“Elections have consequences”. So said former US President Barack Obama. He probably didn’t have our trusty fear gauge, the VIX, in mind, but he may as well have. We are one day away from the US presidential debate. I am not sure this one can deliver the same fireworks that resulted from June 27th. It may devolve into a food fight, with each side hoping to land a definitive blow. What I’ve learned about election risk with regard to derivatives through events like Brexit, the 2016 and 2020 US elections and certainly this one as well is that the clearing price for volatility is impacted by a decline in the willingness and ability to supply it to the market. The result, a VIX stuck at a reasonably high level. I hope you find this discussion enjoyable and useful.
[00:00:01] Hello, this is Dean Curnutt and welcome to the Alpha Exchange where we explore topics
[00:00:06] in financial markets associated with managing risk, generating return, and the deployment
[00:00:12] of capital in the alternative investment industry.
[00:00:19] All big risk-offs start as small ones, said the podcast host contemplating the rich history
[00:00:25] of financial market malfunction in just the last three decades alone.
[00:00:30] That podcast host, yours truly, has recently had an awful lot to contemplate in the realm
[00:00:35] of market prices.
[00:00:37] For us risk event nerds, the materialization of August 5th presents a new opportunity to
[00:00:43] study to ask questions.
[00:00:46] Accompanying the big question of why is the equally important were their warning signs?
[00:00:52] What follows is a brief discussion on whether there is alpha to be had in risk off.
[00:00:57] The central assertion underpinning a yes answer to this question is that convex insurance can
[00:01:03] be bought at the right time and at the right price.
[00:01:06] Not always or even frequently, but often enough such that paying out premium adds value to
[00:01:12] managing portfolio risk.
[00:01:14] Even if you lose most of the time, as you absolutely ought to in insurance strategies,
[00:01:19] alpha can be generated through the big payouts earned during chaos.
[00:01:23] Just ask the accidental chaos king himself, Bill Ackman.
[00:01:28] What do we know?
[00:01:29] First, the always on portfolio hedge doesn't really work.
[00:01:34] The volatility risk premium tells us as much.
[00:01:37] Like the auto insurance or life insurance or catastrophe insurance business, the market
[00:01:42] for financial product insurance wouldn't exist if there wasn't an opportunity to
[00:01:47] make some money providing the product over time.
[00:01:50] It's certainly not without risk, of course, but insurance sales is a decent business,
[00:01:55] both for the principal and agent.
[00:01:58] On the flip side, having no hedge on it all, ever, may be where some investors wind up.
[00:02:05] Drawdowns are a thing, but it's hard to deny the long-term success of compounded equity
[00:02:10] returns realized through a diverse portfolio like the S&P 500.
[00:02:15] Set it and forget it.
[00:02:17] And think really, really long-term is one easy to defend philosophy.
[00:02:22] But taking risk is, well, risky.
[00:02:25] There's countless examples of total ruin in this business that we should not forget,
[00:02:30] even if we are conditioned to do so.
[00:02:32] Orange County, LTCM, Amarith, Lehman, WEMU, MF Global, Malachite, just a few.
[00:02:39] I personally believe deeply in the value of derivatives.
[00:02:42] Buffett famously crafted the phrase FWMDs, Financial Weapons of Mass Destruction in 2002.
[00:02:50] Put in the wrong hands, that means you, Joseph Casano,
[00:02:54] leveraged instruments like derivatives can surely run amok.
[00:02:58] But there are very sound strategies that can be utilized effectively to manage risk
[00:03:02] in the realm of derivatives.
[00:03:04] Basic trades like zero-cost collars can allow an investor to shape the return
[00:03:09] profile, forgoing some upside exposure in order to acquire some downside protection.
[00:03:15] In certain circumstances, but by no means all of them,
[00:03:18] the market pricing setup neatly facilitates what you want to do.
[00:03:23] In this case, you can quote, take what the vol surface gives you.
[00:03:27] That is, look to set up trades where the economics are more favorable
[00:03:30] based on the level of vol across both strike and time.
[00:03:35] With the University of Chicago no free lunch philosophy of market efficiency well impounded
[00:03:41] in my thinking, I do believe that there is alpha to be found in the trade construction process
[00:03:46] in derivatives.
[00:03:48] That alpha may be even as simple as identifying the trades the market is explicitly penalizing
[00:03:54] you for doing and then pursuing them no further.
[00:03:57] A good example is the pricing of S&P vol and skew in the six to 12 month period
[00:04:02] post the COVID collapse.
[00:04:04] The equity vol realized in March of 2020 was so epic and again to quote Buffett,
[00:04:10] gave us a chance to see who was swimming naked.
[00:04:13] From June of 2020 until the end of 2021, a two month 10% out of the money put on the S&P
[00:04:20] traded at an average of 12 vols over what was realized.
[00:04:24] I do get paying up somewhat for downside puts but sheesh that's a big vol risk premium.
[00:04:31] So that's an example of what to avoid.
[00:04:33] How about something to seek out?
[00:04:36] More recently and a significant subject covered on this podcast, the pricing of implied
[00:04:41] correlation and vol vol paved the way for some highly convex trades.
[00:04:47] There's always some overriding explanation for why a price clears at the level it does.
[00:04:52] There are no layups in this most competitive and humbling sport.
[00:04:57] In the case of the exceedingly low implied correlation and vol vol that characterized
[00:05:02] S&P option and VIX option pricing back in May and June, we can point a finger at equivalently
[00:05:09] low realized correlation and vol vol.
[00:05:12] As I've said many times before, the marginal price setter and derivatives is the vol trader
[00:05:17] whose goal is to profit from the differential between implied and realized.
[00:05:22] When realized is low, so too are the profits that accrue from gamut trading.
[00:05:27] This means implied vol is going to be low as well.
[00:05:31] Same for correlation.
[00:05:33] For the two months of May and June, three month implied correlation on the S&P averaged 17%.
[00:05:40] Over the same timeframe, the VIX, that VIX metric for the VIX itself averaged below 80.
[00:05:47] Each of these is a 0th percentile kind of thing.
[00:05:51] On the correlation front, realized was even lower than implied averaging just 13%
[00:05:56] and enticing folks to implement the dispersion trade at skinnier and skinnier levels.
[00:06:02] On the VIX front, it's no wonder the VIX was so low.
[00:06:05] If the vol of vol trader is looking for swings in the VIX to monetize, they were barely any.
[00:06:11] The VIX traded in a 3.5 point range over the May and June timeframe.
[00:06:18] So yes, these prices made sense in terms of what the market was delivering several months back
[00:06:23] and the manner in which the marginal price setter reacts to realize volatility,
[00:06:27] realize correlation, and realized vol of vol.
[00:06:30] Why did the VIX close below 10 more than 50 times in 2017?
[00:06:35] Look no further than realized volatility, which also reached a 50 year low in 2017.
[00:06:42] Why did the VIX reach a new all-time high in March of 2020?
[00:06:46] Realize volatility that exceeded even the GFC, that's why.
[00:06:50] But it's important to keep in mind that even as these prices were justified by how they carried
[00:06:56] in real time, they were, for the same reason, carry very low.
[00:07:01] Low and cheap is not a setup you see very often in the price of optionality.
[00:07:06] Low but not necessarily cheap is probably an apt way to describe the setup when
[00:07:11] price action is muted. If you've already decided that some form of defensive structure
[00:07:17] makes sense as an overlay, then the low price is what appeals to you.
[00:07:21] The poor carry that made the price low shouldn't matter as much.
[00:07:25] As a hedger, you are more looking forward than backward.
[00:07:29] Implied in your decision to hedge is a view that there are clouds on the horizon
[00:07:33] and that well-behaved markets cannot persist.
[00:07:38] At mid-year, with the S&P up 15%, the December year end of 2024,
[00:07:44] 4900 strike put came at roughly $52. That's 10% out of the money and costing a little less than 1%
[00:07:51] of spot. Fast forward to today and the S&P is unchanged and that same put is actually up
[00:07:58] marginally in price even as three months have passed.
[00:08:02] That put exploded in premium reaching $177 on August 5th.
[00:08:08] I think this is a good example of finding value in optionality.
[00:08:11] We're taught that options simply decay and that they can only rise in value when the index plummets.
[00:08:17] Here's an instance of a trade that provided substantial mark-to-market protection when
[00:08:22] you needed it most and because of the repricing hire of Correlation, Vol, and SQ,
[00:08:27] the put has held its premium nicely even as the S&P is up.
[00:08:32] As the car's song goes, let the good times roll, let them knock you around.
[00:08:38] I'm not entirely sure what that means but with the market up 16% on the year
[00:08:42] and with so many fast-moving developments in the economy, the election, the easing cycle,
[00:08:48] I wonder if this levitating market up 46% since the start of 2023 may run into some serious
[00:08:55] headwinds. We are one day away from the US presidential debate.
[00:09:00] I'm not sure it can deliver the same fireworks that resulted from June 27th.
[00:09:05] It may devolve into a food fight with each side hoping to land a definitive blow.
[00:09:10] There will be very little in the way of substantive discussion on the complex issues
[00:09:14] of debt management, foreign policy, immigration, and the tax code.
[00:09:18] Do better folks. I do want to conclude with some thoughts on the VIX into the election
[00:09:24] season. The October VIX future is an interesting security to consider because it embeds the election
[00:09:30] risk. Remember, Oct VIX expires on the 15th to a strip of one-month S&P options.
[00:09:37] Those options will encompass the US election on November 5th.
[00:09:40] What I've learned about election risk with regard to derivatives through events like Brexit,
[00:09:46] the 2016 and 2020 US election, and certainly this one as well,
[00:09:50] is that the clearing price for volatility is impacted by a decline in the willingness and ability to
[00:09:57] supply it to the market. The index vol trader at a large bank whose job it is to provide liquidity
[00:10:03] and potentially sell out of the money puts to clients like hedge funds may be politely tapped
[00:10:09] on the shoulder by his or her internal risk police. They may say something like,
[00:10:14] we don't really know what the outcome is going to be here, but we don't want you to
[00:10:19] be short downside convexity. Sadly, the US is earning a strong reputation for election controversy.
[00:10:26] It hasn't spilled over into the market in any measurable fashion, but it's the fear itself
[00:10:31] that matters. With less supply of volatility, the clearing price rises. We've observed this
[00:10:37] via the VIX curve hump in October for months. Most of the trades we see in the VIX are of
[00:10:43] the hedging variety, long calls and call spreads. When the VIX gets really pumped up,
[00:10:48] you'll see interest in implementing structures like one by two put spreads that bet on a retracement.
[00:10:53] This was very popular in the period around the 2020 election. If one were to sell instead of buy
[00:11:00] a VIX put spread, the economics get flipped around. The trade would take in premium instead
[00:11:05] of paying it out on trade date. Further expressing the view that the index was headed
[00:11:10] lower, the sold put spread would bet that the VIX would not go too far down.
[00:11:15] So here's a trade concept to consider. I'll start with the statement that sometimes you can gain a
[00:11:20] view on whether a trade is attractive by asking yourself whether or not you do the opposite.
[00:11:26] As I speak these words, the Oct VIX 1816 put spread is around 85 cents mid-market.
[00:11:33] Would paying this premium when the Oct VIX future is right around 20 and the US election
[00:11:38] has well earned its right to keep vol bid through the expiry of that Oct VIX future make sense?
[00:11:43] I'd say that's a really tough buy. First you have to lay out 85 cents and you may never get it back.
[00:11:50] You break even only if Oct VIX settles at 1715 or lower and you can make a maximum of only 1.15.
[00:11:58] I'll take the other side. Give me the 85 cents. It's nearly a coin flip in terms of what I take
[00:12:05] in versus payout. Is October VIX really going to settle at 16 or lower? As I often say we
[00:12:12] should respect the reality that anything truly anything can happen in markets, sort of like US
[00:12:17] politics. So of course there's a chance but at least I know where I'm capped out in terms of loss.
[00:12:24] Why do the economics for buying the put spread look unflattering? The vol and the skew both work
[00:12:30] against you because of the elevated VIX you're paying a fair amount on the implied vol side
[00:12:35] and because the distribution of VIX outcomes is viewed as truncated i.e. they can't go much lower but
[00:12:42] certainly can go much higher, the bottom leg of the put strike has a much lower implied vol than the
[00:12:48] top leg that you are paying for. Thus you are paying away the skew also making the pricing
[00:12:54] economics less favorable. To summarize my experience with election risk and other
[00:12:59] macro on the calendar catalysts is that the supply of vol goes down ahead of the event
[00:13:04] and that raises the level of vol. You're not going to get rich being short VIX put spreads but you
[00:13:11] won't get poor either. Trump's recent tweet from September 7th is a doozy beginning with the words
[00:13:17] in all caps cease and desist and speaks of the likelihood that there will be cheating
[00:13:22] and consequences for that suggest that there's little interest in going quietly should the
[00:13:27] outcome not go his way. Again amidst a higher level of realized correlation
[00:13:32] an economy that feels like it could be turning and this very uncertain election I think there's
[00:13:38] just plenty of reason to justify an elevated VIX. The good news is I've reached my 2000 word limit
[00:13:44] and that means I must bid you goodbye for now. I wish you an excellent week.
[00:13:50] You've been listening to the alpha exchange if you've enjoyed the show please do tell a friend
[00:13:55] and before we leave I wanted to invite you to drop us some feedback as we aim to
[00:14:00] utilize these conversations to contribute to the investment community's understanding of risk
[00:14:04] your input is valuable and provides direction on where we should focus. Please email us at feedback
[00:14:11] at alpha exchange podcast dot com. Thanks again and catch you next time.