Post Election Reflection (on Vol)

[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] Well, that was something. A resounding Trump win, a collapse in vol, Bitcoin number go up and up and up.

[00:00:27] The French whale on poly market got paid. A star was born in Scott Jennings, the Fed East, and Powell, in the words of DiCaprio and Wolf of Wall Street, said, I ain't effing leaving.

[00:00:38] That's the summary, but there's lots more to explore, to unpack, as they often somewhat annoyingly say.

[00:00:45] I'll do my best over the next 20 minutes or so to give you some items to consider and try to add some perspective to your risk management process.

[00:00:53] Before that, we got a touch on the weather. Bloomberg reports that 1.6 inches of rain fell in Central Park during September and October, and that is the lowest since records began being recorded in 1860.

[00:01:07] I like to say that markets are a never-say business. No, it's the weather that's never-say-never. I'll take it. It's been glorious. A real mood lifter.

[00:01:16] My tank is filled with reserves for an especially cold winter.

[00:01:19] Markets, like the temps, have been well-behaved.

[00:01:23] Listeners to this podcast will appreciate the carefully laid-out analysis of pre- and post-election behavior of implied volatility.

[00:01:31] The U.S. election fit into a category of on-the-calendar catalysts, like earnings, the Brexit referendum, CPI releases, and FOMC days.

[00:01:41] The playbook, persistently high-implieds heading into the event, yielding a high vol-risk premium.

[00:01:46] Then, a short-lived surge in realized vol, but also a collapse of risk premium post the release of the news.

[00:01:53] The VIX behavior around the 2024 election has fit the playbook quite neatly.

[00:01:59] A VRP, premium of the VIX to recent S&P realized, got to 11 just before November 5th.

[00:02:06] The S&P pushed higher by 2% on 11.6. The VIX collapsed by 20%.

[00:02:11] That's a giant move lower in vol for that level of increase in the market.

[00:02:16] As Gordon Gekko said to Bud Fox in Wall Street,

[00:02:19] the words out, pal, your union buddies are talking.

[00:02:22] Vol traders are a profit-seeking bunch, aren't they?

[00:02:26] And I mentioned the implementation of a large raft of VIX put spreads that were put on ahead of the 2020 election.

[00:02:32] This was a more fragile economic and financial time post-COVID, so the strike prices on these VIX puts were higher.

[00:02:40] But these trades were broadly successful.

[00:02:42] It's too early to tell, but I think the same flurry of downside put trades executed in the VIX in the pre-2024 election period may prove similarly profitable.

[00:02:53] I've been pretty dialed in on trade construction here, making the point that you had to consider not only the post-event vol playbook,

[00:03:00] but also the consistent decline in vol of vol as well.

[00:03:03] At 120 on November 4th, the VIX closed at just 90 last Friday.

[00:03:08] I favored the 1x2 put spread.

[00:03:10] But what about the overshoot risk, Dean?

[00:03:12] An investor clearly interested, but also nervous inquired.

[00:03:16] There's no way to get around it, I say.

[00:03:18] But what we ought to do is look at the block trades that went up and see the extent to which too many folks may be short in a concentrated way at a specific strike.

[00:03:27] If, for example, everyone's got the 17-15 1x2 on, and we start drifting to 15 and lower, and the trade starts marking unfavorably,

[00:03:36] maybe a bunch of folks pull the ripcord in unison.

[00:03:39] If 15s get bought, the VIX could head lower still.

[00:03:42] My quick take is that I didn't see that.

[00:03:45] There are a lot of 13s open, some of which are part of 1x2s.

[00:03:49] But many of those have been bought outright as well.

[00:03:52] Now, the VIX is a cash-settled instrument, so these trades can easily be taken into the expiration.

[00:03:58] But let's take in the impressive sum of put open interest by strike in Novin Deist.

[00:04:03] First, from the 13 to 20 strike, there are 2.4 million puts open in November.

[00:04:08] In December, that same strip of strikes yields 1.5 million of open interest.

[00:04:13] So in total, 4 million puts are open between 13 and 20.

[00:04:18] The notional mid-market value of said puts, 550 million.

[00:04:22] Again, a lot of these are spreads, and positioning does not feel especially imbalanced, but that ain't peanuts.

[00:04:28] I've made a couple of other points on the landing spot for the VIX.

[00:04:31] And rather than write them down all here, I'll share a clip from a recent Bloomberg appearance with Tom Keene and Paul Sweeney surveying the action involved post-election.

[00:04:41] What's the model?

[00:04:43] What's the Dean Kernett model now?

[00:04:45] Yeah.

[00:04:45] On VIX.

[00:04:45] Are we going to 12?

[00:04:47] We could be going a little bit lower from here.

[00:04:49] The playbook has basically been executed just like we expected it, which is the election is in a class of on-the-calendar catalysts, like earnings, like the Brexit referendum, like FOMC days, where all of the uncertainty comes out in one day.

[00:05:08] And implied volatility is very expensive going into it.

[00:05:11] And then once the news is out, implied vol has nowhere to go but down.

[00:05:15] So no surprise at all to see the VIX dump.

[00:05:17] The question is, I think what you're asking is, where does it land from here?

[00:05:20] And there are a couple of things that are going to matter.

[00:05:22] The first and foremost is realized volatility.

[00:05:26] So realized volatility has been trending in the 10 range.

[00:05:29] That's going to justify VIX at around 13.

[00:05:31] Even as I've been emphatic about the post-election playbook for vol, I've also argued strongly that having some hedges in place made a lot of sense.

[00:05:40] These hedges provided the financial cover to stay long a market that has been trending strongly and delivering gorgeous risk-adjusted returns.

[00:05:49] The defensive trade I focused on was the year-end 95-80 put spread on the S&P.

[00:05:54] As of a few weeks before the election, you could have put this trade on for about 1%.

[00:05:59] My view was that instead of funding the insurance by selling an upside call, the market exposure itself was a far better way to fund it.

[00:06:09] That is, the short call component of the put spread caller was not advisable as it exposed the investor to the risk of increasing delta drag on a market rip.

[00:06:18] And that is exactly what's happened.

[00:06:20] The DEES year-end 6,000 call, for example, has exploded in value this last week, going from 40 to around 120.

[00:06:29] And problematically, its delta has surged from 20 to 55 along the way.

[00:06:35] Instead of funding that 1% premium due to the 95-80 put spread, my view was that the market, rather than the short call, was in a far better position to fund it.

[00:06:45] Since November alone, the S&P is up nearly 5%.

[00:06:48] So what are the disruptors to this bountiful season of returns?

[00:06:53] Let me turn again back to this Bloomberg appearance.

[00:06:57] You know, my process is really about noticing things, like Seinfeld, but notice things.

[00:07:00] And what do I notice from yesterday?

[00:07:02] The VIX is down 20%.

[00:07:03] The dollar was up 1.5%.

[00:07:05] That's happened exactly no times before that, except November 9th of 2016, which turns out to be the day after the first Trump win.

[00:07:14] The dollar was up.

[00:07:16] The VIX was down a lot.

[00:07:17] And so I'm just trying to understand if we can glean anything from that.

[00:07:21] A stronger dollar isn't necessarily disruptive to the market.

[00:07:25] But I would say that a stronger dollar in tandem with higher rates and a persistently high level of rate volatility.

[00:07:33] So the move index came down as well.

[00:07:35] But it's pretty sticky.

[00:07:36] It's going to be in the hundreds range.

[00:07:38] And that's not typical for the Fed during an easing cycle.

[00:07:42] I think this press conference is going to be fascinating.

[00:07:45] We're up 80 basis points or 70 odd basis points in the long end since the first year in September.

[00:07:50] That doesn't feel good.

[00:07:52] And so I'm really curious to watch this press conference.

[00:07:55] Right.

[00:07:55] And look, you know, volatility is about change.

[00:07:58] We just had a seismic change in the leadership of the country.

[00:08:02] There's always risk in the market.

[00:08:04] And I'd argue that we just got past a big one.

[00:08:06] The public spoke decidedly, in my view, that it wanted change, even if it meant taking on so flawed a candidate as Trump.

[00:08:13] The left has got some soul searching to do, but the peaceful transfer of power will take place.

[00:08:19] We should recognize that a Trump loss would have almost surely brought accusations of voter fraud.

[00:08:25] And many Trump supporters would have been unable to see it any other way.

[00:08:29] As I've said, skepticism is a hard habit to break.

[00:08:33] But he did win.

[00:08:34] And now markets, at least with respect to the new administration, ought to be asking questions on tariffs, where the geopolitical chess pieces land.

[00:08:42] And as I outlined in that Bloomberg appearance, where rates are headed.

[00:08:46] I'm in the category of folks that Paul Krugman would call deficit scolds.

[00:08:51] You know, folks looking at the numbers and asking out loud, is there a credible plan here?

[00:08:55] There's no need to cite the numbers here.

[00:08:57] The CBO and the Peterson Institute do a fine job of showing the precarious path.

[00:09:03] I'll say that anyone who tries to make light of the risk is doing a disservice to us all.

[00:09:08] In markets, we ought to know a couple of things by now.

[00:09:11] First, changes in risk, as Hemingway wrote, occur gradually, then suddenly.

[00:09:17] Tipping points are unknowable in markets.

[00:09:20] That's what makes them dangerous.

[00:09:21] And I'd argue that our reserve currency status and that most prodigious of fundraising outfits, the U.S. government bond market, are some form of poisoned chalice.

[00:09:32] These luxuries of such value for so long leave us vulnerable to a lack of restraint.

[00:09:39] Perhaps Elon Musk, in the running for future head of DOGE, Department of Government Efficiency, may set us on a better course.

[00:09:47] In the meantime, we'll pay $3 billion per day on our debt.

[00:09:51] I was just watching Wall Street again from 1987, and early in the movie, head of sales Lynch, played incidentally by James Caron, the Pathmark guy, said to Bud Fox, who's just encountered a trade error,

[00:10:03] someone's got to pay, ain't going to be me.

[00:10:06] That sounds like the U.S. taxpayer reflecting on our hemorrhaging fiscal circumstance.

[00:10:12] Let's see what happens.

[00:10:14] When Trump won in 2016, the S&P, the dollar, and rates moved up in happy tandem.

[00:10:19] This is different.

[00:10:20] Both the stock of and average cost of debt is considerably higher now.

[00:10:25] Inflation, certainly reasonably under control, still remains above target.

[00:10:29] When Trump took the reins in 2017, core PCE was roughly 100 basis points below where it is now.

[00:10:37] To me, it's really unclear how Fed policy is going to work this time around, given that we are above 2% target,

[00:10:43] and also that the 10-year has risen some 60 basis points in yield from when the Fed eased in September.

[00:10:50] Let's end this discussion with a bit on that beast of a benchmark called the S&P 500.

[00:10:55] It's delivering a sharp ratio that it ought not to be able to.

[00:10:58] Over the last 365-day period, I see it up 39% on a 13 realized vol.

[00:11:05] Subtract the 5% risk-free rate, and we are around a 2.5 sharp.

[00:11:10] A 1 sharp is good.

[00:11:12] A 2 is amazing.

[00:11:13] 2.5 is just off the charts.

[00:11:15] You got there in 2017 when the S&P was up 20% on a 6.5 realized.

[00:11:21] I don't know.

[00:11:21] I'll take the 39 and 13 realized vol versus the 20% return and 6.5 realized.

[00:11:28] If anything, sizing your exposure in a 6 realized vol regime is a hassle.

[00:11:33] It's almost as if you can't get enough daily value at risk on your sheets,

[00:11:37] and you also know that it could be the case that it ends badly.

[00:11:41] The reflexivity when vol is that low is pretty pronounced.

[00:11:44] It ended with the XIV event in Feb 18.

[00:11:47] Needless to say, other equity indices by sector, by style class, by geography,

[00:11:52] are having trouble keeping up with the S&P.

[00:11:55] What about adding to this already incredible risk-adjusted return

[00:11:58] through derivatives overlay strategies?

[00:12:00] After all, one can acquire Delta by going long calls or call spreads,

[00:12:05] short puts or put spreads, or some combination of any of these.

[00:12:09] The CBOE has done a nice job creating various indices,

[00:12:12] and they include the BXM, or Buy Right Index, the RXM, or Risk Reversal Index,

[00:12:18] the PPUT3M Index, which buys 10% out of the money puts

[00:12:21] against the long position in the index.

[00:12:24] They also include the CLLZ Index, which is the S&P plus a collar

[00:12:29] that buys a narrow and near-the-money put spread financed by an OTM call.

[00:12:34] And let's not forget the put index, which simply gets long via put selling.

[00:12:38] Now, it's not the case that all of these are scaled totally apples to apples.

[00:12:42] I don't think we can simply compare the returns,

[00:12:44] but we can compare the risk-adjusted returns.

[00:12:47] In big picture, it remains very difficult to compete with the S&P.

[00:12:51] This is, of course, a backward-looking tabulation.

[00:12:54] We're looking in the rearview mirror and declaring a winner.

[00:12:57] There's always a winner by definition.

[00:12:59] But as it relates to option overlay strategies,

[00:13:02] let me share some forward-looking thoughts as well.

[00:13:04] I'd like you to consider that same 95-80 put spread

[00:13:08] I've been yammering about for several podcasts now.

[00:13:10] First, I will acknowledge that spending premium, even a dime of it,

[00:13:14] immediately puts in the danger zone of benchmark underperformance.

[00:13:19] In this context, the short call that is packaged with the put spread

[00:13:22] as part of the large collar trades in the market

[00:13:25] make the trade cost zero and solve the premium drag problem.

[00:13:29] However, that same short call brings with it short delta.

[00:13:33] As I highlighted earlier, the Dease 31st 6000 call

[00:13:36] had just a 20 delta at the start of Q4.

[00:13:39] It's now approaching 60.

[00:13:41] It will rise further should the market rally more.

[00:13:43] The underperformance for me is a bigger risk

[00:13:46] than burning some premium for the outright put spread.

[00:13:49] A three-month 95-80 put spread costs right around 83 basis points.

[00:13:53] That's using 16 and 27 vol.

[00:13:57] Each of these is rather low in its own right.

[00:13:59] The spread between them is pretty favorable in the 87th percentile

[00:14:03] over the last two years.

[00:14:05] What call does one need to secure those 83 basis points?

[00:14:09] It's a shade below 105.

[00:14:11] Getting called away from a long position up 5% over a quarter

[00:14:15] and also receiving the dividends, another 35 basis points or so,

[00:14:19] along the way isn't bad at all.

[00:14:21] Do that every quarter and you're up more than 20%

[00:14:24] all while the put spread operates on your behalf,

[00:14:27] on the defensive line, protecting the long side of your portfolio.

[00:14:31] But let's step back and think about what volatility is all about.

[00:14:35] It's about how the market processes change, about new news.

[00:14:39] And it's pretty difficult to argue that we have not just experienced

[00:14:42] profound change in the leadership and governing philosophy of the United States.

[00:14:47] Taxes and tariffs, regulation and immigration,

[00:14:51] foreign policy and Fed policy.

[00:14:52] It's likely I said the same thing around this time in 2016.

[00:14:56] What happened in 2017?

[00:14:58] The lowest vol in more than 50 years in both the stock and bond market.

[00:15:03] So there's that.

[00:15:04] But this time may surely be different.

[00:15:06] We'll start 2025 with inflation north of Target,

[00:15:10] but the Fed trying to ease.

[00:15:11] With the long end paying little attention to the front end.

[00:15:14] With a mountainous stock of government debt and staggering financing needs.

[00:15:19] With a forward P-E ratio on the SPX of 22.

[00:15:22] Competing with the original tech bubble.

[00:15:24] We also live in a time of breathtaking change.

[00:15:27] And the option value of long tech exposure can't be understated.

[00:15:31] I see plenty of room for both upside and downside in 2025.

[00:15:36] It should be really interesting to say the least.

[00:15:39] I wish you an excellent week.

[00:15:41] And I'll catch you next time.

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