Three hundred odd years ago, Sir Isaac Newton told us that “no great discovery was ever made without a bold guess.” My sense is he didn’t have the order book in Emini futures in mind, but his words do translate well to our world of financial instruments. In this short pod, I revisit the events of August 5th, a day when prices normally well discovered went dark. The implications are real and we ought to learn from this short-lived but real episode of instability. As we approach the “4 E’s” – employment, earnings, the election and the easing cycle – there’s a good deal to consider with respect to playing defense in markets. I hope you find this interesting and useful.
[00:00:01] [SPEAKER_00]: Hello, this is Dean Curnutt and welcome to the Alpha Exchange.
[00:00:05] [SPEAKER_00]: Where we explore topics in financial markets associated with managing risk, generating return
[00:00:11] [SPEAKER_00]: and the deployment of capital and the alternative investment industry.
[00:00:20] [SPEAKER_00]: In markets, prices are discovered.
[00:00:22] [SPEAKER_00]: Emerging from the search for equilibrium is a price that sits right between the bid
[00:00:26] [SPEAKER_00]: and offer as supply and demand come into balance.
[00:00:29] [SPEAKER_00]: In a truly liquid market, the bid asks spread can be impossibly tight.
[00:00:34] [SPEAKER_00]: With truckloads of interest ready to buy just below that mid and similarly impressive
[00:00:39] [SPEAKER_00]: amount of selling interest just above it.
[00:00:42] [SPEAKER_00]: A quick glance at my trustee OMON page on the terminal shows me that the SPICE
[00:00:47] [SPEAKER_00]: of 10-6X-BRE-55 call is 2-Sense wide and that's with the S&P down 84 handles today.
[00:00:55] [SPEAKER_00]: Impressive.
[00:00:56] [SPEAKER_00]: Price discovery is a term like liquidity that is bandied about with frequency in the sport
[00:01:02] [SPEAKER_00]: of high finance.
[00:01:03] [SPEAKER_00]: Both are important.
[00:01:04] [SPEAKER_00]: More price discovery and greater liquidity strengthen markets.
[00:01:08] [SPEAKER_00]: Liquidity begets liquidity, as they say, and it's pretty difficult for a market to be
[00:01:13] [SPEAKER_00]: highly liquid if prices are not well-discovered.
[00:01:17] [SPEAKER_00]: 300 odd years ago, Suraisignut and told us that quote,
[00:01:20] [SPEAKER_00]: no great discovery was ever made without a bold guess.
[00:01:25] [SPEAKER_00]: My sense is he didn't have the orderbook and e-many futures in mind,
[00:01:29] [SPEAKER_00]: but his words do translate well to our world of financial markets.
[00:01:33] [SPEAKER_00]: In today's markets liquidity provision is highly electronefied.
[00:01:38] [SPEAKER_00]: In most every major market, the end user can boot up his or her laptop,
[00:01:43] [SPEAKER_00]: log on to a trading platform and have at it, buying and selling on a near 24-7 basis.
[00:01:49] [SPEAKER_00]: Prices are always, or at least almost always, they're to ponder, waiting to be acted upon.
[00:01:56] [SPEAKER_00]: Stocks, bonds, commodities and currencies, and now crypto, and don't forget, there are options
[00:02:01] [SPEAKER_00]: on all of them.
[00:02:03] [SPEAKER_00]: I put forth that the discovery of 99% of prices is achieved almost entirely by inference,
[00:02:09] [SPEAKER_00]: reducing the challenge of making Suraisignut's bold guess.
[00:02:13] [SPEAKER_00]: What do I mean?
[00:02:15] [SPEAKER_00]: Let's consider option pricing on the S&P 500.
[00:02:18] [SPEAKER_00]: At this point, there are countless strikes and explorations.
[00:02:22] [SPEAKER_00]: In September alone, there are 20 separate expiration dates, wondering how many business days
[00:02:27] [SPEAKER_00]: there are in September? Yep, 20. How about strikes? With the S&P at 5600 or so,
[00:02:34] [SPEAKER_00]: strikes run from as low as a thousand to as high as 7200. More than 250 of them.
[00:02:41] [SPEAKER_00]: Per day puts in calls. For the month of September,
[00:02:46] [SPEAKER_00]: well more than 10,000 put in call options will expire in the S&P alone.
[00:02:51] [SPEAKER_00]: One month in a single underlying asset, a smorgas board of instruments coming at you
[00:02:56] [SPEAKER_00]: inviting you to trade. That's a lot of prices to look after and, of course, beyond the capacity
[00:03:02] [SPEAKER_00]: of us mere mortals to keep track of without a giant assist from technology.
[00:03:07] [SPEAKER_00]: In options, the price discovery process starts with those that are close to the money and lie
[00:03:13] [SPEAKER_00]: in the expiration sweet spot. That's the initial bold guess required to start the process.
[00:03:19] [SPEAKER_00]: How to move from here to the giant matrix of prices across a wide swath of strikes and
[00:03:25] [SPEAKER_00]: expiration. Luckily, the smart folks at places like Jane Street know a little bit about
[00:03:30] [SPEAKER_00]: fair value in derivatives and are adept at constructing models that capture the entire
[00:03:35] [SPEAKER_00]: of all surface. Once the first price is discovered, the math geeks and their trusty machines take over from
[00:03:42] [SPEAKER_00]: there. In the multi-dimensional world of derivatives, thousands of strike prices and expiration
[00:03:48] [SPEAKER_00]: dates, these prices are so voluminous, so instantaneous that it's a good bet that we take the discovery
[00:03:55] [SPEAKER_00]: process for granted. These prices live and breathe so consistently alongside us, they almost
[00:04:01] [SPEAKER_00]: surely impact how we think of what we believe. As Cliff has not said many times in his work on
[00:04:07] [SPEAKER_00]: volundering, private equity and credit appear to have embraced the Sharper Asia enhancement
[00:04:13] [SPEAKER_00]: associated with not being sure where prices really live. We don't know, so we use last month's
[00:04:20] [SPEAKER_00]: estimates said the PE Han show feeling ignorance was bliss amidst a 7% market spoon. But it should
[00:04:28] [SPEAKER_00]: clear that knowing where you can liquidate or add to positions is highly desirable. Of two
[00:04:33] [SPEAKER_00]: portfolios with similar risk and return characteristics, we should favor perhaps by a considerable
[00:04:39] [SPEAKER_00]: amount, the one with the capacity to be unwound in a hurry. Why all this broad, almost philosophical
[00:04:47] [SPEAKER_00]: discussion on price discovery you ask? Listeners of this podcast will not be surprised that August 5th
[00:04:54] [SPEAKER_00]: is still very much on my mind. And it is the breakdown of price discovery in the central insurance
[00:05:01] [SPEAKER_00]: market, options on S&P 500 that we ought to remain vigilant on. A month after this consequential
[00:05:08] [SPEAKER_00]: episode of market disruption, if market prices are any indicators no one is really listening.
[00:05:15] [SPEAKER_00]: Over the last 10 days of August, the S&P realized just about 10. Sit on a beach with a book
[00:05:21] [SPEAKER_00]: enjoy a poolside cocktail in lobster roll, play a light round of golf or fire up the Bloomberg
[00:05:27] [SPEAKER_00]: terminal and throw some ships at insurance. Maybe better to engage post-labor day. Understandable
[00:05:33] [SPEAKER_00]: but don't wait too long. Let's take a spin of where we are in the POV. Price of all that is,
[00:05:40] [SPEAKER_00]: if we compare the price of one month options on the S&P as of the close of August versus the
[00:05:46] [SPEAKER_00]: end of July, we see some pretty fascinating changes. Both 10% out of the money put and call
[00:05:51] [SPEAKER_00]: vol is essentially unchanged. But at the money vol was down 4. That's material and makes the setup
[00:05:58] [SPEAKER_00]: for a simple trade like an index put spread quite favorable. Bloomberg is telling me that at the
[00:06:04] [SPEAKER_00]: money down 10, vol skew is in the 95th percentile over the last two years. The changes in this skew
[00:06:12] [SPEAKER_00]: make sense to me. Even as the S&P did rally by 2.3 percent in August, that first Monday was a
[00:06:18] [SPEAKER_00]: dozee for those folks charged with managing tail scenarios. Thus, the far out of the money options
[00:06:23] [SPEAKER_00]: by 10% or more have not seen any real vol decline from a month earlier even as they've taken
[00:06:30] [SPEAKER_00]: at the money vol in lower by a fair amount. When at the money vol declines but the wing vol
[00:06:36] [SPEAKER_00]: as they say and referring to out of the money options does not decline put and call spread pricing
[00:06:42] [SPEAKER_00]: benefits. 30 years ago right around this time I took Jean Phamma's extremely impactful analytical
[00:06:49] [SPEAKER_00]: finance class at the University of Chicago. He had lots of one lineers about markets, two of them.
[00:06:56] [SPEAKER_00]: All models are false but that doesn't mean they're not useful. And related, we don't get to see
[00:07:02] [SPEAKER_00]: true distribution of returns in markets. On the second one, he means that we observe just a slice
[00:07:08] [SPEAKER_00]: of returns that we've recorded from the past. We have no idea what's coming. We don't see the true
[00:07:15] [SPEAKER_00]: distribution of asset returns. An example I always use is in back-testing a tail hedging strategy
[00:07:21] [SPEAKER_00]: at the end of 2016. You would have no idea that 2017 would see the S&P realized below 7 for the
[00:07:29] [SPEAKER_00]: entire year and the VIX closed below 10 more than 50 times. On the flip side, if you were sizing
[00:07:36] [SPEAKER_00]: and stress testing a vol selling program at the end of 2019, you were unaware that an 81
[00:07:42] [SPEAKER_00]: VIX and 3 successive 9% daily moves in the S&P were coming your way a few months later in March
[00:07:50] [SPEAKER_00]: of 2020. So we will never see the true distribution. We just observe an empirical slice of the past.
[00:07:59] [SPEAKER_00]: But 2017 and 2020 help inform us about the boundaries of all both low and high. With this in
[00:08:06] [SPEAKER_00]: mind, August 5th of 2024 should teach us something about the tails in the S&P. These events of
[00:08:13] [SPEAKER_00]: disruption are valuable even if they are short-lived because we gain important information as to
[00:08:18] [SPEAKER_00]: what it takes to destabilize the system. I for one was surprised that it took so little. We should
[00:08:25] [SPEAKER_00]: always be thinking about how market price changes are a function of some combination of new
[00:08:30] [SPEAKER_00]: information and the positioning setup. If a market receives bad news but was already set up quite
[00:08:36] [SPEAKER_00]: long protection, perhaps vol isn't going to pop. In sharp contrast, sometimes new news that doesn't
[00:08:43] [SPEAKER_00]: appear all that important will matter because the market was set up very short-vol or underhaged
[00:08:49] [SPEAKER_00]: before. With the importance of the overlay of financial products in mind, let's talk a little
[00:08:55] [SPEAKER_00]: bit about the universe of derivatives built around the S&P 500 options complex. It is a vast space
[00:09:02] [SPEAKER_00]: to say the least with products both lit and dark. There are ETFs systematic products delivered on
[00:09:09] [SPEAKER_00]: swap in the vast universe of QIS, mutual funds and insurance products. Each of these instruments
[00:09:15] [SPEAKER_00]: sits on either the supplier demand side for volatility through their buying and selling activities
[00:09:20] [SPEAKER_00]: in options on the S&P 500. An open question will always be whether the products themselves
[00:09:26] [SPEAKER_00]: played several in the destabilization of August 5. One thing is abundantly clear. Deep out of the
[00:09:33] [SPEAKER_00]: money puts on the most important insurance market in finance on the S&P 500 index were in short supply
[00:09:40] [SPEAKER_00]: when they were needed most. The market, at least temporarily, broke. It's been very interesting
[00:09:47] [SPEAKER_00]: to observe some of the changes in the VIX ETP landscape recently. Assets in both the SVXY and
[00:09:54] [SPEAKER_00]: SVIX surged post the VIX spike on August 5. This appears to have been opportunistic buying after a
[00:10:02] [SPEAKER_00]: market sell-off, an investor's likely sensed that a 38 VIX was out of bounds versus the general
[00:10:08] [SPEAKER_00]: state of the market risk. They were correct. A topic that gets some coverage in the
[00:10:17] [SPEAKER_00]: VIX will rise for a given decline in the S&P. This beta is a function of a number of factors,
[00:10:24] [SPEAKER_00]: the shape of the VAL surface matters a lot. A very flat skew as was the case for most of 2022
[00:10:30] [SPEAKER_00]: leaves less room for the VIX to move up or down as the S&P 500 moves. A second factor may simply
[00:10:37] [SPEAKER_00]: be fun flows. Back in the VIX ETP heyday of 2016 and 2017, these products like SVXY and XIV were
[00:10:48] [SPEAKER_00]: very large and aggressively traded. Lots of notional value traded each day back then. The SVXY
[00:10:55] [SPEAKER_00]: emotional value traded in 2023 and 2024 through the end of July is roughly 10 to 15 percent
[00:11:03] [SPEAKER_00]: of what it was before the XIV crash in Feb 18. Versus 2016 in 2017, the VAL of daily fun flows
[00:11:11] [SPEAKER_00]: is consistently and considerably smaller recently versus other comparable periods when assets
[00:11:17] [SPEAKER_00]: were the same in the SVXY. There's likely some relationship here to the Muted VIX beta. In this case
[00:11:25] [SPEAKER_00]: money moving in and out can play a role in moving the VIX around. It's generally the case that
[00:11:31] [SPEAKER_00]: the ETP simply reflects the performance of the underlying VIX features trading strategy, but in
[00:11:37] [SPEAKER_00]: tailwagging the dog fashion if the ETPs and the fun flows around them are big enough they create
[00:11:43] [SPEAKER_00]: distortions that can yield a higher VIX beta. It could be the case that the pop in the VIX ETP
[00:11:49] [SPEAKER_00]: assets under management recently is just a one-off, but it's going to be interesting to see if
[00:11:54] [SPEAKER_00]: products get some new life. SVXY traded 14 million shares on August 5th. S. VIX traded 29 million,
[00:12:03] [SPEAKER_00]: even since the volumes are up quite a bit versus before August 5th. I'd like to close out this
[00:12:08] [SPEAKER_00]: discussion with some thoughts on the relative stance of equity VAL an interest rate VAL. We've
[00:12:13] [SPEAKER_00]: had periods when the move to VIX ratio was especially low, think 2021, the meme episode, which caused
[00:12:21] [SPEAKER_00]: a tremendously high VIX even as rate VAL was pinned to the floor by the Fed. We've also had
[00:12:26] [SPEAKER_00]: the opposite, a relatively tame VIX and high move. The SVB period in 2023 is an example. Currently
[00:12:34] [SPEAKER_00]: the ratio is in the 40th percentile over the last two years and 60th percentile over the last three
[00:12:40] [SPEAKER_00]: years. So let's call it middle of the road. Now this is going to be geek alert stuff, but we can
[00:12:45] [SPEAKER_00]: even more by observing the VAL of these implied vol indices. If we were to consider the realized
[00:12:53] [SPEAKER_00]: VAL, both the move and VIX, we would see that the VIX is low VAL high VAL recently with August
[00:13:00] [SPEAKER_00]: 5th of course driving the action. On the right side, the move is in the 83rd percentile over the last
[00:13:07] [SPEAKER_00]: 10 years but it's also been very stable at this high level. Over the past year, the move is almost
[00:13:13] [SPEAKER_00]: always between 90 and 130. That spread amounts to just two to three bases point today in implied
[00:13:19] [SPEAKER_00]: rate changes. So this is more high VAL low VAL as rates come down, there's downward pressure on
[00:13:27] [SPEAKER_00]: the move. There is a statistically positive relationship between the level of rates in the level
[00:13:32] [SPEAKER_00]: of rate VAL. Think post GFC lower forever regime and also the post COVID commitment to zero through
[00:13:39] [SPEAKER_00]: 2021. But it's likely the case as well that there's only so much downside in the move given how
[00:13:46] [SPEAKER_00]: large and unwieldy the US government bond market is. As part of this, there's been a shift from
[00:13:52] [SPEAKER_00]: a price insensitive to price sensitive buyer base in a recognition that prices can gap out
[00:13:59] [SPEAKER_00]: in this theoretically risk-free asset class. My passion for VAL events has me looking forward to the
[00:14:09] [SPEAKER_00]: October 15th 2014. More to explore there. Well, I've breached my 2000 word limit and that's it for
[00:14:17] [SPEAKER_00]: me for now. As folks get back into their seats post labor day, there are lots of questions
[00:14:22] [SPEAKER_00]: beginning with E coming our way about earnings employment, the easing cycle and the election
[00:14:27] [SPEAKER_00]: among them. It's going to be an incredibly interesting next four months. I wish you the best.
[00:14:34] [SPEAKER_00]: You've been listening to the Alpha Exchange. If you've enjoyed the show, please do tell a friend.
[00:14:40] [SPEAKER_00]: And before we leave, I wanted to invite you to drop us some feedback. As we aim to utilize these
[00:14:45] [SPEAKER_00]: conversations to contribute to the investment communities understanding of risk,
[00:14:49] [SPEAKER_00]: your input is valuable and provides direction on where we should focus. Please email us at feedback
[00:14:55] [SPEAKER_00]: at alphaextrangepodcast.com. Thanks again and catch you next time.