The story for the equity markets for the second half of the year has been the struggle between the negative news of a hawkish Fed, slowing economy, and slowing earnings vs. the bearish positioning and survey data that has been persistent. This has led to a negative trend to the equity market interspersed with very short but severe bear market rallies of a double-digit percent. As we come to the end of the calendar year, we can see the bearish market positioning is still present. One place we see this is in the Commitment of Traders data for E-mini S&P 500 futures among the Leveraged Funds. While bearish positioning had been cut in half from August to October, over the past month or so, short positioning is being put back in place.

Another place I like to look to observe market positioning is in the options market. While I do watch and consider survey data, I put more credence in what people are doing vs. what people are saying. The end-user demand in the options market tends to be strong and persistent where there is a demand for put options and a supply of call options. The call supply tends to be more of a systematic nature where either institutional or retail accounts like to use call options to either overlay vs. long underlying positions to add incremental yield and help boost performance, or increasingly to express positive views using short-dated (if not 0 DTE) call options for leverage to a short-term move. On the downside, investors only seek to pay for the insurance of put options when they are most nervous because systematic hedging is a drag on performance that typically is already struggling to outperform the index. We can see this end-user ebb and flow by looking at the put-call ratio. I like to use the U.S. Composite measure with a 20-day moving average to smooth out the noise. Turns in this index have strong and inverse relationship with equity futures – as the index moves higher (more puts relative to calls) there tends to be downward pressure on futures and vice versa. The unwinding of option hedges post-election and FOMC catalysts has provided some support for futures as of late. However, we may be nearing a turn in this average if we look at the most recent daily flows.

As you can see above, there has been a trend higher in the number of puts vs. calls all year long. Market makers might respond to this persistent end-user demand by moving prices. If we look at the strike curve for March options on ES, we see a sharply higher implied volatility for all puts relative to both at-the-money and call options. In fact, call options trade below the at-the-money. The further out of the money we go on the put side of the ledger, the higher the implied volatility. This curve perfectly encapsulates the end-user demand for puts and supply of calls that we historically see, which has been stronger than usual this year. Investors are voting with their checkbooks and making sure they are hedged into the turn of the year.

Stepping back and looking at this phenomenon on a longer-term view, I compare a 200-day moving average of the SKEW Index to ES futures. The premise here is that as investors get more bearish, they stop structurally using index SKEW and instead reduce positions. Thus, bigger drops in SKEW have led to bigger moves lower in the futures. There is certainly noise in this measure, but we can see large drops in the SKEW moving average, which have led the futures moves in 2008, 2015, 2020, and 2022. Does this presage further drops in the futures?

Perhaps the expectation of a larger drop in equity futures comes on the back of earnings and economic data that have been disappointing. In fact, post the U.S. election and FOMC, we can infer that U.S. investors are pricing in higher chance of a recession in the past week. I say this by not looking so much at the modestly lower headline move in the SPX, but by looking at relative sector level performance over this time. We can see the sectors leading us lower in energy and consumer discretionary while positive performance (and presumably flows) can be seen in the defensive sectors of the market – consumer staples, health care, and utilities.

This stands in contrast to the performance we have seen on a YTD basis. The biggest change in the past week vis-a-vis YTD comes in the performance of the energy sector. For most of 2022, the concern has been inflation. Growth has been slowing all year, but prices have stayed stubbornly high. This is a “stagflation” getting priced into the market. Historically and empirically, we see the energy sector, as well as defensive value sectors, perform well in stagflation. However, when the investors’ economic views pivot to deflation, the biggest change in positioning is in the energy sector where the expectation moves from positive to negative performance. Defensive value sectors are still expected to do well when we move into this recession mindset. This is precisely what we have seen in the past week.

This growing sense of a recession makes sense. If we look at PMI and NAHB data, both have a coincident, if not sometimes leading property, of year-over-year changes in ES performance. This year, ES performance has been coincident and maybe even more aggressive than the very sharp moves in both PMI and NAHB. With no bottom in sight at the moment for either housing or PMI, the expectation may well remain for negative YOY performance in futures.

In contrast to the negative economic trends and bearish positioning is the positive seasonality in equity markets in Q4. I show here the past 16 years simply so I can fit it in nicely onto the chart, but it is persistent beyond that, there is an expectation of positive moves this time of year. 2022 has not been immune to this bias with very strong returns already seen in October and November. Does that suggest December will see much of the same? What about the turn of the year?

Turning to technical analysis, I look at the daily Ichimoku Cloud chart. I have also drawn on here a trend channel. We can see that we are running into some resistance near 4,000 in the futures particularly when I look at the lagging span running into the cloud. The MACD is beginning to roll over as well, which suggests we may be setting up for a move lower. The support in futures will come at the midpoint of the channel in the 3,800-3,850 area. However, below that, we may be looking at revisiting the lows seen in June and October.

As someone who grew up in the options market, the next place I always like to turn to is the comparison of implied to historical volatility. The absolute level of implied volatility does not give us the full picture as to whether options are inexpensive or expensive, whether there is fear or greed in the market. Right now, if I look at the March ATM implied volatility in the low 20s vs. the recent historical volatility in the high 20s, it appears to me that traders are anticipating more quiet markets ahead. Perhaps this is due to positive seasonality. More likely, this could be due to the upcoming holidays in the market. But since we are looking at March options, I am less worried about my theta time decay bill and more hopeful that I can find a structure where I can lean into what might be inexpensive options.

I want to find a structure that takes advantage of a move lower in the market. I can see the looming recession and want to take advantage of the negative bias to equity futures if the economy goes into recession. However, I am cognizant that the futures and options positioning already lean bearish. Thus, even though I am in consensus for why this positioning exists, I must acknowledge that the sharpness of the moves lower might be more muted and the risk if a big move may be higher. We are in a market that may take the stairs down and the elevator up. Therefore, I want to look to profit if we drift lower until expiration. Fortunately, when I look at the vol by strike, I see that put options volatility is priced quite high, which tells me I want to try and sell put options if possible. How can you do that and profit with a bearish view? In this scenario I like to use what my colleagues and I would call a split-strike fly. Some of you may be familiar with a broken-wing or skip-strike fly, this is an asymmetric structure where the party that buys the wings takes on more risk by widening out the lowest strike beyond asymmetry (e.g., 100-95-85). It usually means a trader can take in premium but also exposes themselves to a larger move lower. In this case, I think quite the opposite. I think there will be a drift lower, but I think if I am wrong, it may move even lower than that, so I do not want more risk if the move lower is big. I still want to profit if the move lower is larger than I expect, however, there is no free lunch and thus I have to be willing to spend premium for this structure. Since implied volatility is trading at a discount to historical, I am comfortable spending premium for this idea. In this scenario I might look to buy a March 3,900 put, sell two of the March 3,700 puts, and cover the wing buying a March 3600 put. I can see from the expected return chart, my breakeven is about 3,863 in futures and I am spending about 37 ticks for this setup. If I am right, and I drift to my max gain at 3,700, I can make 163 ticks for a potential reward to risk of 4.4 to 1. If I am wrong and the markets move below the 3,600 level, I would still make 63 ticks at every level below 3,600.

Once I get below my breakeven, it is simply a question of how much I make and not if I make. There is risk, though, as we have seen sharp moves higher in the second half of 2022 and we know there is positive seasonality in futures. However, if a trader is willing to take this risk, and position in agreement with the market and be bearish, but take advantage by selling the inflated put options, a trader could create a positive reward-risk setup to capture a potential U.S. recession.

Good luck trading.

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