On the day after Brexit, George Soros sold short 7 million shares of Deutsche Bank. Of course all the other hedge funds couldn’t help but copy the cool kid, and within days, proclamations of a Lehman style collapse for Deutsche Bank filled the financial media.
To add insult to injury, in early August both Deutsche Bank and Credit Suisse were unceremoniously booted from the prestigious EuroStoxx 50 index due to their market cap collapse.
All of this combined to create what Dave Lutz from Jones Trading calls “THE WORLD’S MOST HATED BANK.” (If you are an institutional trader and don’t get Dave’s Bloomberg daily commentary, then run over to sign up. It is top notch).
It is no surprise that amid this avalanche of negativity Deutsche Bank slipped to new all time lows.
I have focused on Deutsche Bank, but it is really a proxy for the gloom investors are displaying towards all of Europe. The idea that Europe will do anything but continue to be mired in their negative rate, politically dysfunctional zero growth economy is the furthest thing from investors’ minds.
Yet over my few decades of watching markets, the one thing I have learned is that large stocks being booted out of indexes is not a good time to get bearish. And the fact every hedge fund in the world is short Deutsche Bank does not make me want to write any pink tickets.
Actually just the opposite. This summer I picked away at a trade that is the anti-thesis of conventional wisdom. Although I understand that Europe might be stuck in this negative rate zero growth environment for a long time, the market is not giving near enough consideration to the fact that the ECB is expanding their balance sheet at a speed that would make Heather Graham blush.
What if by some fluke, the problem in the coming years is that this monetary bonfire finally ignites?
Currently rates are negative in Europe. Negative… Maybe this absurdity will eventually cause even the Germans to pull out their wallet and spend a little.
There is a non-trivial chance that in the future Central Banks will have the exact opposite of today’s problem. Instead of no inflation, it will be soaring. Instead of rates being stuck at zero and below, rates will be rising. Investors, after years of locking in cash flows at asinine low levels, will rush into real assets desperately trying to protect the purchasing power of their money. There will be a torrent of money flowing out of fixed income into stocks, real estate and precious metals.
Yeah, I know… That’s pretty far fetched. And to top it off, it is by no means that original an idea.
But how I express this view is off the radar screen of most traders.
For some strange reason, the Europeans like to list longer dated options than us North Americans. For a big liquid index like the EuroStoxx 50, there are listed options that go as far out as December 2024 and even December 2025.
The liquidity stinks, but if you are patient and pick away, you can still get fills. I have bought the December 2024 3200 strike calls, but it doesn’t really matter which ones you pick. This particular series has an open interest of over 5,500 contracts and settled yesterday at 425.70. The index closed at roughly 3080, so they are a little under 4% out of the money.
For the privilege of being able to buy the EuroStoxx 50 4% out of the money you need to shell out around 14%. So your break even is 18% higher.
Let’s see… What are the chances that the Eurostoxx will at some point in the next 3,000 days be up 18% from here? I think it is a decent bet.
But here is the neat part. Obviously everyone knows this sort of option is sensitive to changes in implied volatility. There is tons of vega. No need for me to explain that part of the trade.
Yet, what most traders overlook is the rho. Usually with short dated options a change in interest rates has little effect on the theoretical option price. However in this case, the rho is massive!
If the interest rate was to move up 100 basis points, the value of this option would increase by $67!!!
I believe the market is underestimating the chance for a stupid explosion to the upside in European stocks that will be accompanied by sharply rising interest rates. If that happens, you won’t be able to buy these options. The time to buy insurance is when no one wants it. I might not be sure of much, but I am pretty sure there isn’t much demand for this type of trade… which is exactly how I like it.
Thanks for reading and have a great weekend,