What a week in markets and one that should give us a lot to chew on with respect to how and why risk episodes materialize. There are certainly some conclusions at the ready and first and foremost is that vol is the only anti-fragile asset. In the trading action on Monday, August 5th, we see the reflexive nature of vol exposures and the manner in which asymmetric outcomes can result. In this short podcast, I share some of what’s on my mind in trying to uncover the “why” of these seismic moves. Out of this, you’ll hear some of my thoughts on product innovation and market liquidity structure. I hope you find it useful.
[00:00:01] [SPEAKER_00]: Hello, this is Dean Curnutt and welcome to the Alpha Exchange where we explore topics in financial markets
[00:00:08] [SPEAKER_00]: associated with managing risk,
[00:00:10] [SPEAKER_00]: generating return and the deployment of capital in the alternative investment industry.
[00:00:19] [SPEAKER_00]: Weekends give us market folks time to reflect and no better time to do so than when we've just experienced some small version of history with regard to risk.
[00:00:29] [SPEAKER_00]: I say small because the equity market fell only modestly.
[00:00:32] [SPEAKER_00]: I say history because the Nikkei experienced consecutive 10% moves and the VIX surpassed 50 during normal market trading hours.
[00:00:41] [SPEAKER_00]: In the 15 minutes that follow, I'll share some thoughts from the vantage point of a podcaster who's seen his share of market movies over the years.
[00:00:50] [SPEAKER_00]: First, let us establish that we are all trying to connect the dots in markets.
[00:00:54] [SPEAKER_00]: Something happens and we are drawn and dare I suggest paid to explain why.
[00:00:59] [SPEAKER_00]: While it's understandable, we surely overindulge in ascribing a cause to the effect we observe and experience.
[00:01:07] [SPEAKER_00]: Too often price action becomes the primary factor that animates the story we construct to answer the question at hand, namely why.
[00:01:16] [SPEAKER_00]: With this in mind and utilizing what I think are the two largest outlier price moves, here are two basic questions.
[00:01:23] [SPEAKER_00]: First, why did the Nikkei move so much?
[00:01:26] [SPEAKER_00]: What role did positioning and leverage going into the weak play?
[00:01:30] [SPEAKER_00]: What role did mechanical price reinforcing strategies like derivatives play?
[00:01:34] [SPEAKER_00]: What can we conclude about yen financed speculation in markets?
[00:01:39] [SPEAKER_00]: What about currency equity market dynamics and correlations in Japan?
[00:01:43] [SPEAKER_00]: Second, why did the VIX move so much?
[00:01:46] [SPEAKER_00]: What caused liquidity in the underlying S&P option market to dry up so much?
[00:01:52] [SPEAKER_00]: How should we think about the role played by the landscape of options based ETFs and mutual funds?
[00:01:58] [SPEAKER_00]: Zero DTEs, leveraged ETFs and other lit strategies that have grown so much in the past few years.
[00:02:05] [SPEAKER_00]: What role might QIS driven exposures have played?
[00:02:08] [SPEAKER_00]: The vast growth of street geek engineered products has leaned considerably more on generating carry than in paying it away.
[00:02:15] [SPEAKER_00]: Both questions are well worthy of exploring.
[00:02:18] [SPEAKER_00]: Sure, the NFP was soft and expectations that the long-awaited Fed easing cycle is a done deal have solidified recently.
[00:02:26] [SPEAKER_00]: But two moves north of 10% in a developed market country stock index?
[00:02:31] [SPEAKER_00]: In a row?
[00:02:32] [SPEAKER_00]: So here's the TLDR.
[00:02:34] [SPEAKER_00]: It's the economy stupid ought to be updated to reflect the reality that the trades that live and breathe in the market matter a lot.
[00:02:42] [SPEAKER_00]: It's the exposures, stupid.
[00:02:44] [SPEAKER_00]: It's impossible to get away from trying to uncover the why of successive 10% moves in the Nikkei and the surge in other risk measures.
[00:02:53] [SPEAKER_00]: We know that the normal distribution doesn't come close to adequately describing the empirical returns for assets like equities.
[00:03:00] [SPEAKER_00]: But even if we account for very fat tails, we've got moves really inconsistent with what a statistical model could account for.
[00:03:09] [SPEAKER_00]: If the Nikkei was a 20 vol asset, it's one month implied vol a few days ago, the odds of even one of these moves amounts to seven plus standard deviations.
[00:03:19] [SPEAKER_00]: As Ace Rothstein said in Casino, it could not happen, it would not happen.
[00:03:25] [SPEAKER_00]: Again, we know the normal distribution fails to explain the tails, but jeez.
[00:03:30] [SPEAKER_00]: With this as the backdrop, I'd like to share a few things that the unruly market action the last few days should remind us of.
[00:03:37] [SPEAKER_00]: First, vol is the only antifragile asset.
[00:03:41] [SPEAKER_00]: It's somewhat tautological to say so, but nothing benefits from disorder like vol does.
[00:03:47] [SPEAKER_00]: Vol is the price index of chaos.
[00:03:50] [SPEAKER_00]: When chaos erupts, its price index soars along with it.
[00:03:54] [SPEAKER_00]: Vol is especially reflexive as well.
[00:03:58] [SPEAKER_00]: And I've covered this concept a fair amount.
[00:04:00] [SPEAKER_00]: How is it reflexive?
[00:04:02] [SPEAKER_00]: The market's collective attempt to insulate itself from chaos raises the price of the insurance contracts providing said insulation.
[00:04:11] [SPEAKER_00]: In the process, the risk structure of the market is recalibrated.
[00:04:15] [SPEAKER_00]: Its exposures, at least some of them are marked to market, often in a punishing way.
[00:04:20] [SPEAKER_00]: The market's attempt to find new equilibrium prices is sometimes complicated by the destabilization that it may bring.
[00:04:27] [SPEAKER_00]: When capital that ensures very unforeseen events suffers heavy losses, you have the makings of a truly reflexive market meltdown.
[00:04:37] [SPEAKER_00]: As we argue that vol is the only antifragile asset, let's have a look at the recent history of the VIX SEP 30 call.
[00:04:44] [SPEAKER_00]: With trailing one month realized vol in the S&P at 6.5, this option contract closed at 45 cents on July 5th.
[00:04:53] [SPEAKER_00]: It would soar to as high as $9 intraday a month later on Monday, August 5th.
[00:05:00] [SPEAKER_00]: Not only did vol explode but vol of vol did as well.
[00:05:04] [SPEAKER_00]: Second and on the flip side of antifragility, liquidity can be a mirage as Eli Ryan has said.
[00:05:11] [SPEAKER_00]: Today's markets in which price discovery is especially electronified leave investors vulnerable to the sudden disappearance of liquidity
[00:05:20] [SPEAKER_00]: as the models that generate prices simply pull away based on an instantaneous mathematical read that a higher vol environment has emerged.
[00:05:29] [SPEAKER_00]: You can provide tighter liquidity during normal times if you can change your mind at a moment's notice.
[00:05:36] [SPEAKER_00]: These engines of modern day electronic liquidity bear no resemblance to the relationship heavy interaction between a salesperson, his trader and his client.
[00:05:45] [SPEAKER_00]: The electronic liquidity pool is nameless faceless and has no ongoing relationship with a counterparty.
[00:05:52] [SPEAKER_00]: With this in mind, why did the liquidity in the VIX and most importantly, the liquidity in the underlying S&P options market break down so much?
[00:06:02] [SPEAKER_00]: It's a question we should really be exploring.
[00:06:05] [SPEAKER_00]: Third, we are reminded of the quote butterfly effect in markets.
[00:06:09] [SPEAKER_00]: This means that small changes in markets can become big ones.
[00:06:13] [SPEAKER_00]: From a risk management perspective, I take it to mean that you need to understand who's alongside you in a trade into what degree.
[00:06:21] [SPEAKER_00]: Their problems and other exposures can become headaches for you.
[00:06:25] [SPEAKER_00]: Should those losses force them out of your trade?
[00:06:28] [SPEAKER_00]: See LTCM in 98, Emerith in 2006, the Quantquake in 2007 and the London Whale in 2013 for instances where you had to be very careful who was alongside you.
[00:06:41] [SPEAKER_00]: In the last week, we have to wonder about the linkages between these markets and the potential that trouble in one asset class or trade structure made its way into other exposures.
[00:06:52] [SPEAKER_00]: Fourth, it's important to remember based on the recent tumult that the correlation of vol is not your friend.
[00:06:59] [SPEAKER_00]: While there's always a worst one, carry trades generally get hurt at the same time.
[00:07:05] [SPEAKER_00]: The vols are correlated.
[00:07:07] [SPEAKER_00]: Don't think you are especially diversified across assets and geographies in carry trades.
[00:07:12] [SPEAKER_00]: These trades tend to make or lose money during similar environments for similar reasons, and that is they hinge on the perpetuation of sameness.
[00:07:20] [SPEAKER_00]: These are anti-change exposures.
[00:07:23] [SPEAKER_00]: When something happens that requires the market to reprice itself, carry gets hurt.
[00:07:28] [SPEAKER_00]: The lesson is not to expect a whole lot of diversification in carry.
[00:07:33] [SPEAKER_00]: Lastly, the price actions should remind us that the vol of correlation is also not your friend.
[00:07:40] [SPEAKER_00]: When markets experience a shock, correlation relationships can shift massively, rendering your earlier assumptions wrong.
[00:07:48] [SPEAKER_00]: The one month correlation of the VIX to the DXY was running positive 40% recently.
[00:07:54] [SPEAKER_00]: Dollar increases tend to be correlated with the VIX rising.
[00:07:59] [SPEAKER_00]: It just went to negative 40%.
[00:08:01] [SPEAKER_00]: Our recent experience in how assets interact with each other very much shapes our distributions and how we price things.
[00:08:09] [SPEAKER_00]: Let's take the incredibly low level of realized correlation amongst stocks in the S&P.
[00:08:14] [SPEAKER_00]: I've been banging the drum hard that this was unsustainable, and as such had important implications for volatility at the index level.
[00:08:22] [SPEAKER_00]: I argued that the best way to buy this correlation was to buy 10% out of the money puts out to year end on the S&P,
[00:08:28] [SPEAKER_00]: which as of the middle of 2024 cost a whopping 110 basis points.
[00:08:35] [SPEAKER_00]: Let's review the price drivers, direction, time, vol, and skew.
[00:08:39] [SPEAKER_00]: The market is down just over 2% since mid-year.
[00:08:43] [SPEAKER_00]: More than a month has passed stealing some of the time value of the option.
[00:08:47] [SPEAKER_00]: And most notably vol and skew are substantial drivers of the price increase.
[00:08:52] [SPEAKER_00]: Even as the S&P is down only modestly since mid-year, these puts have nearly doubled in value despite more than a month passing.
[00:09:02] [SPEAKER_00]: I alluded to the sub 7% one month realized S&P vol that was the case by mid-year.
[00:09:08] [SPEAKER_00]: At the same time, the one day VIX had several closes with seven handles.
[00:09:13] [SPEAKER_00]: Last week by sharp contrast, we saw the highest close just a shade below 40
[00:09:19] [SPEAKER_00]: for this measure outside of days prior to CPI and FOMC in late 2022.
[00:09:26] [SPEAKER_00]: This was a stretch when inflation was both high and volatile and the Fed was tightening.
[00:09:31] [SPEAKER_00]: Let's develop some intuition on why the VIX one day index got so well bid.
[00:09:37] [SPEAKER_00]: We can think of previous vol spikes in the VIX 1D as a function of the quote calendar effect.
[00:09:43] [SPEAKER_00]: That is when the market sees a date on the calendar with an event that has consequence for an asset price,
[00:09:48] [SPEAKER_00]: it prices the uncertainty into options, earnings, OPEC meetings, FOMC meetings,
[00:09:55] [SPEAKER_00]: referendums like Brexit, CPI and FPM, November 5th of 2024.
[00:10:01] [SPEAKER_00]: These are all date certain events on the calendar that the market can see in advance and price in advance.
[00:10:08] [SPEAKER_00]: The market will pay considerably more for options that expire the day or a few days after these events.
[00:10:15] [SPEAKER_00]: This demand is driven by the empirical observation that realize volatility of a stock
[00:10:20] [SPEAKER_00]: is three to five times higher on earnings days versus non earnings days.
[00:10:26] [SPEAKER_00]: The market prices, what are the experiences?
[00:10:29] [SPEAKER_00]: Macro events on the calendar have become the equivalent of an earnings day for the S&P 500.
[00:10:35] [SPEAKER_00]: Realized moves on CPI days in 2022 got really high at the index level.
[00:10:40] [SPEAKER_00]: Two to five percent moves became common.
[00:10:44] [SPEAKER_00]: As inflation has slowed and looks to be cooperative, the CPI day premium has fallen markedly.
[00:10:49] [SPEAKER_00]: So why did the VIX 1D close at 39.4 on Monday, August 5th?
[00:10:55] [SPEAKER_00]: The answer lies in two effects from my 5Cs framework and those are carry and capital.
[00:11:02] [SPEAKER_00]: That is the huge move in the S&P justified such a high level
[00:11:06] [SPEAKER_00]: because vol traders can extract profits from the moves through long gamma.
[00:11:11] [SPEAKER_00]: High premiums and high implied volatility can be paid for options because the swings in the S&P
[00:11:17] [SPEAKER_00]: create sizable profits from trading in the underlying and re-hedging the option delta.
[00:11:23] [SPEAKER_00]: Carry is just a smart sounding way of comparing realized to implied vol.
[00:11:28] [SPEAKER_00]: Higher realized vol inevitably, but certainly not precisely,
[00:11:32] [SPEAKER_00]: will increase the demand for options in the implied vol along with it.
[00:11:36] [SPEAKER_00]: The VIX itself closed at 38.6 on August 5th.
[00:11:41] [SPEAKER_00]: One month at the money implied vol on the S&P closed at 29.
[00:11:46] [SPEAKER_00]: As a rough rule of thumb, you need something like a 1.75% move in the index each day to justify
[00:11:52] [SPEAKER_00]: that level. Note there are a myriad of other factors that matter as well,
[00:11:57] [SPEAKER_00]: but to manufacture the trading profits on a long vol position associated with 29 vol
[00:12:03] [SPEAKER_00]: in the premium attached to it, the index needs to move by nearly 100 handles a day.
[00:12:10] [SPEAKER_00]: That is a lot. But of course that's just an average.
[00:12:14] [SPEAKER_00]: Market returns are fat-tailed. It's more apt to suggest that the 100 handles
[00:12:19] [SPEAKER_00]: represents some pricing of a move 2-4 times that in a given day
[00:12:23] [SPEAKER_00]: along with more moves that are much smaller.
[00:12:26] [SPEAKER_00]: Michael Rourke from Jones Trading has said that quote, broken markets break down.
[00:12:31] [SPEAKER_00]: I've always liked that. And that brings us naturally to talk about the second C, capital.
[00:12:37] [SPEAKER_00]: Prices are simply the level at a moment in time when the capital supplied to sell
[00:12:43] [SPEAKER_00]: overlapped with the capital that demanded to buy.
[00:12:46] [SPEAKER_00]: The market tumult originating in Asia but having global impact appears by all
[00:12:51] [SPEAKER_00]: accounts to have created a material supply demand imbalance in the market for S&P options
[00:12:57] [SPEAKER_00]: and the product suites like the VIX built on top of it.
[00:13:01] [SPEAKER_00]: I mentioned that the VIX closed at 39 but one month at the money implied vol closed at 29
[00:13:06] [SPEAKER_00]: on August 5th. That's a huge discrepancy and gets to the challenges in getting
[00:13:11] [SPEAKER_00]: fair prices in the VIX when liquidity in the underlying product, namely deep
[00:13:16] [SPEAKER_00]: out of the money S&P options is compromised. The question for which I have no definitive answer is
[00:13:23] [SPEAKER_00]: why was it so compromised?
[00:13:25] [SPEAKER_00]: Market prices are equally a cause and effect. They are the ladder in that they respond to what
[00:13:30] [SPEAKER_00]: investors do. But now it's more important to consider the role of price as approximate cause
[00:13:36] [SPEAKER_00]: to wit, the VIX of the VIX i.e. the VIX went absolutely haywire last week.
[00:13:42] [SPEAKER_00]: If the VIX overreacted to the move in the S&P then the VIX overreacted to the move in the VIX.
[00:13:49] [SPEAKER_00]: Putting these together, the S&P is down just 4% from mid-year to August 5th and the VIX was up
[00:13:55] [SPEAKER_00]: 220% over that same time period. There is a giant ecosystem of exposures built on shortfall
[00:14:02] [SPEAKER_00]: that suffered last week. First how about the leveraged single stock ETF products?
[00:14:07] [SPEAKER_00]: Ticker NVDL has quote just 3.6 billion in assets under management. This is a two
[00:14:14] [SPEAKER_00]: times levered product on NVIDIA. There's a lot of this stuff around. Remember, both the leveraged
[00:14:20] [SPEAKER_00]: long and leveraged short products reinforce price in the same direction. On the Bloomberg page,
[00:14:27] [SPEAKER_00]: set up your autofill and type 3x and see the enormous table that shows as a result.
[00:14:33] [SPEAKER_00]: There are a lot of these leveraged funds around. Consider as well NVDY, the NVIDIA Overriding Fund.
[00:14:41] [SPEAKER_00]: It's short the August 122 call on NVIDIA. The implied vol of that call surged from 50 to
[00:14:48] [SPEAKER_00]: as high as 70 recently. As the stock swooned and vol ramps, the delta of the call falls by less
[00:14:55] [SPEAKER_00]: than it otherwise would have if the vol was stable. Thus, the overall long stock short
[00:15:00] [SPEAKER_00]: fall package is behaving more like the stock than you'd want it to on the way down,
[00:15:05] [SPEAKER_00]: something that's unappealing. None of this is meant to be alarmist but rather an appreciation of the
[00:15:11] [SPEAKER_00]: vast ecosystem of trades that have been concocted within the market especially with the advent
[00:15:16] [SPEAKER_00]: of derivatives with any ETFs and the explosive growth of daily reset products. And when the
[00:15:22] [SPEAKER_00]: core hedging instrument for risk assets around the world, the S&P options market becomes
[00:15:28] [SPEAKER_00]: dislocated when those who make the prices either cannot or will not make them, everything else
[00:15:34] [SPEAKER_00]: is impacted by pricing proxy. If we can't price S&P vol, odds are strong that we can't price
[00:15:41] [SPEAKER_00]: the August 122 call on NVIDIA either. There are two competing forces in volatility right now.
[00:15:47] [SPEAKER_00]: First, vol has memory. Second, vol mean reverts. As the market tries to find a new equilibrium
[00:15:54] [SPEAKER_00]: level for asset prices consistent with the new information it now has, some disorder is typical.
[00:16:01] [SPEAKER_00]: That's the memory part. It's also the case that our markets are structurally short vol and liquidity.
[00:16:07] [SPEAKER_00]: So when the former spikes in the latter plummets, there's a certain get out of the way behavior
[00:16:11] [SPEAKER_00]: that sometimes causes vol to overshoot to the upside. We got a real taste of this this past
[00:16:16] [SPEAKER_00]: week. As I've reached my 2000 word limit, let me conclude by saying that markets provide us
[00:16:22] [SPEAKER_00]: with constant opportunity to make mistakes and learn from them. As I've been pounding the table that
[00:16:27] [SPEAKER_00]: low vol correlation and implied vol-a-vol made for some very convex trade opportunities,
[00:16:32] [SPEAKER_00]: I did not anticipate just how off sides US markets and especially the S&P vol market was
[00:16:38] [SPEAKER_00]: set to become. It's a real reminder that you've got to push yourself to entertain scenarios
[00:16:44] [SPEAKER_00]: that are difficult to imagine as part of your risk management process. Until next time, have a
[00:16:52] [SPEAKER_00]: exchange. If you've enjoyed the show, please do tell a friend and before we leave, I wanted to
[00:16:57] [SPEAKER_00]: invite you to drop us some feedback as we aim to utilize these conversations to contribute to the
[00:17:02] [SPEAKER_00]: investment community's understanding of risk. Your input is valuable and provides direction
[00:17:07] [SPEAKER_00]: on where we should focus. Please email us at feedback at alphaexchangepodcast.com.
[00:17:14] [SPEAKER_00]: Thanks again and catch you next time.