A word on basis risk and blowups

Posted by Michael Mescher on 15 Feb, 2017

As you are likely aware, we rarely comment on the market on a day to day basis. Today however, seems appropriate.

As you may have heard, word is circulating that a very large fund purchased a call spread 1x5 on the SP in the past few months (long 1 call, short 5 higher strike calls). As they start to break through their short strike, it is likely that their risk is expanding quicker than anticipated (the fund in question is currently down over 11% ytd and their risk is likely expanding in geometric fashion).

This has arguably led to today’s breakdown in the relationship between SP and volatility. Typically inversely related, we see both appreciating significantly today (currently 1.62 standard deviations from the mean and still expanding). Many people attempt to monetize a VIX roll down strategy through futures. Today is exactly the reason you shouldn’t do that. As you are no doubt aware, Gammon prefers the convexity embedded in options combined with deep analytics to determine efficient trades. This basis risk can be difficult to handicap, but is essential to manage and mitigate. If you have any questions about the dynamics playing out in the market today and how they may affect your portfolio, we are happy to help.