Hedge When You Can, Not When You Have to

[00:00:01] 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.

[00:00:19] Hedge when you can, not when you have to, or so the old adage goes. I've used it time and time again, so much so that, as happens with Mark Twain and axioms from yesteryear, perhaps folks inadvertently attribute the origin of the saying to me.

[00:00:35] I'm even beginning to think I may have actually come up with it, but I don't want a Harvard plagiarism scandal coming my way.

[00:00:42] The pithy proverb is surely meant to summon our sensibilities on risk.

[00:00:47] Implied in it is doing something that doesn't come that naturally, namely, taking defensive action when times are good.

[00:00:54] Buy the umbrella when the skies are blue, I say, mostly because its cost will reflect the seller's understanding that his product isn't set to fly off the shelf at that particular time.

[00:01:05] If the umbrella is protection against an unwelcome downpour and the discomfort that results, then the put option is rainy day insurance against market conditions that turn less propitious and potentially dark and stormy.

[00:01:20] An excellent adult beverage, by the way.

[00:01:22] There's no liquid market for umbrellas, but if there were, one might observe a tight correlation between ominous skies, interested buyers, and rising prices that balance supply with fresh demand.

[00:01:35] Put options are considerably more liquid, with prices made instantaneously observable by the non-unionized army of pricing bots that work for Ken Griffin.

[00:01:44] These are tireless soldiers, posting bids and offers, waiting for response, trading, and then adjusting prices in iterative fashion.

[00:01:53] As Jack Burns said to the hapless Greg Fokker in Meet the Parents,

[00:01:57] Round and round we go, Greg.

[00:02:00] Umbrella discussions aside, the subject at hand is not the weather, though it has been rather tasty here in New York for, dare I say, an unrelenting stretch.

[00:02:09] Rather, the focus will be the market's risk climate and the insurance products that are readily available to navigate what could conceivably be an unwelcome turn of events.

[00:02:20] Specifically, over the next 2,000 words, I'll lay out the case for playing defense through optionality on the S&P 500.

[00:02:28] There's no investment advice coming your way, only the observations of someone who's seen a lot of market movies over the last three-plus decades.

[00:02:36] Let's start with a quick summary of the landscape.

[00:02:39] The S&P is at or very near an all-time high.

[00:02:43] It's been over a month since a down move greater than 1%.

[00:02:47] Two-week and one-month realized volatility are hovering both around 10.

[00:02:52] I say all the time that nothing bad in markets happens when realized vol is below 15.

[00:02:57] So why, then, is the VIX sitting here at 20?

[00:03:00] The election, of course, is keeping implied vol sustainably bid, yielding one of the highest vol risk premiums on record.

[00:03:07] The VIX was recently double one month realized.

[00:03:11] This isn't just a U.S. equity pricing phenomenon.

[00:03:14] It's visible in how the market prices rate an FX vol around the election and FOMC as well.

[00:03:20] In the TLT, for example, from November 1st to November 8th, implied vol jumps by almost five points.

[00:03:28] To give you an idea as to what this means for prices, the TLT, November 1st at the money straddle at 13.5 implied vol costs 2.4%.

[00:03:38] The November 8th straddle, using 18.2 implied vol costs 3.7%.

[00:03:44] If instead we use the same 13.5 vol to price the 11.8 straddle, the premium would be only 2.75%.

[00:03:54] That is, one week is worth 35 basis points in price in a flat term structure, but 130 basis points via the election and FOMC uncertainty.

[00:04:05] We see the same pricing structure visible in FX vol as well.

[00:04:10] Currently, one month implied vol in both the euro and yen trade at material premiums to two-week implied vol

[00:04:16] because the former catches the election and FOMC, but the latter does not.

[00:04:21] In a little more than a week, this will change because two-week implied vol will include November 6th and 7th.

[00:04:28] These very large risk premiums, the VIX trading double recent realized,

[00:04:33] are just not something that happens without an event on the calendar that investors view as highly consequential.

[00:04:40] I like to call these date certain macro events earnings days for a country.

[00:04:45] And what I mean by that is we see in the pricing of FX vol around Brexit or Euro stocks vol around the 2017 French election

[00:04:53] or S&P vol around the U.S. election, the same characteristics we see in the pricing of single stock vol ahead of a company's earnings dates.

[00:05:02] The main attribute is that implied vol remains elevated into the event even in the face of muted realized.

[00:05:09] A second attribute is that post-event implied vol falls.

[00:05:13] In 2016, one-month British pound vol peaked at 29, a week or so before the Brexit referendum.

[00:05:21] It would be less than half that a month later.

[00:05:24] That same year, the VIX reached 22.5 a few days prior to the U.S. election and finished the year at just 14.

[00:05:31] In the post-COVID environment of 2020, the VIX peaked at 40 a few days prior to Election Day.

[00:05:38] It finished the year at just 23.

[00:05:40] A couple of caveats are in order.

[00:05:42] On Brexit, folks quickly realized that not much was going to happen for a long time.

[00:05:47] On the 2016 election, the fears of Trump chaos quickly gave way to an embrace of the large corporate tax cut he championed.

[00:05:56] And in 2020, let's not forget that the Pfizer vaccine was announced, strangely, on November 9th,

[00:06:03] foaming the runway for back to work and blitzing Peloton in the process.

[00:06:08] To summarize, the pricing of uncertainty in each of these macro events has two consistent attributes.

[00:06:15] First, vol is high and rising relative to realized before the event.

[00:06:20] It's almost as if the option violates the normal, honest properties of theta.

[00:06:25] Its price simply does not decay as the event approaches.

[00:06:29] An option that doesn't lose value as time passes?

[00:06:32] Get out of here.

[00:06:33] It's actually not that far from the truth.

[00:06:36] I covered this recently in the special case of options on Fed Days.

[00:06:41] Check out the pod, 0DTE?

[00:06:43] No, 0TTE.

[00:06:46] What we're going to see over the next coming weeks are higher implied vols that reflect the passage of time,

[00:06:52] but little time decay in the price of options that expire on November 6th.

[00:06:56] And second, as the event uncertainty is cleared, vol has plenty of room to head lower,

[00:07:03] given the VRP that has built up and with nothing left on the calendar to keep it at lofty levels.

[00:07:09] Given this history, the 2024 playbook might be some combination of short straddles on the S&P,

[00:07:16] long VIX puts, and other trades that profit from a reduction in uncertainty.

[00:07:20] In 2020, amidst a very high post-COVID vol regime, there were large and I would argue very successful trades executed in VIX 1x2 put spreads

[00:07:31] that would ultimately profit from the post-election vol decline.

[00:07:35] I see a place for considering this same set of trades over the coming weeks.

[00:07:40] Even as history tells us to anticipate a higher market and lower vol once the election uncertainty clears,

[00:07:47] let me use what remains of our time together to make a case for protection.

[00:07:51] Ten years ago this week, on October 15th, 2014, the, quote, upcrash in the U.S. Treasury market occurred.

[00:08:00] Over the course of a very short period of time during the morning,

[00:08:03] the yield on the 10-year Treasury note plummeted by 37 basis points.

[00:08:08] Prices, which move inverse to yields, as the Wall Street Journal reminds us of, soared.

[00:08:14] There was no news out that one could really tie to the extreme move.

[00:08:19] Perhaps it's less scary when prices are shocked higher versus lower,

[00:08:23] but it's worth reflecting on these episodes of market malfunction.

[00:08:28] Continuous price discovery is something we largely take for granted.

[00:08:32] So much so that we build trading strategies around the assumption.

[00:08:36] A decade after the UST upcrash, the national debt has doubled to $35 trillion,

[00:08:42] and the buyer base has evolved somewhat away from central banks and towards cash futures arbitrage traders.

[00:08:49] There's no business plan from each party for righting the fiscal path.

[00:08:54] We probably need to add enormous, or in Trump's parlance,

[00:08:58] huge Treasury supply to death and taxes as the only guarantees in life.

[00:09:04] Speaking of Trump, he just reached 60% odds in polymarket.

[00:09:09] Clearly half the country is going to have what might be a near breakdown should he win.

[00:09:14] MSNBC hosts most certainly will.

[00:09:17] I often say that risk management suffers from the limitations of our imaginations.

[00:09:23] It's very difficult to forecast the election outcome and considerably more challenging

[00:09:28] to game out the complicated mix of actions and reactions the outcome may put in motion.

[00:09:33] The world, and certainly the ratings agencies, are aware of the combination

[00:09:37] of our impressive debt stack with no improvement in sight,

[00:09:41] along with the erosion of governance we are experiencing.

[00:09:44] The federal debt ceiling is reinstated the first day of next year.

[00:09:47] I think there's a real setup for insurance over the next two to three months, and here's why.

[00:09:53] First, if you are even close to benchmark to the S&P, you've got an easy budget for it.

[00:09:58] Spending some shekels on protection feels like Kamala's campaign team

[00:10:03] buying up ad space with the billion dollars she's raised.

[00:10:06] The S&P is up 24% year-to-date and is annualizing 30%.

[00:10:11] Throw in a 12.7 realized vol and a 5% short rate, we are at a 2-sharp ratio.

[00:10:17] It was Rick Ocasio from the cars that told us,

[00:10:21] let the good times roll.

[00:10:22] He followed up with, let them knock you around.

[00:10:26] Billy Joel told us, you're only human.

[00:10:28] You're supposed to make mistakes.

[00:10:30] I put these two classic songs together and believe that it's impossible to think straight

[00:10:35] about risk after running a 2-sharp.

[00:10:38] And here's the deal.

[00:10:39] By the way, as Joe Biden might say,

[00:10:41] the same beastly benchmark ran a sharp of around 1.6 in 2023.

[00:10:47] These are incredible risk-adjusted returns for any asset class,

[00:10:51] much less one that costs zero to access and can be unwound in a moment's notice.

[00:10:57] The S&P year-end 95.80 put spread costs 97 basis points.

[00:11:02] That's half as much as the S&P is up in October alone.

[00:11:06] The giant quarterly put spread collar on the S&P that just got rolled to the end of 2024

[00:11:11] has been a huge focus for the market.

[00:11:14] The trade out to D's 31st is long the 95.80 put spread,

[00:11:18] funded by the sale of a roughly 105% strike call.

[00:11:23] I love buying the 95.80 put spread.

[00:11:26] I'd refrain from selling the 105 call.

[00:11:29] Here's why.

[00:11:30] The S&P was up 21% through the first three quarters of this year.

[00:11:34] If we look back to 1990 for instances when the S&P was up at least 10% for the first three quarters

[00:11:41] and then look at the subsequent performance in Q4,

[00:11:44] we see an average return of 7%.

[00:11:47] Of 12 occurrences, 11 are positive.

[00:11:51] Trending markets continue to trend.

[00:11:53] In selling the December 31st 105 call at around 12.5 vol,

[00:11:58] you're shorting an extra 25 delta.

[00:12:00] That's not immaterial.

[00:12:01] You want to be long this market.

[00:12:04] And the 24% year-to-date gain easily affords you the budget to pay the less than 1% premium

[00:12:10] needed to get hold of the year-end 95.80 put spread.

[00:12:14] While there are plenty of sound reasons to implement a put spread collar on a mechanistic basis,

[00:12:19] I'd argue that in Q4 of 2024,

[00:12:22] offsetting that 1% premium with the call is not the best idea.

[00:12:26] What about pricing on the put spread?

[00:12:29] The three-month 95.80 SKU screens in the 99th percentile over the last two years and 94th percentile over the last five.

[00:12:37] You finally, thank you August 5th, get paid a little bit more to collect the vol SKU.

[00:12:43] Let me finish with a short, unofficial two-part hedging decision questionnaire.

[00:12:48] First, do I have gains to protect and a budget that easily pays for the insurance?

[00:12:54] Yes and yes, clearly.

[00:12:56] I'd add a sub-question here, which is,

[00:12:58] do I believe that when the good times do roll,

[00:13:01] we become vulnerable to being knocked around?

[00:13:05] I think that these incredible sharp ratios cloud our thinking on matters of risk.

[00:13:10] They leave us especially vulnerable.

[00:13:13] Second question, is the hedge a good deal?

[00:13:15] Here we can ask and answer the question in three ways.

[00:13:19] First, is the put spread price high or low in historical context?

[00:13:24] It's low.

[00:13:25] I looked at prices of a three-month 95.80 put spread recently

[00:13:29] and each of the last 10 years on this same date.

[00:13:32] Only 2017's gamma chokehold saw a lower premium than today's.

[00:13:38] Next, we can ask, does the trade carry well?

[00:13:41] By this, we invoke some comparison of realized to implied vol.

[00:13:45] The carry is not great, as we've cited the high vol risk premium.

[00:13:49] But given the stickiness of election vol,

[00:13:52] this premium should do a good job of holding at least until November 5th.

[00:13:57] This was the same argument I made for selling October VIX put spreads

[00:14:01] and successfully banking the premium.

[00:14:03] Of course, by using the put spread on the S&P,

[00:14:06] we are reducing the premium and decay risk of the hedge.

[00:14:10] Lastly, we should always be considering the value proposition of the hedge

[00:14:14] set against the forward-looking uncertainties.

[00:14:17] Is the trade a good deal when considered in this context?

[00:14:20] Here, I will argue absolutely.

[00:14:23] The November 5th, November 7th vol spread doesn't exist without good reason.

[00:14:28] The Fed meeting will conceivably come as the election results are not yet determined.

[00:14:33] An important lesson that markets consistently provide,

[00:14:36] but investors generally fail to heed,

[00:14:39] is the speed with which liquidity conditions can change.

[00:14:42] My portfolio is more liquid and diversified than I realized,

[00:14:46] said no one ever amidst a risk-off.

[00:14:48] We could or could not be barreling to such a circumstance.

[00:14:52] It's impossible to know.

[00:14:54] In most cases, the post-event vol declines and markets find a way to bounce.

[00:14:59] In that case, your 1% insurance fee won't matter.

[00:15:02] I like being long, but view the insurance as exceptional value given the known and unknown

[00:15:08] unknowns.

[00:15:09] Well, that's plenty for me.

[00:15:10] I do hope I've kept you interested.

[00:15:12] As I seek to grow the audience of listeners, your feedback,

[00:15:15] to the extent it is glowing and positive,

[00:15:18] is always appreciated.

[00:15:20] I'm kidding, of course.

[00:15:21] Kind of.

[00:15:22] I do sincerely wish you an excellent week.

[00:15:25] Let's keep trying to figure all this stuff out together.

[00:15:51] Thanks again, and catch you next time.