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Navigating Rocky Oct After a Crushing Sept in US EquitiesSeasonality is pervasive in financial markets. Some are benign while others are not. The “September Effect” refers to a month when equity returns gets crushed. Typically, this is followed by a volatile October. Other well-established pattern in equity markets is the "Santa Claus Rally" which is known to occur during December. Equities go bullish with increased optimism, holiday spending, and portfolio rebalancing before the end of the year. Then, there is also the "January Effect" where small-caps tend to outperform large-caps in the early part of the year. Essential to remember that historical trends do not guarantee future performance. This paper delves into the September Effect followed by the volatility which tends to be witnessed during the month of October. Portfolio managers can prudently position their portfolios to gain from rising volatility and sharp price moves in October and the rest of the final quarter. WHAT EXPLAINS POOR EQUITY RETURNS IN SEPTEMBER? There is no exact rationale explaining why September is historically the worst month of the year for equities. Over the last 94 years, September is the only individual month that has declined at least 50% of the time. Scott Bauer, CEO of Prosper Trading Academy surmises in an opinion note that three drivers plausibly explains this: 1. Post Summer Vacation: In the lead up to summer in Europe, average trading volumes grind lower resulting in lower volatility from June to August. When portfolio managers and investors return in September, their collective rebalancing of portfolios cause panicked exits as they create space for new holdings. This mass-exodus of selling shares pushes prices lower making September the worst month for stocks. 2. Year-end for Mutual Funds: Many mutual funds close their fiscal year in September. These funds purge their portfolios during this ill-fated month. 3. New Bond Issuances: Like equity trading activity, bond issuances ease during summer and return with vengeance and spikes in September. New issuances channel existing money into bonds forcing investors to rotate out of equities and into bonds. SEPTEMBER US EQUITY MARKET PERFORMANCE IN THIS MILLENNIUM Does the September effect prevail in the current millennium? Since start of 2000, September indeed is the worst month for S&P 500 stocks with average returns of -1.8%. Surprisingly, the months with the highest occurrence of negative returns is not September but January. Over the last 23 years, January had 13 months of negative returns. June along with September rank second with 12 occurrences of negative returns during the same period. The chart below summarises average monthly returns of S&P 500 index. Clearly, on average, September stands out as a poor performer while April is the best . Interestingly, the S&P 500 shares tend to deliver positive returns with average upside performance of 3.22% in the fourth and final quarter of the year. Likewise for Nasdaq 100, the September Effect is even more pronounced with index plunging 2.61% on average. Unlike S&P 500, February (14 of 23) has the highest number of months with occurrence of negative returns. The month with the second highest occurrences of negative returns are September, June, and December with 12 of 23 years marking a negative return. The chart below summarises average monthly returns on the Nasdaq 100 index. While September crushes Nasdaq stocks, October is the best month thus far this millennium. October and November deliver positive returns with a pullback in December. On average, Nasdaq 100 upside performance stands at +2.44% in the fourth quarter. A CRUSHING SEPTEMBER IS FOLLOWED BY A ROCKY OCTOBER While September is the king of worst month for stock returns, October claims the crown for being the most volatile. Over the last 23 years, the S&P 500 equity returns show the largest exaggeration in October. Range as used below is defined as the high minus the low of the month and then expressed as a percentage as month’s opening level. Analysis shows that equity returns move by 9.1% in October compared to 6.9% on average for the rest of the months in the year. Similarly, observations in Nasdaq-100 also point to exaggerated range of returns during the month of October. Range in Nasdaq monthly returns stand at 11% in October compared to 9.2% on average for the rest of the months in the year. Based on expected returns and volatility, investors in S&P 500 can expect large swings in returns in October as evident from the chart below. Likewise, Nasdaq 100 investors can expect large swings in October returns based on observations over the last 23 years. OUTLOOK FOR FINAL QUARTER OF 2023 Twenty-three years of historical observations point to a positive upward bias in equity returns for the last three months of the year. This time however, the outlook going into the final quarter is beset with head winds. Not one but five of them approaching in parallel. Risk lurks in many places. Strong dollar. Oil skirting near $100/barrel. Resumption of student loan repayments. Record high mortgage rates driven by higher for longer policy stance. Automotive workers striking at multiple plants potentially leading to higher labour costs and automotive inflation. Dollar is trading at 10-month highs. The US 30-year mortgage rates at record high levels unseen in 23-years. The 10-year US yield are at levels last observed during 2007. Gathering of these dark clouds are starting to show up in the University of Michigan’s US Consumer Confidence index. Since June, American exceptionalism boosted the index to 71.73 clocking a 52-week high. However, with a raft of concerns weighing on the consumers, the index has started to drop the last two months. HARVESTING VOLATILITY EXPANSION USING CME MICRO OPTIONS ON S&P 500 AND NASDAQ 100 INDEX In times of uncertainty, where seasonality leans towards a bullish rally but fundamentals signal a bearish grind, portfolio managers can position to gain from volatility expansion and sharp index moves in either direction. Options can be used to engineer a convex portfolio. Convexity in finance refers to portfolio strategies which enjoy outsized and solid gains while limiting downside risks. Convex strategies deliver non-linear returns with substantially higher gain for every unit of pain. LONG STRADDLE USING OPTIONS ON CME MICRO E-MINI S&P 500 FUTURES Long straddles involve holding a simultaneous long call and long put position at the same strike price for the same expiration period. Let’s look at a hypothetic long straddle using Micro E-Mini S&P 500 Options expiring on 29th December 2023 at a strike price of 4400. The straddle pay-off is visualised in the chart below. This trade will generate positive returns when (a) index rises above 4655, or (b) index falls below 4145, or (c) volatility expands . The premium required for this trade (as of 2nd October 2023): (Premium for Call Option + Premium for Put Option) = (USD 631.7 + USD 636.65) = USD 1268.35. If index rises 10% to 4840: Call option would pay out ~USD 1568 = ((4840 – 4400) x 5 – Premium for Call Option) = (440 x 5 – 126.34) while the put option would expire worthless, so, net profit would be: (Net PnL from Call leg – Net PnL from Put Leg) = (1568 – 636.65) = ~USD 932 By the same measure, the long straddle will suffer losses if the index remains flat or its moves are muted. It also loses money if volatility remains flat or contracts. If index remains at 4400: Both options would expire worthless, so, the position would lead to a net loss of the premium paid = Loss of USD 1268.35. LONG STRADDLE USING OPTIONS ON MICRO E-MINI NASDAQ 100 FUTURES Let’s look at another hypothetic long straddle using Micro E-Mini Nasdaq 100 options expiring on 29th December 2023 at a strike price of 15250. The straddle pay-off is visualised in the chart below. This trade will generate positive returns when (a) index rises above 16416, or (b) index falls below 14084, or (c) volatility expands. The long straddle will endure losses if the index remains flat or its moves within a narrow range. It will also lose if volatility remains flat or shrinks. MARKET DATA CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com DISCLAIMER This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services. Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
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