"How to Trade Without Conviction" - BofA's Equity Derivatives Team on navigating the current vol regime

The sharp move higher in US rates last week only adds to the macro instability that is threatening the low levels of equity vol. But more micro dynamics also suggest an unstable low vol regime, namely the combination of low single stock correlation (12^th percentile since 1990) yet more elevated single stock volatility (59^th percentile). That said, timing the eventual equity selloff and pick-up in Index vol is difficult. This is increasingly the case as (1) S&P vol grows more dependent on Tech vol and (2) Tech grows less sensitive (for now) to the macro backdrop. Hence, we continue to like chasing the upside via risk-limited structures while "getting paid to wait" for hedging an eventual shock - for example through structures like our W-trade. For asymmetric upside, we like S&P call calendars, as high rates and steep vol term structure make it attractive to sell longer-dated calls above all-time highs to fund multiple shorter-dated ATM calls. On a mark-to-market basis, the structure is likely cheaper than outright calls if equities sell off, while providing similar upside in a moderate-to-large rally.

We (BofA) discussed in the 27-Jun Global Equity Volatility Insights report whether a floor in equity vol was near, as the VIX fell below 13 despite still-elevated economic volatility & policy uncertainty, the near-record gap between equity and rates vol, and the lagged effect of higher rates - all features absent in prior low volatility regimes. The sharp move higher in US rates last week only adds to the macro instability that is challenging this environment of low equity vol.

But more micro dynamics also suggest today's low equity vol levels may be an unstable equilibrium, not a new normal - namely the combination of low stock correlation (Exhibit 8) yet relatively high stock volatility. Single stock correlation has been weighed down by major performance divergences between stocks & sectors (Exhibit 9) due to large moves in rates, the rise of AI, and a lack of clarity on the outlook for inflation, growth, and Fed policy. In contrast, single stock vol has remained more elevated, particularly vs. other sustained low volatility eras like 2013-19, 2003-07 & the mid 1990s (Exhibits 10-11).

Timing the eventual equity selloff and pick-up in index vol is of course difficult. Doing so today is arguably even more challenging because S&P 500 vol is heavily slaved to Tech vol (Exhibit 12), and Tech has become a seemingly idiosyncratic story unusually dislocated from the macro backdrop.

Hence, we've been arguing for (e.g. see 21-Jun GEVI) and continue to like chasing the upside while hedging the tails and "getting paid to wait" for the shock - for example through structures like the W-trade, which has broadly carried flat-to-positive thus far in 2023.

For asymmetric exposure to the upside, one solution we like is S&P call calendars (sell longer-dated calls, buy shorter-dated calls). The reset higher in rates since the banking crisis has helped re-establish a historically attractive entry point to the trade (Exhibit 13), as it raises the forward and makes long-dated calls (struck as a % of spot) expensive vs shorter-dated calls.

We suggest buying short-dated near-ATM calls and selling fewer long-dated calls struck beyond all-time highs; e.g. sell 1x Jun24 4850 call (struck at new highs) to buy 1.5x Aug 4425 calls (struck near-the-money), and collect $0.40 (ref. 4409.53).

As a result, one gets exposure to a continued summer rally while banking on no new highs into next year (if both legs held to expiry), a view we're comfortable with as Fed funds head towards 6% and US recession risks remain on the horizon (see 7-Jul US Economic Weekly).

On a mark-to-market basis, the call calendar is likely cheaper to own than an outright call if equities sell off, while providing similar upside in a moderate-to-large rally (Exhibit 14).

~ FIN ~

For what it's worth, we like the trade. This takes advantage of the term structure which in our opinion is *stressed* by an overabundance of overwriting and systematic volatility selling targeting the very front of the term structure and transmitting through into the 1-3 month space.

Given the current vol regime & market structure, we would tactically monetize favorable moves with short upside in 0DTE positions during conventional rallies (we talk more about this in our group / course), and we would encourage positional scalping on the Aug Call leg during spot up / vol up days.

VS Commentary:

People often ask about this idea of "tactically monetizing favorable directional moves" by using 0DTE dynamics to add edge to your overall positional performance through time. Let me explain this.

If you've read our course material, joined our group, or even cleverly strung together my opinions on the matter through various notes and comments, etc., you'll know already that we consider certain dynamics of the 0DTE space unique / unconventional, and a bit confounding when constrained by the traditional understanding of GEX / market structure.

What are these dynamics? The space appears to be comprised of two strong but counterbalancing types of order flow:

• Institutions across the industry have taken to 'theta harvesting' in the 0DTE contract, primarily by opening short put spreads, call spreads, and iron condors - all of which tend to cluster and concentrate around strike prices far OTM. For our purposes here, "far OTM" can simply refer to strikes which are out of the money by a greater distance than the 0DTE straddle price. In our observations, we mark these at the open, not the prior close (which is the default for information obtained from most reporting sources). So let's say we closed at 4480 but opened at 4505, and the SPX 0DTE 4505 straddle was worth $18 on the open -> we would consider 4505 to be the reference point and the straddle boundary to be 4505 + / - $18. So it will be typical to see open short positions established where the 'short' strike of a spread is 4485 or lower for Put Spreads, and 4525 or higher for Call Spreads.

• Directional traders, scalpers, etc. on the other hand tend to open long outright option positions early in the day at strikes inside of that same range*,* often at or near the money.

So we have two counterbalancing things going on -> We have dealers put into a negative local gamma (around the ATM / opening reference price) position which becomes longer gamma as we move ~ > 1 straddle price away from the ATM . . .

Do you see where this leads dynamically?

Institutions generally do not close or roll these positions (there are of course some exceptions). The spreads are - by their very nature - capped risk; the firms are well bankrolled and tend to view this business like a casino views the business of providing games of chance to fools (they are the *house*).

The directional traders, gamma & range scalpers on the other hand have a different set of constraints and risks with respect to their withering positions. What do we observe in the data and the trading flows? These positions are closed. Of course they are. There's actually a bit of game theory problem here among holders of "winning bets" placed at the open. When do you close? Given the heavy volumes and open interest on strikes, you are racing against a consortium of traders holding the same winning lottery ticket you are. If all winners waited, the lottery ticket could potentially be worth a substantial take (for everyone). But if you wait, you run the risk of missing your chance to cash in, as others rush to capitalize on a 200-300%+ 1-day return, sparking a reversal in futures / SPY rather quickly.

For these reasons, 0DTE flows actually can behave in a manner consistent with volatility suppression - even when dealers are *net* negative gamma, locally*.*

So, who cares, unless we can make more money, right?

**When we get conventional rallies / selloffs which ****favor** our position, we prefer to monetize these gains via selling off some percentage of our net delta exposure USING the 0DTE contract as the proxy.

Word of caution - we are speaking here of spreading these contracts against a long option / long gamma exposure. We wouldn't advise stacking negatively convex positions, even if the underlying opinion of 0DTE dynamics is strongly held.

By conventional rally, we are referring to a low intraday (short timeframe) variance move, where the top of the range (as defined by that 0DTE straddle price heuristic) is being pressed, but we are not seeing strong SPOT UP / VOL UP dynamics in the curve behind 0DTE.

In the event we see strong spot up - vol up dynamics*, we prefer to *at least* wait until the day's move in vol fades at least 20% off its top.*

We hope this gives you something to think about -> & as always... love hearing how you guys are adapting to this environment.

Cheers!