In China, the “vol shot” heard round the world occurred recently with the Chinese government throwing the kitchen sink at the economy and market, seeking to revive the relatively lifeless patient. As it usually does, at least temporarily, it worked. Insofar as asset price reaction that is. An explosion in volumes ensued as did the classic “stock up vol up” dynamic made most famous in 2021 during the Meme stock episode. In this short pod, I review the five characteristics of price/vol spirals, their implications and how these unique episodes resolve themselves. I also cover US Election risk and how its impacting the VIX. I hope you enjoy and find this useful.
[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] Good listeners, believe it or not, this podcast is going to be celebrating its sixth anniversary in the coming weeks.
[00:00:26] A hundred and eighty episodes or so in, and I've been fortunate enough to host discussions with hedge fund founders, monetary policymakers, chief investment officers, and heads of various sell-side strategy efforts.
[00:00:40] I even had a CIA agent on.
[00:00:42] Central to these conversations is exploring the critical topic of risk and reward and where the latter can be advantageously earned without attracting too much of the former.
[00:00:52] These matters are complicated, to be sure, and that is why I've sought the highest quality guests to share their thought process and frameworks on investing and risk management.
[00:01:03] I'm queuing up some new guests for the Alpha Exchange.
[00:01:06] Perhaps you have a recommendation.
[00:01:08] Email me at feedback at alfaexchangepodcast.com.
[00:01:12] There is no charge.
[00:01:14] As we work towards finishing 2024, I'm going to share some of my updated thoughts in, you guessed it, 15 minutes and 2,000 words.
[00:01:24] So here goes.
[00:01:25] My last pod was entitled, Option Prices Are Singing.
[00:01:29] I explored some of the risk indicators coming from the options market in gold and oil, as well as the ongoing favorable behavior of the VIX and its beta to the S&P.
[00:01:39] When we talk about vol, we can go across assets through sister markets like commodities, rates, and credit.
[00:01:46] We can also incorporate different geographies, and that is where we will begin, specifically in China.
[00:01:52] The vol shot heard around the world occurred recently with the Chinese government throwing the kitchen sink at the economy and market, seeking to revive the relatively lifeless patient.
[00:02:03] As it usually does, at least temporarily, it worked, insofar as asset prices reacted, that is.
[00:02:11] Investors like David Tepper quickly got the joke with a compelling CNBC appearance and likely using the old bill gross adage, shake hands with the government and buy what they're buying.
[00:02:22] An explosion in vol and volumes ensued.
[00:02:25] The classic stock up, vol up, made most famous in 2021 during the meme stock episode, made its way forcefully into pricing.
[00:02:34] If, as I discussed in my most recent podcast, option prices are singing, then China is today's opera of option prices.
[00:02:43] It's difficult to understate how interesting the last three weeks have been in China-related price action, but here are five observations and the implications.
[00:02:51] We can tie all these together and learn quite a bit from history.
[00:02:56] I'll use FXI as the asset to make the points.
[00:02:59] The big picture, these assets have experienced not a rally, but a giant upshock in price.
[00:03:06] Option prices have noticed.
[00:03:08] First, this kind of sudden spike in realized volatility produces a deeply inverted term structure of vol.
[00:03:15] That is, the short expiration options have the highest implied vols and they steadily decline as maturity lengthens.
[00:03:22] It's normally the case that a term structure inverts when the underlying asset spirals lower in price, not higher.
[00:03:30] And because this is an up crash, not a down crash in price, a deeply inverted strike skew emerges.
[00:03:37] That is, in very atypical fashion for a stock index, the out-of-the-money call vol is considerably higher than the out-of-the-money put vol.
[00:03:46] That's our second observation and it, again, is rare.
[00:03:50] Normally, for an equity index, it's the put skew that can dominate.
[00:03:54] In fact, inverted term structures and steep put skews typically go hand-in-hand.
[00:04:00] In the FXI, we do have the inverted term structure, but we have a steep call skew.
[00:04:05] And the reason for this is our third observation.
[00:04:09] There has been a huge premium of realized vol on up days versus down days in the FXI.
[00:04:15] Let's put this in context and first recognize that markets generally crash down, not up.
[00:04:21] We all know about the dangerous risk-offs that have materialized over the last three decades.
[00:04:26] That 100-year storm seems to occur every five to seven years.
[00:04:31] In the FXI, from September until October 7th, the realized vol on down days was 23.5%.
[00:04:38] The realized vol on up days, 65%.
[00:04:42] That is an absurd spread.
[00:04:45] If the option strike skew is pricing the relative force with which the market will move up versus down,
[00:04:51] then these incredible numbers justify the substantial skew.
[00:04:56] That is, an investor will pay handsomely for the chance to rent upside exposure when the moves are so swift to the upside.
[00:05:04] Related to the last statement is observation number four on the price action in the FXI.
[00:05:10] And that is a massive positive correlation on the order of 90% between the spot price and implied vol.
[00:05:17] This is the essence of stock up vol up.
[00:05:21] Again, I want to reinforce just how unusual this is.
[00:05:24] It is most often the case that when an index rises, implied volatility falls.
[00:05:30] Our base example is the very consistent negative correlation between the VIX and the S&P.
[00:05:35] In the FXI, for a three-week period ending on October 7th, the index rallied by 42%.
[00:05:42] One-month implied vol went, in the process, from 21 to 62.
[00:05:49] Outside of GME and AMC, I must put this in the nearly unheard of category.
[00:05:56] Okay, and last point of the five that I think are important to consider in this FXI vol saga is the giant surge in volumes,
[00:06:05] especially call volumes in names like FXI, KWEB, ASHR, and BABA.
[00:06:11] If the gold rush is on, at least for a bit, FOMO rules the day.
[00:06:16] And it's unclear if it's the demand for calls driving up the implied vol or the massive upshock and realized vol,
[00:06:23] but the call gets you the delta, gamma, and vega trifecta.
[00:06:27] Grab them with both hands.
[00:06:29] In FXI, the 10-day average of the ratio of calls to puts was almost 4 to 1.
[00:06:34] That's something.
[00:06:35] So there's your five.
[00:06:37] Inverted term structure and call skew, premium of up-vol to down-vol, positive correlation of spot-to-vol, and massive call volumes.
[00:06:46] A couple of conclusions are in order.
[00:06:48] First, in the words of Soros,
[00:06:50] When I see a bubble forming, I rush in to buy, adding fuel to the fire.
[00:06:56] Forget valuation.
[00:06:57] There's a freight train you simply cannot afford to get in front of.
[00:07:01] Capital that might lean short is dissuaded from doing so, as it is simply too risky.
[00:07:06] These prices can take on a life of their own.
[00:07:09] Buyer beware gets flipped to seller beware.
[00:07:12] Second, we have seen the five-part act previously described several times before.
[00:07:17] This sequence is the same playbook from the meme period, a self-reinforcing spiral of price and vol.
[00:07:24] Other examples include the original internet bubble.
[00:07:28] Crude in 2008, gold in 2011, bitcoin in 2017, Tesla in 2020, and silver in 2021.
[00:07:37] No analogs are perfect, but there are some very consistent outcomes, most all of which simply undo the five parts above.
[00:07:45] That is, the term structure and skew disinvert.
[00:07:49] The premium of up-to-down vol goes away as the upshocks become less frequent,
[00:07:54] and the weak hands that got long take the money and run, causing large realized vol on down moves.
[00:08:00] Even as the underlying asset price falls, the vol falls too.
[00:08:04] The premium is simply unsustainably high once the underlying asset can no longer maintain its violent move higher.
[00:08:12] Thus, the positive correlation between price and vol retreats, very possibly turning negative.
[00:08:18] And lastly, the craze will always dissipate with a normalization of option volume and put-call ratios.
[00:08:24] So, it was no surprise whatsoever to me to see the FXI dump by 9% on Tuesday, October 8th,
[00:08:32] and to see implied vol come down substantially in the process.
[00:08:36] There's just never a case when an index can basically crash,
[00:08:40] and for vol to be considerably lower outside of it having experienced the five-part series I've run through.
[00:08:47] Over October 7th to October 8th, one month at-the-money implied vol fell by 13%.
[00:08:54] Importantly, in nearly every case of a meaningful stock-up, vol-up episode,
[00:09:00] spot and vol are lower six or so months later.
[00:09:03] Remember, the dealer's delta on out-of-the-money calls is marked to a very inflated implied vol in these price-vol spirals.
[00:09:11] When that implied vol comes in, so does the dealer's delta, causing selling.
[00:09:17] Now, the FXI may be very unique because it's government-sponsored and they surely can keep it going.
[00:09:23] But we can learn from other episodes.
[00:09:25] On Twitter, I took a quick look at the Reddit run at the SLV, the silver ETF, in Feb 21,
[00:09:32] and how that ended in lower spot and vol months later as well.
[00:09:36] Okay, if you got this far, bravo.
[00:09:39] The punchline is simply that there's rarely been a better setup than right now to hedge long FXI exposure with a collar.
[00:09:46] You are net selling vol, collecting the call skew, and locking in incredible gains in an asset
[00:09:51] that will likely see both its spot and vol go lower in the next six to 12 months.
[00:09:58] We are now going to move on to domestic risk considerations,
[00:10:01] and that is going to bring us into a conversation with our favorite index, the VIX.
[00:10:07] October 7th was the first day that the calculation incorporated what I call the EVRP,
[00:10:13] the Election Vol Risk Premium.
[00:10:14] Remember, the VIX doesn't know anything.
[00:10:17] It has no opinions.
[00:10:18] It just dutifully does what the SIBO white paper tells it to do,
[00:10:22] incorporate a strip of one-month options on the S&P.
[00:10:25] Those one-month options now reflect the bump in implied vol from November 5th to November 6th.
[00:10:32] Thus, on October 7th, the VIX popped 18% on just a 1% decline in the S&P.
[00:10:38] That's no August 5th, but 18x is a very high beta.
[00:10:43] Let's go back to 2020.
[00:10:45] Election Day then was 11-3.
[00:10:48] The same phenomenon occurred then as it has just occurred,
[00:10:52] as the VIX calc brought in options that expired on November 3rd.
[00:10:56] On October 3rd, 2020, the VIX was actually up by 1%, even as the S&P was up by 1.8%.
[00:11:04] That's never happened before outside of one other time during COVID.
[00:11:08] I keep asking myself about this bump in implied vol around the election.
[00:11:13] November 5th at the money vol in the S&P is 13.8.
[00:11:17] November 6th is 16.3.
[00:11:20] The, quote, implied move on the day after the election is, in my estimate, 2.5%.
[00:11:25] Now, is the market really forecasting a nearly 150-handle move in the S&P that day?
[00:11:32] Not really.
[00:11:33] As I've said a few times, I view these two implied vols as clearing prices that result from differences in the supply of insurance.
[00:11:42] On market pricing, I've talked for a few months about how sticky the October VIX was going to be.
[00:11:48] Currently at 21, it trades double two-week realized vol on the S&P.
[00:11:53] How can that be?
[00:11:54] After all, the economics of profitably owning volatility require realized vol to do its job of permitting enough capture
[00:12:03] on re-hedging the delta when the underlying moves.
[00:12:06] 11 realized vol simply don't cut it.
[00:12:09] The epic VRP was anticipated.
[00:12:12] In my view, it's a function of the incremental withdrawal of some of the risk-bearing capital provided by the sellers of insurance.
[00:12:20] All else equal, less supply will raise the clearing price.
[00:12:23] We might be making a bigger deal out of the U.S. election than it needs to be,
[00:12:28] but we are just fixated on it and all of the unknowns.
[00:12:31] The weeks prior to the June 2016 Brexit referendum were an interesting period that offers some lessons on how the withdrawal of market liquidity
[00:12:42] and risk-bearing insurance capital can start with a base asset and then spill over into other assets.
[00:12:49] I recall quite well how inflated British pound vol got in the weeks prior to Brexit, with short-dated vol well into the 20s.
[00:12:57] It's not something you see very often for a developed market currency.
[00:13:02] As GBP vol went higher, becoming less liquid and more expensive in the process,
[00:13:08] Eurostox vol started to rise as well.
[00:13:10] Ultimately, Eurostox vol got to an unaffordable level as well.
[00:13:14] When the asset you want to hedge becomes too costly, as it did in British pound and then Eurostox vol,
[00:13:21] you search for proxy hedges.
[00:13:24] S&P vol got dragged into Brexit because the base hedging assets became non-economic in price.
[00:13:30] While there's already some premium for sister asset classes for vols around November 5th and 6th,
[00:13:36] I wonder if S&P vol drags other assets further higher if this election uncertainty grows.
[00:13:43] Polls of all kinds, along with betting sites, all suggest this is an epically tight race.
[00:13:48] Doesn't mean it will remain so.
[00:13:51] Carter pulled slightly ahead of Reagan, not too far from the 1980 election.
[00:13:55] It turned out, of course, to be an electoral college landslide for Reagan.
[00:13:59] But 2024 is different because we must deal with something called skepticism.
[00:14:05] When Tim Donaghy was reffing NBA games 20 years ago, we may have screamed,
[00:14:10] you suck, at him after a call went against our team.
[00:14:14] But we never suspected he was deliberately impacting the outcome.
[00:14:18] We still scream at officials, but we are free from the burden of thinking that their bad calls are more than just that.
[00:14:25] In U.S. politics, skepticism is a very hard habit to break.
[00:14:29] It's reinforced by a media business model that profits handily from the sale of it.
[00:14:35] We invite this skepticism into our minds, carrying around devices that feed it to us.
[00:14:40] Our social media experiences are neatly tailored to provide what we've asked for and to keep our attention.
[00:14:48] It's some version of good guys versus bad guys.
[00:14:51] There's no business model for nuance, either in politics or in the media business that covers it.
[00:14:56] I think we ought to be watching the ratings agencies.
[00:14:59] Each has expressed concerns around U.S. debt.
[00:15:02] Shocker.
[00:15:03] But more importantly, they've made comments on the erosion of our governance.
[00:15:07] Here's what Fitch had to say when it downgraded the U.S. in August of 2023.
[00:15:13] Erosion of Governance
[00:15:16] In Fitch's view, there has been a steady deterioration in standards of governance over the last 20 years,
[00:15:21] including on fiscal and debt matters, notwithstanding the June bipartisan agreement to suspend the debt limit until January 2025.
[00:15:31] These factors, along with several economic shocks, as well as tax cuts and new spending initiatives,
[00:15:37] have contributed to successive debt increases over the last decade.
[00:15:41] Additionally, there has been only limited progress in tackling medium-term challenges
[00:15:46] related to rising Social Security and Medicare costs due to an aging population.
[00:15:53] We will run a 7% deficit in 2024,
[00:15:56] and neither party has anything approaching a business plan for a safer fiscal path.
[00:16:01] A deeply contested election outcome could wake up the ratings agencies again.
[00:16:06] I think they're worth watching.
[00:16:08] Fine friends, that time has arrived.
[00:16:11] My 15 minutes of fame are again up.
[00:16:13] Have a fantastic week.
[00:16:15] I wish you well.
[00:16:16] Till next time.
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