A reader who works for a market-making group in the Eurodollar options writes in to describe a new ED market entrant and notes that “what we have seen over the past 3 months is unprecedented.“
WHAT: A mysterious customer has been trading downside put-spread ratios, where they are selling the extra put units. They have done this to the point where they are short MILLIONS of put units in long-dated options. Goldman Sachs has even started taking the other side of the trade for size, but they continue to push it their way (how much capital can they possibly have). Is this why rate vol has collapsed to near record levels?
Consensus estimate among local Chicago trading groups is that this customer is short approx 3 million puts, amounting to 1 million straddles in volatility risk. The capital requirement for this position is estimated to be $1 billion. They continue to add every trading day.
EFFECTS: “It has pushed skew and put volatility well beyond all time lows (see below for recent analysis by a Eurodollar broker).”
POSSIBILITIES: “The trader must have access to huge amounts of capital to sustain such a large position. If interest rates were to rise in any volatility-inducing manner (rise quickly – aka futures breaking), this player could be on the hook for HUGE money. We believe if 2-3 year interest rates rose 1.5-2%, this player would have losses in the billions, and capital requirements would skyrocket.”
Some have ventured a guess that PIMCO is the mysterious customer?
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And here is a detailed trade analysis courtesy of x-fa’s John Hayden.
This is the PnL Heatmap of the EDZ0 55/60 PS1x4 (+4Leg) at a purchase price of 0 Ticks. The time step is set at 30 Days and you will see the Fut Price on the vertical. Additionally the Volatility is set to Roll Forward so as we move forward in time the Vol Surface is reduced along the same path as the current Atm Vol Term Structure. For comparison, the following is the same heatmap with Vol set to Static (Fixed)
This trade really boils down to where 5-10 Delta long dated Put Skew is priced. And friends it is CHEAP. It is so cheap that it gives me great pause as to why someone would buy 1/sell 4 at these levels in this size. I have no idea. The following shows how cheap this vol is. Here are 5 year charts of the 5% Put, 10% Put, and ATM Vols.
Not only is the Put side on its all time lows – but the Risk Reversal is on it all time lows as well (Puts cheap).
The heat map says it all. The owner of 4 legs at Even literally has no risk … unless vol comes in. Here is the Static
Heatmap with Atm Vol run at the low (52%) (Which puts the Put area well below levels we have ever seen.)
As you can see there is very little change to the worst case scenario a year out. In other words its hard to lose when you own something for nothing.
You can imagine how ugly this trade could get for the seller of 4 legs if Vols peak and the Risk Reversal flips back to Puts.
In closing this trade is good for many reasons. It also gives the owner of 4 Legs a nice back stop to trade against if vols gravitate higher – and at very little risk.
I have saved the best for last … Here is the 5Y LookALike lookback on the 1by4 (+4Leg). It is hard to believe…
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