Signal du Jour - HYG - Sharpe 2.12 Win Rate 66%

"Want some mate? Want some?" says the street seller trying to get a dime out of you

At Sharpe Two, our belief is simple: the data should mirror what the market is buzzing about, and vice versa.

The prevailing market narrative suggests the Fed has finished its current rate-hiking cycle.

At least for now.

Our focus isn’t to debate this but to spot mispricing opportunities in the perception of risk within the bond sector.

The current market narrative in bonds

Our spotlight today falls on the HYG ETF, which tracks a range of high-yield corporate bonds.

Volatility in HYG this year has been much calmer than last year. Yet it started picking up from July to November, as the market was getting antsy about a potential rate hike before the end of the year. It didn’t happen, and with only one FOMC meeting until the end of 2023, it is commonly accepted that it will be postponed to later times next year.

In response, HYG rallied in line with the entire bond sector as investors couldn’t avoid very attractive yields.

That is for the market context. Let’s now get into the data.

The (counter-intuitive) signal you get from street sellers

There are multiple ways of looking for mispricing.

Today, we’re sizing up the gap between forward-looking option prices and the backward-looking nature of the underlying price.

The approach is straightforward: we normalize the at-the-money straddle price observed at the close with the recent underlying volatility and derive a Z-score from it.

How to interpret the Z-score?

• Above 1, the straddle price is more expensive than the usual moves in the the underlying. If the market conditions make sense, it may be a good time to sell the straddle.

• Below -1, the straddle price is cheaper than the usual volatility observed in the underlying. Is this a good reason to buy it?

Probably not.

At Sharpe Two, we believe that option prices are a forward-looking aggregation of the collective views of the marketplace. If the market implies that the straddles in HYG are cheap, it may be for a very good reason, and we should think twice before jumping on the opportunity.

Think about it - let’s imagine that while on a casual stroll, a street seller offers you Rolex watches at a stunning 80% discount, with his best tagline, “Want some mate? Want some?”. You will probably ask, “Why so cheap?” and even more likely pass on it.

We don’t judge if you decide to buy’em.