25 Sayings on Vol and Risk…Part 1 of 5

[00:00:00] Hello, this is Dean Curnutt and welcome to the Alpha Exchange where we explore topics in financial markets associated with managing risk, generating return, and the deployment of capital in the alternative investment industry.

[00:00:15] Well folks, it's 2024 and whenever we start a new year I can't help but look back to see what songs are celebrating anniversaries. Let's start by going back 50 years. What songs came to be in 1974?

[00:00:32] I'm old enough to be a big fan of Steely Dan and Rick it don't lose that number is a personal favorite. Let's throw in Eric Clapton's cover of the Bob Marley song, I shot the sheriff into the mix as well.

[00:00:43] Lastly, Time, an absolutely brilliant song if Pink Floyd is your thing as it is mine. What else happened in 74? Well, Henry Aaron surpassed Babe Ruth as the all-time home run leader, hitting number 715. There's no evidence that Hammer and Hank was on the juice, the clear or the cream

[00:01:00] either. The Oakland A's win their third straight world series. A year into the dawn of Black Shoals option pricing technology and the advent of listed options on the SIBO and markets had a bunch to deal with.

[00:01:12] The aftermath of the Arab oil embargo saw the price of crude quadruple. The SPX fell by 30% as the Nifty 50 buckled. And of course in 1974, the resignation of President Richard Nixon. I'm looking forward to a great year at the Alph exchange excited to be hosting

[00:01:29] conversations with expert guests and hoping to contribute to your thought process on global market risk. Markets are tough stuff, humbling to anyone for whom intellectual honesty is important. Yogi Berra told us that quote, it's tough to make predictions, especially about the future.

[00:01:46] A little closer to the world of markets, economist John Kenneth Galbraith said that quote, the only function of economic forecasting is to make astrology look respectable. Ouch. I do believe that the Fed has a perfect record in forecasting recessions. They've missed every one of them.

[00:02:03] All right, with this in mind, I wanted to share with you some of my thoughts about the current state of market risk as this new year is now sufficiently underway. By the way, I'm fully in the category that you can wish folks a happy new year

[00:02:15] well into January. I've just read that the cutoff is January 7th. That apparently is when the flood of folks trying to fulfill resolutions at the gym starts to thin out. I say it's simply goodwill and given the insanity that grips the world and the

[00:02:30] good old USA these days, especially important. A number of years ago, I created a list that I call 25 sayings on vol and risk. In the spirit of seven-minute abs and 12 holiday recipes, I think lists are an important way to connect concepts.

[00:02:45] 25 is a lot to get through, so we're going to simply divide them into five, creating a series of half hour episodes. I can't promise you ripped abs, but I do hope I can keep your attention and again make a positive contribution to how you think about markets.

[00:03:00] A lot of this stuff is pretty derivative centric, but I do think there are broader takeaways for the investor whose better years have not been spent glued to the Bloomberg Oman screen or watching the ups and downs of the VIX index.

[00:03:12] So let's get underway, shall we, with the first five sayings on vol and risk and how we should think about them in light of today's backdrop for risk and reward. Saying number one is that quote, big moves matter most.

[00:03:27] This is a nod to how critically important large moves are in determining the profitability of option trades. While many investors are buying call or put options to gain directional exposure, there's a large contingency that is hedging that exposure with a position in the underlying asset.

[00:03:43] Options are convex instruments. For a call option, this means that it will enjoy a larger gain for a given rise in the underlying, then it will suffer loss for the same decline in the underlying. When the changes in the underlying are small, this convexity effect is not

[00:03:57] of great consequence. However, the math of vol trading is such that substantially large one day percent moves have enormous impact on P&L. Over the course of a month, a single 4% move is the approximate equivalent of 5-2% moves with respect to its impact on volatility.

[00:04:15] The investor who pays premium to be long this vol is hopeful for these substantially large moves. Let's do a quick review of what we see in the S&P. In 2023, sadly, for the long vol crew, there was just 1-2% up move and 1-2% down move.

[00:04:32] There are a couple of returns near the 2% threshold, but this is pretty skinny stuff in terms of daily moves. Is it any wonder that the VIX ended 2023 at around 12, nearly 50% below its starting point as the year began?

[00:04:46] I like looking at these daily moves for a couple of reasons. First, show me a dearth of sizable moves and it's easy to conclude that overall realized volatility was low. There were 46 2% moves up or down in 2022 in the S&P

[00:05:03] and that led to an overall level of realized volatility of 24% on the year. In 2023, with just two such moves, realized vol was only 12. But there's something else important. A long stretch of quiet impacts investor psychology. The water is warm, come on in, one might say.

[00:05:22] When there's no moves of consequence, our antennae that typically sends danger lose its way. Take the Volmageddon episode of February 2018. That came after an epic run of low vol. It was a pretty isolated event. A mathematically driven unwind of a product run amuck.

[00:05:41] There was little else on the risk front, economic, geopolitical or monetary to point to. But it was such a shock that it left the VIX more than 50% above its start of 2018, three months later. One might argue that the event imposed substantial enough losses

[00:05:57] on short vol strategies to require a higher entry point to sell vol in order for the capital base to rebuild. We also might suggest that market psychology left investors looking over their shoulder. After the suddenness of that risk episode, leaving folks more cautious than usual,

[00:06:15] perhaps leaving them buying options to hedge. So yes, big moves do matter most. Just ask James Cormier and our friends at optionssellers.com who told us in a remarkable YouTube apology video how the moves in NatGas caused their client portfolios to go boom.

[00:06:34] If you haven't already, this 12 minute video is a must see. As my friend, Joe Niles said, quote, this is literally the perfect video, ageless with a team of Hollywood directors and writers, you couldn't have produced a more entertaining, cringy, narcissistic, hilarious video than this, unquote.

[00:06:54] For James and team, the old adage that short vol traders, quote, eat like birds but shit like elephants seems rather appropriate. But being long vol is no panacea either. To be sure, being long optionality does have some wonderful characteristics.

[00:07:09] I like to frame it as a product that gets longer when you want it to and also less long when you want it to. Act more like the stock on the way up and less like it on the way down, gorgeous. But alas, there's a cost to acquiring

[00:07:22] this compelling characteristic and that is the option premium, which from the day you part with it is a decaying asset. And that brings us to our next saying that quote, theta is the rent on gamma and the rent is often too damn high.

[00:07:37] Let's take the first part, theta is the rent on gamma. This old saying is loaded with intellectual honesty. To get long the attractive feature of gamma, you need to pay the bells, the rent via theta. The linkage between gamma and theta, especially for short dated options

[00:07:54] means that when realized vol is very low, option premiums have a tendency to melt away. This can sometimes make even low priced options difficult to pay for. After 365 days of sun, are you taking a call from your neighborhood flood insurance broker? Probably not.

[00:08:12] In fact, for us vol geeks, we can compute the one day P and L for holding a Delta neutral option position and see explicitly the math that connects gamma and theta. Short dated options, especially those that are very close to the money have intense levels

[00:08:27] of both gamma and theta. They are mirror images of one another. And thus when gamma is very high, a very attractive attribute, so too is the cost of doing business in the theta decay. So yes, theta is the rent on gamma

[00:08:41] and in the spirit of former New York City mayoral candidate Jimmy McMillan, the rent is too damn high. You may recall that McMillan ran for mayor under the uniquely named rent is too damn high party some 20 years back. Well, the average rent for a one bedroom

[00:08:57] in New York City is nearly $4,000 per month. Sheesh, that's as much as Apple's new Vision Pro when you kick in some of the extras. You can also use 4,000 to get cataract surgery buy 4,000 gems or diamonds as part of an in-app purchase

[00:09:11] on a game your kid got hold of on your iPad indulge in an 82 inch flat screen or head to Vegas and put it all on black. Choose your own adventure please and let me know how it goes. So why is the rent too damn high

[00:09:25] in the world of options? Well, despite what Scott Patterson's book Chaos Kings would have you believe in its fawning account of the success of Universal in owning options there's this thing called the Valrus premium. And this VRP as we call it essentially tells you

[00:09:41] that just like your car insurance provider your stock insurance provider is also in the business of making money. Thus the option premiums required to be long optionality over time more than it up. The quiet periods in markets cause time decay that detracts from overall returns.

[00:09:59] And just like the exorbitant New York City rents highlighted by McMillan, market option premiums can be budget busters. Thus the safety that comes from options is real but the cost for acquiring said safety can reduce the effectiveness in getting a peaceful night's sleep. Let's put this Valrus premium

[00:10:17] into some simple and historical context. Over the last 10 years the average level of one month implied volume in the S&P is 15. But the average level of one month realized vol is just 13. Moreover, the frequency with which implied vol outstrips subsequent realized vol is substantially high.

[00:10:36] Over the past decade for example the VIX has been higher than one month realized vol about 85% of the time. We might call this the realized vol shortfall. Now this alone is not a conclusively damning outcome for being long vol. What do we know about the distribution

[00:10:52] of stock market returns? They are left-tailed and they are fat-tailed. Thus if the average level of one month realized vol is 15 it turns out that the highest observed one month is 100 and the lowest is three. Like a seventh grade history class with a substitute teacher

[00:11:09] the stock market can become quite rowdy. When it goes, it goes. And that is when shortfall exposure can be especially punishing if not as optionsseller.com, LDCM, AIG's Joe Casano and Morgan Stanley's Howie Huber showed us a lights out experience. Let's go to saying number three

[00:11:31] which is quote hedge when you can, not when you have to. Let's go back to our New York City rent example. You paid your 4,000 for the month and wanna take a stroll through Central Park but the skies are beginning to ever so darken. Being a think ahead guy

[00:11:47] and not wanting to be exposed to a potential downpour you spot a street vendor selling umbrellas. He's at $5. You bid him for and he yells take a fill. You've paid some option premium. You've got some insurance but also your $4 price might not be there tomorrow

[00:12:03] should that rain materialize. If it does one might expect demand for the Brawley as they are apt to say in the UK to skyrocket. The now empowered street vendor eager to balance supply and demand and maybe make a profit in the process is gonna raise the price.

[00:12:19] In markets it's easy to postpone paying for options when implied vol is low because realized volatility is often even lower. Let's take the recent action or lack of it in the S&P 500. One month realized volatility is now below nine. That's about 60 basis points per day

[00:12:38] in daily move on a close to close basis. That's hardly enough to motivate even the defensively minded risk taker off the couch and into a conversation on hedging. You've heard me say before that financial objects at rest tend to stay at rest.

[00:12:52] Low volatility periods occur for a myriad of factors which in general do not change overnight. As a result, low vol today tends to be a reasonable predictor of low vol tomorrow and next week. What I worry about is the complacency that seeps into market psychology and positioning.

[00:13:09] If owning options has not proven favorable and profitable then almost by definition being short them has. Let's look briefly at an ETF called the PPUT, PPUT which simply buys and rolls 5% out of the money puts on the S&P each month

[00:13:25] marrying the hedge with a position in the underlying. In 2023, the S&P delivered a glorious 26% total return. The PPUT trailed it by a noticeable amount delivering just 19%. So we know that hedging can be costly. The efficacy of the always on hedge is not a thing

[00:13:44] unless you operate in the fantasy land of Bernie Madoff's split strike conversion strategy. But I always want my conversations with investors to consider hedging when the sky is clear and the umbrella is cheap. I've seen it all too often that when a risk off event

[00:13:58] does occur, the sticker shock from higher option prices can be difficult to overcome leaving the investor frozen. The VIX moves from 12 to 15 on some sniff of turbulence and the decision making process is thrown into disarray. There's another aspect of hedging

[00:14:15] when times are good and insurance costs are low and that's market liquidity. There's no truly agreed upon measure of liquidity but some version of market depth and bid offer are gonna be some part of it. No surprise, volatile markets are generally illiquid ones.

[00:14:30] I explored this in pretty good detail on a recent podcast with Stanford professor Darrell Duffy. He and colleagues have done some really interesting work on the treasury market meltdown of March 2020 showing the connection between vol liquidity and dealer balance sheet capacity. Ultimately, someone's gotta sell you the insurance

[00:14:48] better to buy it from him or her before the storm just ask homeowners in Florida. Now, does it actually pay off to hedge when you can but not when you have to? Put differently, is it better to be long vol when the starting point is low, high

[00:15:03] or somewhere in between? My work is inconclusive on this front. In 2017 as the VIX went below 10 one might have been chomping at the bit to own options but the second half of 2017 would see Realize vol reach levels skinnier than most could have imagined

[00:15:18] and the decay in owning options was very painful. It also proved quite painful to be buying options in early 2009 at very high VIX levels. Realize vol would turn out to be high in 2009 but the starting option prices were simply too hefty to monetize.

[00:15:35] So the starting point is not definitive though we can argue that at the limits of Very High Vol, putting us in the teeth of both the GFC and the COVID crisis when the VIX reached 80, the price of insurance is too high to make the protection worth it.

[00:15:48] It simply may be too late. To give you a quick sense, let's compare pricing on a one month at the money put on the S&P during the peak of the COVID crisis versus a left tail event of Low Vol that occurred in 2017 right around the 30th anniversary

[00:16:05] of the 87 stock market crash. My trusted GV screen on Bloomberg tells me to use 78 and a half and six and a half vol respectively. That mere one month's worth of insurance would have cost 9% in March of 2020. In October of 2017, just 78 basis points. Vol itself can be very volatile.

[00:16:28] Let's shift gears a bit and move on to saying number four which is quote, stock returns like politics are not normal. Can I get an amen? In election years upon us folks in the celebrity death match we all feared is a near certainty.

[00:16:43] In one corner, hailing from Scranton PA graduating at the top of his class from the University of Delaware and teaching at the University of Pennsylvania. Sorry, scratch those last two. Joe Biden, hail square off with a man that actually did go to U Penn

[00:16:57] before launching his own college, Trump University and selling branded stakes and ties. This should be a doozy. I've checked the predicted markets which thankfully Bloomberg makes available on a time series basis through the easy to remember tickers PRIT, US4T for Trump and PRIT, US4B for Biden.

[00:17:21] It is a dead heat. Lord save us. US politics are not normal by any stretch. And what we have seen is the steady growth in polarization. Let's take a common subset of the issues for which the left and right disagree. Taxes in the social safety net,

[00:17:37] guns, abortion, immigration, policing and a broad set of culture war categories among them. Consider one party for a moment. Let's say the left within a party. There are far left folks like AOC, centrists and more conservative Democrats like Joe Manchin. There's a distribution of views

[00:17:55] even within a single party. The same as the case on the right. We can argue if the left has moved further left or the right has moved further right. But what has surely occurred is that the overlap of center left and center right has become more elusive.

[00:18:10] And the cacophony of congressional commentary from the fringes on both sides has been more than unhelpful. It's been destructive. Being the option enthusiast that I am, I somehow find myself contemplating this political schism in the context of a certain three-legged option trade, the fabled iron butterfly.

[00:18:28] In this multi-legged beast, a broker's delight by the way, an investor simultaneously sells a straddle and buys a strangle. On the S&P for example, with the index sitting at 487, one could sell the 487 straddle collecting right around $11. Against this, one could buy the 477, 497 strangle

[00:18:48] paying a bit more than four. There's very little net delta to the package here. The payout on this bad boy at expiration looks like the top half of a diamond. The best result would be the spy to finish exactly at 487, the straddle strike.

[00:19:03] This way you'd walk away scot-free with all that premium generated. You'd, of course, have lost on the strangle you bought, but net-net you were up seven. Well, what if the index goes up or down a large amount? Suppose the spy finishes at 450. You lose 37 on the short 487 put,

[00:19:21] but make 27 on the long 477 put. You were out 10, but you did collect seven to do the trade. You are out a net of three. The result is the same on a surge in the index. This may be a captain obvious statement,

[00:19:36] but in the no free lunch world of high finance, the straddle always costs more than the strangle. You're all asking, how does this all relate back to US politics? Which can we all agree that like asset returns are not normal?

[00:19:49] The straddle is the center left and center right. The strangle is the fringe of each party. Wouldn't it be nice if the center of both parties exerted more influence than the fringes? In today's politics, the far left and far right, the strangle carry way too big a stick.

[00:20:06] We are in for surprise after surprise in 2024. We just learned that a robot call posing as Joe Biden made the rounds with New Hampshire voters suggesting they skip voting in the primary. It's apparently an AI version of Biden. Or maybe the story about the deep fake

[00:20:22] is itself a deep fake. I'm not even sure anymore. A recent financial times article is entitled quote, audio deep fakes emerge as weapon of choice in election disinformation. From the most recent FT magazine, quote, it's merely a matter of time until disinformation leads to calamity.

[00:20:41] The article features Trump and Biden locking lips, something you may not be able to unsee as I myself have not been able to. I also wanna point you to recent work from Ian Bremmer's Eurasia Group. In their top 10 list of risks,

[00:20:56] the US versus itself is listed as number one. This is a compelling, if not frightening read and I encourage you to access the document. Here's the opening paragraph from Eurasia Group quote, while America's military and economy remain exceptionally strong, its political system is more dysfunctional

[00:21:15] than that of any other advanced economy in industrial democracy. And in 2024 faces further weakening. The US presidential election will worsen the country's political division, testing American democracy to a degree. The nation has an experience in 150 years and undermine US credibility on the global stage.

[00:21:36] The abnormal nature of politics in the manner in which asset price returns have proven not to be normally distributed might be related. First in markets, we know that the predicted 100 year storm per the bell curve seems to actually occur every five to 10 years in markets.

[00:21:53] The normal distribution is a seductive construct that creates a dangerous certainty about unforeseen risk outcomes and may contribute to vulnerability in tail events. I will just leave this section in asking the question, what risks could be more systemic than some US political crisis? Elections, border sovereignty,

[00:22:12] the debt ceiling, the debt itself, a toxic brew amidst the polarization and the hazards of technology inspired disinformation. Let's round out this conversation with saying number five on vol and risk. And that is that quote, financial market insurance is not like hurricane insurance.

[00:22:31] This is derived from LTCM's Victor Haganis quote after the hedge funds demise. My read on this is that while mother nature dictates the timing and severity of the next hurricane, the financial market equivalent may arise endogenously, propelled by the forceful unwinds of trades

[00:22:48] that enjoy too much success for too long. Note, this is not a discussion on climate change in area in which I have no expertise whatsoever. I am a warm weather guy to be sure though, and I find myself increasingly reliant on getting in trips to Florida

[00:23:03] during the cold and dark New York winters. I'm also known to walk around my house with multiple and I mean up to four layers of clothing, including a full ski hat. Some might say I look ridiculous just ask my kids.

[00:23:15] Mother nature is no gamma and Vanna bean counter. She doesn't see when lots of cat bonds have been bought at skinny levels of risk premium and decide that a wildfire or flood or tornado is overdue. The financial products that enable the risk taking do not cause the risks.

[00:23:32] The pricing environment certainly does respond to profits and losses. A long drought will embolden sellers of flood insurance encouraging them to demand less premium. The opposite, a so-called hard market is also the case. A big event in which the insurance pays out

[00:23:47] may leave the risk takers nursing losses in demanding higher premium levels, but the events themselves are not related to the ecosystem of risk built around them. What Victor Higani is saying from his painful experience at LTCM is that the presence of the trades themselves

[00:24:02] in the market, especially when they become an active part of the conversation on risk can create a self-fulfilling risk off. For LTCM for example, the giant exposure to short equity volatility estimated between $40 and $80 million of Vega led their OTC counterparties to handicap the potential that the funds

[00:24:22] deteriorating position might lead to a mass unwind of these trades. The result is that long dated implied vol was bit up furthering the market to market losses for the fund. The exposure created the reaction which then further impacted the exposure. There are more recent examples.

[00:24:39] Consider the SVB debacle brought on by ill time purchases of duration by the bank in 2021. It turns out that at 1.2% yield, the tenure note is a not so risk free asset. By 2023, the Fed's tightening cycle had led to deep losses for SVB and a breathtaking deposit flight facilitated

[00:25:00] by the speed with which fear can spread on social media and the speed with which technology has enabled vast sums of money to be moved with two taps and a swipe. As interesting a risk event as SVB was, it was the boomerang of lower rates that occurred

[00:25:16] in its aftermath that brings relevance to the notion that financial market insurance is not like hurricane insurance. As fears that the failure of SVB could give rise to an uncontained bout of deposit flight grew, the two year treasury note rallied ferociously

[00:25:31] leaving it 125 basis points lower in a matter of weeks. This rally too late of course to save SVB caused several giant funds losses as they were short volatility convicted that nothing like this could possibly occur. The sloppy unwind of these wrong way derivative trades

[00:25:50] almost surely contributed to the degree of rally and surge in implied volatility in the short part of the US yield curve. The trades, especially ones that have a convexity aspect to them become part of the overall markets risk dynamic. It's a unique thing.

[00:26:05] There's much more to say at all these subjects but we'll save some for later. We've got many more sayings to work through in our five part series. We'll sprinkle in these episodes with podcasts in which I host a conversation with an expert guests.

[00:26:19] Thank you for listening and wishing you a fantastic 2024. You've been listening to the Alpha Exchange. If you've enjoyed the show, please do tell a friend. And before we leave, I wanted to invite you to drop us some feedback. As we aim to utilize these conversations

[00:26:35] to contribute to the investment community's understanding of risk, your input is valuable and provides direction on where we should focus. Please email us at feedback at alphaexchangepodcast.com. Thanks again and catch you next time.