ODTE? No, OTTD!

[00:00:01] Hello, this is Dean Curnutt and welcome to the Alpha Exchange.

[00:00:06] Where we explore topics in financial markets associated with managing risk, generating return

[00:00:11] and the deployment of capital in the alternative investment industry.

[00:00:20] It's the Monday after the week when the Fed went 50.

[00:00:23] There was at least someone certainty about the decision before 2 p.m. last Wednesday.

[00:00:28] The war per page on the terminal, world interest rate probability, had to have been

[00:00:32] summoned countless times by streetfighters seeking guidance for Mr. Market.

[00:00:37] It said that Pal himself became so fixated on the betting odds and so familiar with this

[00:00:42] Bloomberg nemonic that he created his own cheat code.

[00:00:46] For Pal, Warp became what I really prefer.

[00:00:49] And that my friends was 50 basis points.

[00:00:52] Never mind that inflation's above target, or that IG credit spreads were in the 5th percentile

[00:00:58] or that financial conditions were already very easy.

[00:01:01] For J.P., the old risk management added is not hedge when you can, not when you have to,

[00:01:06] but rather ease when you can, not when you have to.

[00:01:10] 50 in the books and presumably more to come.

[00:01:13] The market until presented with further evidence on economic weakness was left to do what

[00:01:18] it must, react to the Fed's reaction.

[00:01:21] Gold Bitcoin, the S&P up, Val lower, nothing really out of bounds.

[00:01:26] Warp, what I really prefer, Pal was heard muttering with satisfaction to himself,

[00:01:32] marking his own fresh VXX shorts to the market outcome he created, contemplating the beauty of

[00:01:38] positive carry. Come on, I'm just kidding. Sort of.

[00:01:42] But let's take stock of the post-fed prices we see in what they mean.

[00:01:46] Sit back, please, for 15 minutes and 2,000 words and maybe, just maybe, I'll have given you

[00:01:52] a good or two of useful guidance. And if not, let's seek out at least one chuckle, a chortle,

[00:01:58] a giggle, a T.H. in the words of George Costanza.

[00:02:02] Let's start with some commentary on the S&P 5630 strike September 18th Strattle.

[00:02:10] Inspiring on Fed Day, this combination of put-and-call options had very unique risk characteristics

[00:02:16] over the course of the day, with distinct behavior from the 930 AM open to the 2pm announcement

[00:02:24] versus after the decision. At this point we are all very familiar with 0DTE, 0 days to expiration

[00:02:32] options. These ultra short dated hits of dopamine come and go in the blink of an eye.

[00:02:38] They have all kinds of gamma and the Greeks come right at you. The morning of Fed Day,

[00:02:43] that set 18th, 5630 put-and-call combo was 0DTE. On a normal non-Fed Day, this straddle would need

[00:02:52] a quick and decisive move in the S&P in the morning, either up or down to compensate for this

[00:02:58] substantial time decay that is the flip side of the intense gamma. Without a big enough move,

[00:03:04] the options theta would undermine the fleeting option premium. The gamma and theta characteristics

[00:03:10] of 0DTE are attached at the hip. But the 0 days to expiration straddle on Fed Day was no normal

[00:03:17] 0DTE. We might call this particular straddle 0TTD. That is 0 theta to decision. You do know I like

[00:03:28] a good acronym. 0 theta to decision. Allow me to explain by way of my 5c's framework for

[00:03:36] explaining the pricing of all. The 5c's carry credit calendar, capital and concern. I've explored

[00:03:44] this in detail in past podcasts in order to account for the factors that play an important role

[00:03:50] in explaining how the market prices implied volatility both cross-sectionally and through time.

[00:03:57] The calendar component captures the matter in which known date certain catalysts for asset

[00:04:02] price movement are reflected in option prices. Traders know, for example, that the 4 earnings

[00:04:10] dates for a company each year, sponsor volatility, that is roughly 3 to 6 times higher than the

[00:04:17] volatility of the remaining 248 non-urneings days. If you like more money, then less, sort of a basic

[00:04:25] premise and economics and finance, you'll pay more for the option that includes the earnings

[00:04:29] date and the extraval that comes with it. Higher option prices and higher implied vals reflect

[00:04:36] this greater demand. Our 0TTE straddle is a unique example of the calendar component of the

[00:04:43] 5c's. The fed decision isn't just a day on the calendar, it's a specific time of day on that date.

[00:04:50] It's not like non-form payrolls which comes out before the market opens. It's not like in video

[00:04:56] earnings, which come out after the market closes. Powell and his teammates at the fed have decided

[00:05:02] they want to give us the goods during the trading day. So we need to think about the 930 to 4 trading

[00:05:08] session on Fed Day as 2 and in a way 3 sub-sessions. Let me explain. You may recall the 1980 song

[00:05:17] 8 Nothing Going On but the rent. For Fed Days, it's 8 Nothing Going On pre-event. With this in

[00:05:24] mind, as trading came to a near-stand still in typical fashion ahead of a monetary policy decision last week,

[00:05:31] I took some time to map out the behavior of the 0DTE and 0TTD. 5630 strike straddle on Wednesday.

[00:05:42] I posted these charts on Twitter. What did we see? This straddle had literally 0 theta to decision.

[00:05:49] From 930 AM to 2PM, the price of the straddle had minimal movement and basically suffered

[00:05:56] not a scent of time decay. Fascinating. Five of the 6 1.5 hours of the day came and went

[00:06:03] and this theta intensive straddle held all of its time value. When time passes and the underlying

[00:06:10] asset doesn't move in price and the straddle holds its value only one thing can be happening

[00:06:15] and that is a steady increase in implied volume. This offsets the theta that would normally

[00:06:20] be draining the option of its time premium. The straddle seller of the 0TTD option reminds me

[00:06:27] of the Hampton's house owner who wants 100,000 for the summer or 100,000 for the entire year.

[00:06:34] September to May don't matter much to the matter Lords who most certainly won't be seen at

[00:06:39] in Toneys during the winter. The 5630 straddle lost almost no value from 930 to 2PM.

[00:06:47] From 2PM to 4PM is a very different story. First of course it too we learn the decision to go 50.

[00:06:55] The market race tire at 1. quickly up 50 handles. The problem hour for the straddle owner

[00:07:01] is that at least one part of the event uncertainty, the decision itself was now behind us.

[00:07:07] implied volume began to quickly deflate for the straddle, now with just two hours to

[00:07:12] expry and no longer supported by one component of the unknown. The impressive pop in the S&P

[00:07:18] faltered and the straddle which traded around 60 at 2PM was at just 50 by 220 with the S&P

[00:07:25] up 24 on the day. But there was one more glimmer of hope and one source of risk premium left,

[00:07:32] the 230PM press conference. Here the market would ascribe value to the uncertain matter in

[00:07:38] which pal might frame out the decision. Certainly happened before. Once 230 came around and JPE

[00:07:45] gave us not much more the 0 TTD straddle reverted back to its true colors of 0 DTE and was

[00:07:53] gobbled up by the theta monster. It would expire worth less than $10.

[00:07:58] Alright, so we covered 0 DTE and its sub variant 0 TTD. It's now time we briefly recap the prices

[00:08:06] of risk that present themselves post-fed and finish with another date on the market's calendar.

[00:08:12] I like to say that nothing bad in markets happens when realized vall is below 15.

[00:08:17] What I'm referring to is the matter in which volatility interacts with concurrent returns.

[00:08:23] There's nothing predictive here, but not really a surprise when realized volatility is well-behaved

[00:08:29] markets do well. Can we take a moment and celebrate financial pundits use of the word well-behaved?

[00:08:36] It's like these statistics or kids. We're often told that inflation expectations are well-behaved.

[00:08:43] And by the way, break evens are indeed well-behaved. Just hit up the ILBE page on Bloomberg.

[00:08:50] I do digress. Back to vall and returns. Since 1990, the S&P has spent 60% of the time

[00:08:58] realizing below 15 and 80% below 20 on a one month basis. Returns are steady and positive in these

[00:09:05] buckets. With realized vall below 10, the average one month return is 1.9%. The worst return is

[00:09:14] negative 5.1%. That's actually pretty amazing. The S&P lost 5% and didn't even manage to

[00:09:21] realize 10 vall in the process. Drip, drip, drip, talk about a stealth drawdown. What about between

[00:09:28] 10 and 15 realize vall? The index spends just under a third of the time in this realized vall bucket

[00:09:34] and delivers an average return of 1.3%. The worst return is negative 9.6%.

[00:09:43] Returns do start to suffer above 20 realized vall. In the 20-25 bucket, the average one month return is

[00:09:50] down 1.2%. Out. Of course, we can remember back to the boom market run up to the internet

[00:09:58] crash 25 years ago. That was a high realized vall positive return regime. It did end badly,

[00:10:05] but there was a wave to ride at least for a while. One aspect of this bucket we began to see

[00:10:10] is negatively skewed return outcomes. The max return is 13.3%. But the minimum is negative 18.3%.

[00:10:19] To level set on this bucket and what it takes for the market to realize between 20 and 25 vall,

[00:10:25] we are talking about roughly 1.25 to 1.5% a day in daily moves. At today's S&P level,

[00:10:33] that's 60 to 80 handles not a small number. Of course, the bulk of the heavy lifting is going to be

[00:10:40] done by a few very apparent returns when the S&P falls 2 to 3%. The math of standard deviation

[00:10:47] in which a day's return is squared means that big moves do matter most. Back to mapping vall

[00:10:55] and returns. It's interesting to look at realized vall from 25 all the way to 50, and the relatively

[00:11:02] small amount of damage to returns. For example, in the 25-30 realized vall bucket, the average

[00:11:09] return is just negative 20 base of spuence. Huh? What's going on here? There's a double-edged

[00:11:15] sword with volatility. The asset price decline that comes with it certainly hurts returns,

[00:11:20] but it's often a pivot point. When selling pressure reaches a point of exhaustion,

[00:11:25] markets can bounce sometimes sharply. In this bucket, the max loss is negative 18 and a half percent,

[00:11:32] but the max gain is almost 15%. There's another factor at work during high levels of

[00:11:39] realized vall, and that's the fed. The central bank pretends to look past market developments,

[00:11:45] but it's not merely a lender of last resort. The scars of contagion will never heal for the fed,

[00:11:51] and it perhaps rightly has the view that when asset prices become unruly, it needs to assume its role

[00:11:57] in crowd control, less of full blown riot breakout. Open mouth operations in sue or in the words

[00:12:04] of Kevin Bacon from Animal House, all is well. When realized vall is 50 plus, there is no escape

[00:12:12] for asset prices. The concurrent returns are devastatingly bad, negative 9.2 percent. This is what

[00:12:19] the fed fears most. Senarios like the GFC and COVID require a whack-a-mole approach to keeping the patient

[00:12:25] alive. Last point on this. While this is the most toxic bucket with respect to real-time returns,

[00:12:32] it's the most advantageous bucket for returns 6 to 12 months later. If you can be committing

[00:12:38] fresh capital during chaos, the odds are fantastic. You will be rewarded out a number of quarters.

[00:12:45] This is really the basis of my thoughts on how a well-designed hedging plan can empower buying

[00:12:50] in stressed markets. Okay, let's finish with some thoughts on our favorite index, the VIX,

[00:12:56] and its behavior post-the-fed decision. Two topics of some regularity on this podcast

[00:13:01] over the past month or so have been the VIX beta and the VIX floor. By VIX beta, we simply mean

[00:13:08] the degree to which the VIX moves as a function of a given movement in the S&P. Clearly, the VIX

[00:13:14] is negatively correlated to the market. S&P down, VIX up, and vice versa. But to what degree? We can see

[00:13:21] that this beta comes and goes. From 2022 until well into 2024, movements in the VIX were pretty

[00:13:29] muted. But then came August 5th, a 65% surge in the VIX on a 3% sell-off, more than 20x.

[00:13:38] September 3rd was a mini version of this reinvigorated beta. The S&P fell by 2% and the VIX

[00:13:44] popped by 33%. Over the month leading into the fed meeting, a given movement, the S&P yielded

[00:13:51] to move in the VIX about 10 times that. So here's my observation as I see my word count as approaching

[00:13:57] 2000. When the market decided that it like Powell really preferred 50 basis points in the S&P

[00:14:04] surged by 1.7% last Thursday, the VIX fell by just 10%. The recent 10x VIX beta would have

[00:14:11] predicted a 17% decline in the VIX. The more modest decline might be that sellers of insurance

[00:14:18] and the risk police who keep a watchful eye on them are saying they just can't provide

[00:14:23] convexity to the market at levels much lower than current ones. If we do hit a real rough

[00:14:29] patch for real eyes-vol, Carrie is going to suffer and that will put downward pressure on implied

[00:14:35] vol. I personally maintain that the US election, that unfortunate, unpriceable source of uncertainty,

[00:14:43] is going to be a real headwind for equity index fall falling much from here. There's some

[00:14:53] you won't get poor either. All right folks, that's going to be it for me. I'll be very interested

[00:14:58] to see how the market reacts to economic data over the next couple of weeks. I hope all goes

[00:15:03] well for you until next time. You've been listening to the Alpha Exchange. If you've enjoyed

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[00:15:19] understanding of risk. Your input is valuable and provides direction on where we should focus.

[00:15:24] Please email us at feedback at alphaexchangepodcast.com. Thanks again and catch you next time.