marks the beginning of the next window of increased vulnerability, because supportive liquidity flows will then cease.

My plan is to position the model portfolio net short (current state: neutral) with low leverage during the coming week, and add short exposure on a confirmation of a beginning breakdown.

Current Trades and intra-week Updates

A summary of changes and planned activity. (Find detailed price target tables, risk management, trade setups, model portfolios, and trading FAQs below.)
Updates, as announced in the Member Area, will be listed here in green.

Update Wednesday February 17 — pre-market
Tuesday’s pre-market session came within a couple of points of the lower boundary of my target area (3970) for an entry into an additional short position. As expected, the gamma pull of the 3900 level is very strong, and the market opened significantly lower, which points to the likelihood that mean reversion will continue to overwhelm current momentum. Until Friday I expect price to gravitate towards 3900 with outer boundaries set by recent extremes (3890 – 3960). On Friday a lot of the options gamma that holds price constrained will expire and a larger directional move is in the cards.

New short position entry level: 3930 – 3950; 25% ES/SPY Sep 3500/350 Put Options.
This will tilt the portfolio short (with no leverage) and leave 50% of the trading capital in cash to be added once a down move is confirmed by a close below key support (3850 – 3880; level changes with shifting zero gamma and 20 dma).

Gamma Dip Table adjusted with new high.
Zero Gamma remains unchanged.

The model portfolio on Monday:
I entered a short position on Friday (3920 – 3935) and currently hold 25% of the trading portfolio in ES/SPY Sep 3500/350 Put Options, which hedges out my long-term ETF position for a neutral exposure of the combined investment and trading portfolios.

I plan to add an additional short position either at the next price target (3970 – 4000), or at a time target before next Wednesday’s close (if we fail to reach the price target Monday or Tuesday, I will use Monday’s range to determine a new entry level — check back for an update on Tuesday / Wednesday pre-market). This added position will tilt the portfolio short, but only by using 50% of the trading capital. I want to keep risk low and leave room for additional short positions once a down move is confirmed by a close below key support (3840 – 3870).

The basic idea is to switch to a short exposure at low position size, as dangers for a larger correction are high and the period around OpEx (2/17 to 2/26) often marks significant turning points in the market.

Publishing note: If you want to read my report on Sunday to prepare for the next trading week, you will usually find it up on the website by late afternoon. With the Monday morning email, I will sometimes add updates if my outlook is influenced by the Sunday / Monday pre-market open.

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

(These change gradually and at major inflection points)

Current Market Environment (defined by Meta Strategy Indicators): Quiet 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 — Bull Market: We can now wait for warning signals for a potential regime change from the Meta Strategy model rather than try to predict highly uncertain long-term developments.
• Volatility: Vix has closed below the important 20 level on Friday, designating the regime a “Quiet Bull Market Regime”. This is a positive backdrop, as it triggers equity buying by volatility adjusted funds. In the beginning of last week, however, a spike in the VIX / S&P 500 correlation triggered a warning signal, which may have been false, but could also hint at trouble brewing for the coming two weeks. 

Current Influential Market Drivers

(These details change frequently, as new information is included continually)

• Institutional “smart” money is leaving the party: The Smart Money Index is falling while the S&P 500 hovers near all-time highs, and (except for Friday) the last trading hour has seen increasingly weak breadth. Both measures have been signaling corrective moves or sideways consolidation periods in the past.

• Excessive speculation: Despite a substantial pullback, there has been no normalization of these extremes. Trading volume (specifically in high-risk penny-stocks) surged to all-time highs, as did options speculation. This continues to add market instability, which is likely to be flushed out eventually.

• Sentiment Extremes: SentimenTrader has one of the most in-depth collections of sentiment indicators, and as of Friday not a single one of their core indicators was showing pessimism, while more than 50% of them were showing optimism. This is a rare occurrence, and the only period that was able to sustain such extremes over a long period of time was the goldilocks momentum market of 2017, which did eventually end in the infamous “Volmageddon” event of February 2018. The longer these extremes build up, the harder they crash.
• Strong trend, momentum and breadth: This positive backdrop continues to be very influential, but first cracks have appeared, as new highs have met with breadth divergences. The best performers (Russell 2000, IWM and Nasdaq, QQQ) have rarely been able to continue at such an incessant pace without some form of consolidation in the past. The Nasdaq 100 doubled from its one-year lows, which has led to exceptionally weak average 1 to 3 month return. However, over the longer term (6 to 12 months), positive returns occurred well above 80% of the time across numerous momentum and breadth studies (S&P 500).

• Seasonality: February and March historically show a choppy performance in US presidential election years.
• 02/12 Gamma Exposure: @ 3935 = Long (GEX: approx. $20 billion per 1% move in SPX); Zero Gamma = 3860; Call Wall = 3900; Put Wall 3550; Absolute Gamma 3900 (details about gamma exposure).
  Options market makers’ long gamma exposure suppresses volatility in the S&P 500. A market drop towards the zero gamma support zone has a high probability to bounce back, which I systematically use in the “Buy the Gamma Dip” trading strategy. Supportive flows will slowly abate during the week, as we are nearing monthly OpEx on Friday.

Conclusion and most probable scenario

We are back in a Quiet Bull Market Regime, the most common environment, which is usually the best time for my trading approach. But, except for positive signs from falling volatility and long-term momentum, unsustainable extremes in sentiment and speculation are raging unabated. This build-up of market fragility has been going for a long time now, with momentum emerging as the winner again and again. 

Because this clearly cannot go on forever, the current market lacks convincing opportunities. Risk for long positions is high, as current instability can suddenly materialize as significant downside with little advance warning. Short positions in a euphoric market environment, on the other hand, are difficult and frustrating, because speculative frenzy can last an irrationally long time.

Current positioning has low conviction, and position sizes, accordingly, are small. I will monitor the situation closely for signs that point to an imminent turn around (some of these started to appear in the beginning of last week). My main orientation, to tilt either way, is currently derived from an analysis of supportive liquidity flows that give us a timeline: From mid-week, and especially after next Friday, short positions offer an increased chance for success, as OpEx dates have a higher-than-average chance to see a turn around in the market. Alternatively, a sustained up-move is also made easier by the removal of the strong gamma “pin” to the 3900 level.

Should we get through the potentially weak period around OpEx (2/17 to 2/26) unscathed, we may be gaining additional support to move up until mid-March.

Main Fundamental market drivers

• Central banks and fiscal stimulus: The FED Balance Sheet’s rise, as well as the steep climb in money supply (M1 & M2), are highly correlated with a climbing stock market — two positive coincident indicators worth keeping an eye on.
• Meta Strategy indicators: All six of the fundamental strategy indicators have now recovered to give a green signal and would need to flip back to red to materially change the positive post-pandemic outlook.
• Stock valuations: 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)”.
• The pandemic as a “Great Disruption”: Another interesting thesis is the potential return of the “Roaring 20’s” after the pandemic, through the high-tech revolution of the 2020s.
• Coronavirus pandemic: Barring major, unexpected developments, the pandemic slowly ceases to be an influential fundamental factor. The end game is now largely priced in, including some disruptions in the vaccination effort and through current virus variants.

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*
3920 – 3940	yes	current high		add short √
3970 – 4000		measured move	main target	add short (upper end)

*Size of planned exposure changes: individual position sizes normally are 25% of the trading portfolio capital.

Short Targets	target reached	comment	target probability	derivatives exposure change*
3850 – 3880		key support (previous high, 20 dma, zero gamma – adjusts with new highs)	min. target	add short on close below
3790 – 3810		previous key support
3660 – 3700		last major low	main target
3600		put wall support, initial correction target

CURRENT TRADE SETUPS

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

Setup levels adjust with new highs — please check back for updated table during the week when indicated key levels are reached or new highs are made.

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 fine tune the entry into portfolio long positions, when levels coincide with my trading portfolio’s target areas – be careful not to overshoot maximum exposure levels. Depending on how close I am to my desired overall exposure, I may give priority to the exits in the target tables above.

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 — it can be used to calibrate entry points; the stop loss level should be placed well below zero gamma.

Preferred Instruments: ES/MES Futures, options or CFD; 
Probability for success = 70% (backtest from 2013 to 2020; real time results from 05/20 — in some cases I will take the overall market assessment into account, if it is likely to skew success probabilities for individual trades lower); 
For simplicity, I usually use the same instrument as in my current derivatives long positions indicated in the model portfolio below. 
Position size: One current individual position (25% regular or 15% reduced), split into two entry points; check marks indicate filled trades.

High S&P 02/16	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
3965	3905	3880	50	3892,5	3825	3960	3960	3860

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: switch from gold to equities in the coming months on gold strength paired with weakness in stocks.
  • maximum risk (approximate distance entry to exit): S&P 500 2x leveraged ETF: 5% – 10%; 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)

Starting at the beginning of 2021, I list a moderate portfolio version using leveraged ETFs next to the high-leverage derivatives portfolio. The moderate version will experience lower volatility and will not lead to net short exposure in a bull market, but it will partly hedge the Investment Portfolio at opportune times. (Look at the Current Portfolio Leverage Levels in the table below for easy comparison.)

Have a safe trading week!

David

Trading Practicalities — FAQ (these are my own general preferences):

• Limit Orders: I place GTC (good-till-cancelled) limit orders with my broker (IB) at both entry and exit targets, generally well before these targets are reached. Then, as circumstances might change (i.e. trade setups, options price estimates, and overall price targets), I can make adjustments to those orders.
  When trading a breakout, I use the following method: After a daily close beyond the resistance / support area, I enter a limit order to be filled on a re-test of that breakout level.
  I prefer to use instruments based on S&P 500 futures (ES options or ES/MES futures), as they are traded overnight when a lot of exaggerated price spikes happen.
  In my tables, I list SPX prices (they have to be adjusted slightly for the futures) and include overnight prices in all my calculations (including orders that were filled overnight).
• Stop Loss: I often work without a stop loss, especially when I start building new positions using options. I then assume my worst case scenario as a full 100% loss of the premium I paid. Such a loss will happen only very rarely, but the assumption that it is a possibility is important for setting position sizes that avoid over-leveraging.
  When “placing” a stop loss beyond support / resistance, it is always as a mental note rather than a literal stop-limit order with my broker. I generally wait until the level is breached and confirmed near the market close, then place a limit order to sell (preferably just before the close to avoid the overnight gap risk).
  Break-even stop loss: To avoid a winning position turning into a loser, I will often set a mental break-even target for the entire position (noted in updates and the model portfolio table). As there are bound to be small differences in each trader’s process, I won’t specify exact levels, but instead will leave it to your discretion to set the exit based on your specific entry level. I will mark the stop loss as hit according to my own actual positions.
• Options expiration and strike selection: To avoid excessive time decay, I like to keep options expiration relatively long-term, in case market swings last longer than expected. Short-term probabilities should play out within 1-8 weeks and I want to avoid the last 2-3 months in an option’s lifetime (as time decay really accelerates then) — to that I add a bit of a margin of error to reach an expiration 5-7 months out. (I select the nearest quarterly expiration date, as my preferred ES futures options have limited monthly expirations available.)
  The option’s strike usually equals my expected main target, as this takes optimal advantage of options convexity. Specifically, for puts, I tend to go further out-of-the-money (to maximum targets), because I like them to be sensitive to an expected volatility spike. And for calls, I tend to stay closer near-the-money (main targets) to reduce the inherent disadvantage from declining volatility in a rising market.

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