Speaker 1: Hello, and welcome to another episode of The Odd Lots Podcast.
Speaker 1: I'm Tracy Alloway.
Speaker 2: And I'm Joe Wisenthal.
Speaker 1: Joe, do you know what's coming up?
Speaker 2: The Odd Lots pub quiz?
Speaker 1: That's true? Also Valentine's Day?
Speaker 2: This a little bit later on. What else? What else
Speaker 2: do you have in mind?
Speaker 1: Do you do you celebrate the anniversary of Vollmageddon.
Speaker 2: Do I celebrate it?
Speaker 3: Yeah?
Speaker 2: I mean who doesn't. No, I don't celebrate it. But
Speaker 2: that was such a formative moment. So that was February when.
Speaker 1: Was the twenty eighteen six year anniversary.
Speaker 2: That was one of our first like really good episodes
Speaker 2: where we sort of had a good We talked about
Speaker 2: what blew up the short vall etf XIV. I feel
Speaker 2: like we go back through our history. That was like
Speaker 2: an important episode.
Speaker 1: Wait, don't say that was one of the first good ones,
Speaker 1: because we're doing this for your years before twenty eighteen.
Speaker 2: You're right, We've had many good I think that was
Speaker 2: like a it was a highlight. It was a highlight.
Speaker 1: Okay, yes, okay, Well, I do in fact celebrate the
Speaker 1: anniversary of Valmageddon because I always enjoy going back to
Speaker 1: tweets around that time, because there are a lot of
Speaker 1: volatility traders on social media who have very strong and
Speaker 1: often erroneous opinions, and one of the opinions they were
Speaker 1: holding around January twenty eighteen was that everything was fine. Yeah,
Speaker 1: shortfall was this perpetual money maker, no issues with the
Speaker 1: two volatility exchange traded notes that eventually ended up blowing up,
Speaker 1: one of which was XIV, as you pointed out, and
Speaker 1: I remember tweeting things in January of twenty eighteen, stuff
Speaker 1: like if the VICS curve inverts, which was about to happen,
Speaker 1: this would be an absolute disaster for XIV, and I
Speaker 1: had a bunch of people pushing back complaining about the
Speaker 1: axis on my chart, and lo and behold, about a
Speaker 1: week later, XIV not only blew up, but was dead
Speaker 1: within a couple of days and actually royaled the market
Speaker 1: as well.
Speaker 2: I remember there it was very popular XIV, this vehicle,
Speaker 2: and there was a sound intuition about it, I think,
Speaker 2: which is that you know, is this basically betting against
Speaker 2: the VIX And you start with the assumption that Okay,
Speaker 2: people systematically and perpetually overpay for downside protection. Understandable people
Speaker 2: pay for insurance and so you can harvest that premium
Speaker 2: basically by taking the other side, and that by and large,
Speaker 2: shorting VALL is a sort of like a good way
Speaker 2: to a way that people super charge their returns and
Speaker 2: look like a core thing is that when we talk
Speaker 2: about VALL, I think like we are mostly in life shortfall.
Speaker 2: Anyone who owned stocks for a long period or any
Speaker 2: period is SHORTVALL, where sort of like VALL is bad
Speaker 2: for portfolios, et cetera. So like when we talk about
Speaker 2: specifically shorting VALL though, then that's where it gets interesting.
Speaker 1: Yeah, So this is one of the things that I
Speaker 1: find very remarkable about our current moment, which is that
Speaker 1: you know, shorting VALL post the two thousand and eight
Speaker 1: financial crisis became a very popular strategy because you had
Speaker 1: low interest rates, so people wanted to pick up yield
Speaker 1: wherever they could. Yeah, you also had central banks out
Speaker 1: there in the market literally crushing volatility, So you knew
Speaker 1: that there was the put that sort of existed over
Speaker 1: the overall market, so why not try to monetize it.
Speaker 1: There wasn't a lot going on up until twenty eighteen,
Speaker 1: so it made sense to bet on nothing, basically on
Speaker 1: things not happening. But what I find really fascinating about
Speaker 1: the current moment is we seem to be seeing a
Speaker 1: return of that short volatility trade. So you and I
Speaker 1: have discussed on this podcast these shorter dated options, one
Speaker 1: or zero dated options becoming incredibly popular, absolutely exploded voting
Speaker 1: in terms of volume. There's other types of derivatives that
Speaker 1: are also becoming more popular. And yet when I look
Speaker 1: around at the market, it seems like there is so
Speaker 1: much potential for one off events. You know, the FED
Speaker 1: is hiking rates, we have geopolitical risk, as you know
Speaker 1: we always talk about, joke about on this show, supply
Speaker 1: chain disruptions. The chance of one off events actually happening
Speaker 1: seems greater than ever, and yet shorting fall is popular
Speaker 1: and measures of aall itself remain pretty low. The VIX
Speaker 1: is pretty low, the volatility of the VIX index, the
Speaker 1: VVIX is really low. So I think we need to
Speaker 1: ask why is shortfall back, and why is it particularly
Speaker 1: popular at this moment in time, and what does it
Speaker 1: mean for the wider market.
Speaker 2: Let's do it.
Speaker 1: I am very happy to say that we do, in
Speaker 1: fact have the perfect guest. We're going to be speaking
Speaker 1: to Chris Sidel. We've had him on the podcast before.
Speaker 1: He is the co cio of Ambrose Group, and he
Speaker 1: is now officially one of my favorite guests ever because
Speaker 1: he brought us donuts. And if I sound more energetic
Speaker 1: than normal, it's because I'm currently on a sugar rush.
Speaker 1: And also I'm talking about volatility and you took us
Speaker 1: in this morning. I did not, although you tried to
Speaker 1: get me on. Can you imagine if I had a
Speaker 1: donut ends in at the same time.
Speaker 2: That would be bad?
Speaker 1: Okay, Chris, thank you so much for coming back.
Speaker 3: On odd Lots. Thank you so much for having me.
Speaker 3: So when we.
Speaker 1: Talk about short volatility, you know, Joe and I discussed
Speaker 1: it a little bit in the intro, but what is
Speaker 1: the expression of going short volatility?
Speaker 3: Yeah, the expression of going short volatility is taking a
Speaker 3: bet that the normality will continue, right, So effectively, if
Speaker 3: you are betting on long volatility, you are pretty much
Speaker 3: betting on the abnormality taking place.
Speaker 2: So, I mean, I said it in the beginning, but
Speaker 2: I sort of think that most life and investing is
Speaker 2: implicitly short. Well, if you have spy in your retirement account,
Speaker 2: then you know you think it's just generally going to
Speaker 2: go up very time. That is normal. That is so
Speaker 2: as you but per your definition, that is an implicit
Speaker 2: short volatility. How does it get expressed in the options market?
Speaker 2: And or maybe a question is why do people make
Speaker 2: that bet in the options market rather than just going
Speaker 2: the implicit route of being long risk assets.
Speaker 3: Yeah, because I think it's something that generally pays off
Speaker 3: the majority of the time. Within the spread as to
Speaker 3: how you can trade it, there's this embedded risk premium
Speaker 3: that I mean, sure people could argue that there's an
Speaker 3: equity risk premium as well, but the expression towards how
Speaker 3: you apply this, whether it's short s and p puts,
Speaker 3: short mixed calls, short variant swaps, it has a tendency
Speaker 3: to win the majority of the time, and this expression
Speaker 3: lulls market participants into very poor habits of expressing the training.
Speaker 3: Imagine you have taken a trade and you're going to
Speaker 3: win ninety percent of the time, and when the trade
Speaker 3: is working against you, you're adding more size and you're
Speaker 3: adding more conviction. Over the course of years, when the
Speaker 3: trade is beginning to work against you, you have a
Speaker 3: tendency to believe that this is just another one of
Speaker 3: those cases right, It's like being rewarded for buying the dip.
Speaker 3: If you do it over and over again, you're going
Speaker 3: to feel this conviction towards it. But in short volatility terms,
Speaker 3: eventually it catches up and it all goes wrong at once.
Speaker 1: Yeah. The journalistic euphemism that was usually deployed is picking
Speaker 1: up pennies in front of a steamroller. Right, So why
Speaker 1: don't you talk to us about the numbers that you're
Speaker 1: seeing in the market. We say, shortfall seems to be
Speaker 1: back and bigger than ever. What are the actual figures
Speaker 1: around that?
Speaker 3: Yeah, So I think it's important for listeners to have
Speaker 3: a little bit of an understanding of my background and
Speaker 3: why it is we track these numbers. So I was
Speaker 3: a prop trader on two different desks camera securities in
Speaker 3: Xanthis Capital, and then I went to a large Canadian
Speaker 3: investment bank. I spent three and a half years there
Speaker 3: and most of my time was spent trading exotic derivatives.
Speaker 3: Then myself and a couple of my partners who are
Speaker 3: XCTC excitadel guys, we got together and we said, hey,
Speaker 3: we could run this carriy neutral tail restrategy, which effectively
Speaker 3: when volatility is exploding, it's going to have this massive return.
Speaker 3: But when markets are dormant, we use a lot of
Speaker 3: short term proprietary trading to be flat. So you'll have foundations,
Speaker 3: high networked individuals, family offices that will use something like
Speaker 3: this as a hedge in their portfolio.
Speaker 1: Right.
Speaker 3: Because of that, we need to understand the derivative market
Speaker 3: microstructure and also the ecosystem, understanding how certain agents in
Speaker 3: that ecosystem are participating with one another. So over the
Speaker 3: last year, would start to come up in the data
Speaker 3: was that the short volatility trade was coming back in
Speaker 3: huge size. So when you think about the SMP complex,
Speaker 3: in the VIX complex, the net short VEGA notional today
Speaker 3: is two times higher than when it was during January
Speaker 3: of twenty eighteen, which was the month right before VALLMA,
Speaker 3: get it.
Speaker 1: This is when we're going to have to define vega.
Speaker 1: We should just do all the Greek letters, just cut
Speaker 1: them out of the way right now, but vega.
Speaker 3: Yeah, So in VALL terms, right, think one point of
Speaker 3: a VALL move and how much you'll make or lose. Okay, right,
Speaker 3: So if your net long a million bucks of vega
Speaker 3: and volatility moves up one vall point you'll make a
Speaker 3: million bucks vice versa. Right, So what that's saying today
Speaker 3: that number the netting short exposure is two times higher
Speaker 3: than where it was during January of twenty eighteen, which
Speaker 3: is right before vallom again. Additionally, and I sent you
Speaker 3: guys this chart from Morning STARU, which is such a
Speaker 3: crucial chart in my opinion. These derivative income generating funds,
Speaker 3: the AUM in these have increased by over ten x
Speaker 3: since January twenty eighteen. Right, that's another sort of fact
Speaker 3: that's pretty insane to think about.
Speaker 1: What's the definition of a derivative income fund?
Speaker 3: Yeah, so it's the same thing as to what we
Speaker 3: were talking about at the beginning of the pod, where
Speaker 3: we said different expressions towards harvesting these volatility versus premium traits.
Speaker 2: It's intuitive to me why there was so much interest
Speaker 2: in these income generating deriative strategies during the ZERP years
Speaker 2: when you couldn't just generate income by going out and
Speaker 2: buying a government bond. But now you can get five
Speaker 2: percent or whatever. So why is the like, why do
Speaker 2: people go to the exotic route for income generation when
Speaker 2: they are very plain, vanilla things that actually pay yield
Speaker 2: these days.
Speaker 3: I think twenty twenty one is a year that will
Speaker 3: go down in the derivative history books because what happened
Speaker 3: during that year was you had a slew of new
Speaker 3: mandate additions between large foundations, pensions, rias, endowments, mainly because
Speaker 3: of what transpired in twenty twenty. You had a really
Speaker 3: big ball move in twenty twenty, and then also in
Speaker 3: Q one of twenty twenty one, you had the whole
Speaker 3: Meme Stock sort of debacle. So if you were a
Speaker 3: large institution that did not have exposure to derivatives and
Speaker 3: that type of mandate, you almost looked at as archaic
Speaker 3: in a way, right, So at that time, a lot
Speaker 3: of these institutions said we want we want to start
Speaker 3: trading options. Simultaneously, what was going on was the exchanges
Speaker 3: started listing more and more tenors, right, so you started
Speaker 3: having seven days till expiration options, five days till expiration,
Speaker 3: zero days till expiration, and a lot of the consultants
Speaker 3: at these larger institutions started realizing, well, back in the day,
Speaker 3: if we wanted to sell a twenty percent out the
Speaker 3: money SMP put, we have to wait one quarter to
Speaker 3: collect five bucks in premium terms. Right today, we could
Speaker 3: sell a zero DT option for fifty cents and do
Speaker 3: that twenty times over and over and over. And what
Speaker 3: this does on paper is that it changes the path dependency, right,
Speaker 3: so you really won't get hurt for one little thing
Speaker 3: happening at the end of the month or the end
Speaker 3: of the quarter. The problem with that is that on
Speaker 3: paper it looks like that, but when you run certain
Speaker 3: correlations you realize that you're still taking the same exact trait.
Speaker 3: Because if you wake up tomorrow and you say balls
Speaker 3: are up five ball points across the wall surface and
Speaker 3: the term structure, you're going to realize that seven days
Speaker 3: till expiration option and the one month till expiration option
Speaker 3: are both going to be negatively impacted.
Speaker 1: Maybe this is a good chance to talk about the
Speaker 1: ecosystem of the options world. So, setting aside the derivative
Speaker 1: funds which are buying these things, someone is also selling
Speaker 1: them the options. Usually the market makers are the dealers,
Speaker 1: So what is the role of market makers in this process?
Speaker 1: And then also I'm curious how cheap it is to
Speaker 1: go short volatility in general now, because this was also
Speaker 1: a hallmark of the twenty tens, which was it was
Speaker 1: pretty cheap to do these trades, right, and so that
Speaker 1: was also another part of the appeal, like why not
Speaker 1: just pick up a little extra yield for not that
Speaker 1: much more?
Speaker 3: Right? So, in the ecosystem, the market makers play a
Speaker 3: very unique role because if you look at some of
Speaker 3: the data that some cell side research doesthks put out,
Speaker 3: it's not really entirely correct because a lot of these
Speaker 3: deaths like to take a certain narrative, but that positioning
Speaker 3: changes day by day with these market makers. So it's
Speaker 3: not to say that at every single day their long
Speaker 3: gamma or short camera. It's at certain moments where that
Speaker 3: positioning becomes unbalanced and can really create that more cascading
Speaker 3: effect in cheapness and richness in volatility terms. We're seeing
Speaker 3: one of the lowest levels of tail exposure that we've
Speaker 3: ever seen, huh. And this is something that is really
Speaker 3: surprising because everybody understands you shouldn't sell teals. That was
Speaker 3: something that people learned in two thousand and eight, twenty eighteen,
Speaker 3: twenty twenty. Yet that exposure keeps making its way back
Speaker 3: into the market and right now forward skew that like
Speaker 3: thirty days out skew and I'm not trying to get
Speaker 3: super esoteric with the VALL terminology, but just that type
Speaker 3: of WINGI exposure has been oversupplied over the last let's
Speaker 3: call it six to nine months.
Speaker 2: Wait, sorry, just to be clear, there is not currently
Speaker 2: a lot of people buying de facto tail insurance right now.
Speaker 3: Correct, not at all.
Speaker 2: It's weird. I mean, I guess on some level, I'm
Speaker 2: surprised because right like things seem crazy, and there's wars
Speaker 2: going on, and people are concerned about what the Fed
Speaker 2: is going to do, and the economic environment is uncertain,
Speaker 2: and the political environment is uncertain. On one level, it
Speaker 2: feels like it would be an environment that would be oh,
Speaker 2: I want to grab tails, I want to buy insurance.
Speaker 2: On the other hand, the stock market is at all
Speaker 2: time highs volatility is low. Clearly, just looking at financials,
Speaker 2: this is not a market environment in which many people
Speaker 2: seem particularly concerned about very much.
Speaker 3: Well, why would you buy tails up? Think about this,
Speaker 3: It's been four years since the last real fall move.
Speaker 3: So in the face of rising inflation, in the face
Speaker 3: of a declining SMP in twenty twenty two, in the
Speaker 3: face of a mini banking crisis, in the face of
Speaker 3: all those things, you've been able to sell vall make money.
Speaker 3: This is why. So some of the data that we
Speaker 3: track is like US equity short ball hedge funds that
Speaker 3: AUM has grown six times since twenty eighteen. Why would
Speaker 3: that AUM grow because those funds are doing insanely well
Speaker 3: because you've been able to sell volatility left and right
Speaker 3: and really just get away with it. A generic straddle
Speaker 3: selling program, like without having any sort of true quantitative input,
Speaker 3: you just wake up every day and sell straddles has
Speaker 3: made money handle for FIST over the last four years.
Speaker 1: Could it be the case you mentioned the shorter tenors
Speaker 1: that are now available, and this has been a much
Speaker 1: discussed point among market commentators, the impact of zero and
Speaker 1: one day options ODT and one DTE. Could it be
Speaker 1: the case that people are buying less tail risk exposure
Speaker 1: or extreme downside protection in favor of maybe hedging themselves
Speaker 1: on a day to day basis with the shorter dated options.
Speaker 3: So what we're seeing is that during certain events that's
Speaker 3: the case. However, that doesn't take away for the reach
Speaker 3: that you have in that thirty day exposure because when
Speaker 3: you look at the volume across the VIX complex, and
Speaker 3: you look at the volume traded in that thirty day exposure,
Speaker 3: it's still heavy. It's still there. So people that are saying, well,
Speaker 3: nobody's going to hedge with thirty day options anymore because
Speaker 3: they're hedging with zero DP so the vics won't go up,
Speaker 3: that's really a bad view. And there's one real point
Speaker 3: that I'll bring up that will push back on that
Speaker 3: in a pretty large way. If you are an institution,
Speaker 3: a multi billion dollar institution, and tomorrow, god forbid, there's
Speaker 3: a geopolitical event, are you going to hedge a multi
Speaker 3: billion dollar book with zero DT options. There's no way
Speaker 3: any sophisticated fund is going to realize, well, I probably
Speaker 3: need to extend my duration on that hedge, so that
Speaker 3: reach for one to let's call it three month old
Speaker 3: will always be there. It's just that in the recent environment,
Speaker 3: again over the last four years, that has not been
Speaker 3: the case because we really have not been met with
Speaker 3: a catalyst that has tested the broad market just real.
Speaker 2: Quickly going back to a short straddle trade, which are
Speaker 2: very popular or it has been a big money maker.
Speaker 2: As you said, that's just betting that markets won't move much,
Speaker 2: but selling a call and selling a put at the
Speaker 2: same time. Implicitly, it's just like you're just betting that
Speaker 2: things basically stay in a neuro range.
Speaker 3: Correct, you're selling.
Speaker 2: Yeah, how did shortvall make money in twenty twenty two
Speaker 2: when the stock market.
Speaker 3: Was going down? That was the main point of twenty
Speaker 3: twenty two. If you were a VALL trader, and you
Speaker 3: don't need to take my word for it, you could
Speaker 3: look at how well shortfall funds did in twenty twenty two,
Speaker 3: really because there was not a pickup in equity fall
Speaker 3: and a lot of people misunderstand this because rates VALL moved,
Speaker 3: fx fall moved. It was almost like every fall in
Speaker 3: every aspect move except for US equity VALL. So when
Speaker 3: you look at and you can look at just the
Speaker 3: VIX to begin with, right, nix is a great representation
Speaker 3: of something like that because it's variance right, So it's
Speaker 3: really VALL squared. SMP fall squared is going to give
Speaker 3: you VIX. So SMP thirty implied. VALL always stayed in
Speaker 3: that range from like twenty to I believe the high
Speaker 3: end was like thirty something. It's really difficult to get
Speaker 3: VALL to move up when you have a lack of
Speaker 3: realize move and panic that's coming in. So a slow
Speaker 3: grind down every day, going down one percent, half a percent,
Speaker 3: two percent, that's not really going to get people panicking
Speaker 3: to bid for that insurance protection.
Speaker 1: Let's go back to the sort of worst case scenario
Speaker 1: that you were touching on earlier. But just before Christmas,
Speaker 1: I think it was like a Wednesday or a Tuesday,
Speaker 1: there was a sharp drop in the S and P
Speaker 1: five hundred, and this kicked off a wave of speculation
Speaker 1: about the degree to which shorter dated options had exacerbated
Speaker 1: that fall into the close. And the thinking here is that, well,
Speaker 1: when stocks start to move down like that, all the
Speaker 1: market makers have to go out and hedge their exposure,
Speaker 1: and so you can get this sort of doom feedback
Speaker 1: loop in the market where stocks keep going down because
Speaker 1: dealers have to hedge the fact that stocks are going down.
Speaker 1: Walk us through that dynamic, and then how much are
Speaker 1: you actually seeing an impact in the wider market from
Speaker 1: these shorter dated options on a day to day basis.
Speaker 3: Yeah, So we wrote a paper early on in twenty
Speaker 3: twenty three. They got a lot of attention. Surprisingly, it
Speaker 3: got attention from regulators and central banks, and I think
Speaker 3: when some of the regulators reached out to us, it
Speaker 3: was because they understood as well just how severe a
Speaker 3: certain situation can end up being, and they want to
Speaker 3: collect data on that as well. So when you talk
Speaker 3: about zero DT, it usually falls into two camps. You
Speaker 3: have Camp A that says, oh, no, nothing's going to happen.
Speaker 3: The positioning off sets one another, this is not a risk.
Speaker 3: And then you have Camp BE that says this is
Speaker 3: going to create a massive catastrophe. This kind of stuff, right,
Speaker 3: this is a black Swan event, And I don't think
Speaker 3: either or are true.
Speaker 1: Right.
Speaker 3: This becomes a problem when dealers are hedging their exposure
Speaker 3: in a high ball environment. So what ends up happening
Speaker 3: is during normal conditions, when you have most of the
Speaker 3: flow that's leaned to sell these shorter data and options,
Speaker 3: that is stabilizing to the broad market. However, when volatility
Speaker 3: is going up and these end users are not only
Speaker 3: closing their position but opening new ones, that puts dealers
Speaker 3: under pressure where they now need to hedge their exposure
Speaker 3: and reflexively that could drive the asset price lower or
Speaker 3: instant cases higher as well. So in this situation, it's
Speaker 3: not really a case of the SMP going from zero
Speaker 3: percent on the day to down five percent. It's what
Speaker 3: does this look like if the SMP is down five
Speaker 3: percent and then could escalate to down ten percent. The
Speaker 3: second point to that that I'll bring up, and this
Speaker 3: is a very valid point. If you are a hedge
Speaker 3: fund or or an asset manager, you understand that the
Speaker 3: larger primes are concerned with trading with their clients trading
Speaker 3: this stuff because of the lack of visibility around certain
Speaker 3: intra day margin requirements. So if you're a hedge fund,
Speaker 3: you have a certain EMS that may be outsourced somewhere else.
Speaker 3: It's just like an execution management system, right, So you
Speaker 3: might be trading somewhere else and those positions are settling
Speaker 3: at the end of the day. The PB is not
Speaker 3: really able to see that. So if those positions go
Speaker 3: against you, you may be on the hook for certain
Speaker 3: exposure that is not accurately assessed for That's really the
Speaker 3: second Yeah, that's the second problem there.
Speaker 1: I have so many questions already, but I do think
Speaker 1: this is actually an important point, which is that in
Speaker 1: a lot of the commentary on shorter dated options and
Speaker 1: zero TTE, there's an implication that it's all these stupid
Speaker 1: retail traders who are using these things. And you know,
Speaker 1: people talk a lot about Wall Street bets, and it
Speaker 1: is true that you can find some out there stories
Speaker 1: about people on Wall Street bets losing and also making
Speaker 1: money on shorter dated options, But a big portion of
Speaker 1: this is huge institutional ostensibly sophisticated investors.
Speaker 2: I'm glad you brought that up, because actually this brought
Speaker 2: me back to something that I wanted to return to,
Speaker 2: the sophisticatid investor. Talk more about what happened in twenty
Speaker 2: twenty one with the introduction of these mandates, because I
Speaker 2: do think that feels like a very important element that like,
Speaker 2: we can always talk about market environments and we are
Speaker 2: in a high wall environment or a high rates environment
Speaker 2: or a low rates environment, but if the allocation is
Speaker 2: going to change and new products exist, we see how
Speaker 2: that affects the market. What specifically were these decisions that
Speaker 2: were made where these big institutions felt that they had to,
Speaker 2: like tell us a little bit more about some of
Speaker 2: these decisions.
Speaker 3: Yeah, so think of twenty twenty. Twenty twenty was a
Speaker 3: year that option trading did very well on both sides.
Speaker 3: Hedging programs did very well. And then also when the
Speaker 3: market rebounded, certain stock replacement programs did extremely well. When
Speaker 3: twenty twenty one came Q one and the memestock craze hit,
Speaker 3: that was almost like the nail in the coffin, where
Speaker 3: you had certain investors and boards that started pounding on
Speaker 3: the door and saying, why are we not exposed to options?
Speaker 3: Because look, everybody's making money, not in the sense that
Speaker 3: they want exposure to MEME stocks, but they're saying, hey,
Speaker 3: we should have long call tech exposure, you know, or
Speaker 3: we should have vultility risk premium harvesting programs. And ultimately
Speaker 3: that put a lot of pressure on certain consultants. It
Speaker 3: put a lot of pressure on certain teams. But as
Speaker 3: I said, simultaneously, when the exchanges began listing more and
Speaker 3: more tenors, people started realizing that, well, idly, we probably
Speaker 3: want to engage in these volatility risk premium harvesting programs
Speaker 3: because look, if this is what the S and P
Speaker 3: is doing, look how much more we can make by
Speaker 3: selling Vault. And now the path dependency has completely changed,
Speaker 3: so ideally this becomes an easier trade for everybody.
Speaker 2: Tracy, now I am reminded it's so funny all these
Speaker 2: things I forgot from that time. But there was like
Speaker 2: that big thing with like soft Bank, because you know,
Speaker 2: a massive buyer of just like long call options. Yeah,
Speaker 2: on tech Is. If it weren't already exposed enough to
Speaker 2: tech Beta, they also bought a bunch of call options
Speaker 2: on tech Stock got to double down.
Speaker 1: Now, I do find it remarkable that they're like everyone
Speaker 1: thinks Wall Street bets and that retail craziness was sort
Speaker 1: of people trying to imitate Wall Street, But now we
Speaker 1: basically have Wall Street trying to imitate the retail crowd
Speaker 1: and the sort of yolo mindset of let's just try
Speaker 1: to make as much money as possible on a sort
Speaker 1: of in as short an amount of time as possible.
Speaker 1: I want to go back to the impact on markets,
Speaker 1: and I take the point about the doom loop scenario,
Speaker 1: although as you say, you don't think it's as bad
Speaker 1: as you know, getting a sort of Black Shoals esque
Speaker 1: kind of crash. But one thing I guess I don't
Speaker 1: quite understand in this argument is people are not going
Speaker 1: to keep doing the same stuff if the market is
Speaker 1: falling significantly. So if someone has a put that went
Speaker 1: up five hundred percent, they're probably going to sell some
Speaker 1: of it, right, So if you have people selling puts,
Speaker 1: then wouldn't that bring in buying from the market makers,
Speaker 1: which could actually stabilize the market in that scenario.
Speaker 3: No, No, So when an end user is short the put,
Speaker 3: the market maker is effectively long the put, right, So
Speaker 3: at that time, if they're long the put, they're going
Speaker 3: to be long the underlying on the other side, so
Speaker 3: long stop. It changes when the end user is now
Speaker 3: long the put, that puts the dealer short the put.
Speaker 3: If they're short the put, that's bullish, which means that
Speaker 3: they now need to sell the underlying on the other side. So,
Speaker 3: and this is where this comes into like a second
Speaker 3: order effect. Naturally, if the end user is selling this,
Speaker 3: the market maker is stabilizing this. When that position starts
Speaker 3: to move against them, what's the what is the end
Speaker 3: user going to do? They're either going to close off
Speaker 3: that position, right, or they're going to close it off
Speaker 3: and then take more of the other side. So they're
Speaker 3: going to say, Okay, we're closing this off and maybe
Speaker 3: we're going to bat on long volatility.
Speaker 1: Oh I see, okay.
Speaker 3: That is when the market maker begins to get put
Speaker 3: under pressure. And just to be clear, this has existed
Speaker 3: since derivatives started trading. I think people think that gamma
Speaker 3: heaging is something that came about six years ago. That's
Speaker 3: not the case. If you were a market maker in
Speaker 3: the early two thousands in the nineties, you realized that, hey,
Speaker 3: this is how we hedge of a derivatives book. So
Speaker 3: that second order effect only becomes more relevant because the
Speaker 3: sheer size of what you're trading is so much larger.
Speaker 3: So now you have back in the day, you had
Speaker 3: twenty market makers. Today you have four, right, four main
Speaker 3: market maker or let's go it, five that really control
Speaker 3: the flow in the US equity mark.
Speaker 2: These are really big bank trading desks.
Speaker 1: Are these not just banks?
Speaker 3: Not just banks? I probably I'm not going to name them,
Speaker 3: but like.
Speaker 2: Well, just like what are the nature of these, like
Speaker 2: the four or five?
Speaker 1: I'll whisper to them to you after the show, but
Speaker 1: I don't wait, we could I mean, we have no
Speaker 1: limitations on market Yeah, okay, so people like JP Morgan, Citadel,
Speaker 1: that kind of thing.
Speaker 2: So just big trading shops, yeah, okay, so some bank
Speaker 2: but not necessarily bank, yes, okay.
Speaker 3: Yeah, So going back to the numbers right index option
Speaker 3: trading has grown two times since twenty eighteen, and equity
Speaker 3: option trading has grown almost two and a half times
Speaker 3: in totality. So when you think about the concentration risk here,
Speaker 3: you have less market makers and more options being traded.
Speaker 3: So of course it's natural to think that those market
Speaker 3: makers will get caught all sizes on positioning, especially when
Speaker 3: the end user is so dogmatic in their application of
Speaker 3: this shortfall trade.
Speaker 1: You know you mentioned was it ems earlier? What is
Speaker 1: the underlying risk management architecture for managing these positions? Because
Speaker 1: it has to be there must be so many numbers
Speaker 1: involved with this, and like the values are constantly changing,
Speaker 1: so things like gamma and delta are changing along with
Speaker 1: the market. And if you are one of the market makers,
Speaker 1: I can only imagine all the different exposures you have
Speaker 1: at any one point in time that you are trying
Speaker 1: to calculate in real time as well, how do people
Speaker 1: actually do it?
Speaker 3: So if you are a sophisticated vall arbitraasure, you will
Speaker 3: have certain in house systems that monitor certain second order
Speaker 3: Greek exposure like vallavall right spot moves in gamma exposure
Speaker 3: van A exposure. Very few people in the world who
Speaker 3: need to care about that. You know, for the most part,
Speaker 3: if you are an RIA or even like a macro
Speaker 3: hedge fund that's trading options, you're probably going to be
Speaker 3: on like a certain bank platform, and that's going to
Speaker 3: be okay, right, because you really don't need to care
Speaker 3: about second order Greek exposure. But if you are more
Speaker 3: so a dynamic ball shop, those things become more important.
Speaker 3: I think when you're thinking about the problems of an
Speaker 3: ems and how that translates to something like this, and
Speaker 3: then also the applications of shortfall, really you have to
Speaker 3: understand that the majority of the world and how they
Speaker 3: trade is not like a sophisticated ball shop. It's like
Speaker 3: an RIA that's going to wake up and say, hey,
Speaker 3: we need to make fifty basis points every month, so
Speaker 3: sell these options, and if the position begins to move
Speaker 3: against them, they're gonna say, oh well great, sell some more,
Speaker 3: and then it moves against them. Sell some more, and
Speaker 3: then it moves against them, and then maybe they'll capitulate
Speaker 3: the position. So it's not really the bulk of the
Speaker 3: world is not really dynamically trading these things. They're more
Speaker 3: so dogmatically taking a one sided view on this, and
Speaker 3: that's why you get those ball blow ups.
Speaker 2: Yeah, who is longfall these days? Because you know, again
Speaker 2: in my mind, I just think, you know, very my, very.
Speaker 1: Root of my theoretically they should net right, the amount
Speaker 1: of people shortening ball should be offset by the amount
Speaker 1: of people going to And.
Speaker 2: Also I just think like, if I had a lot
Speaker 2: of money, I would want to take out some insurance
Speaker 2: against some sort of law. But if the people with
Speaker 2: the money, even them, are sort of like sort of
Speaker 2: changing their strategies, is there anyone who's structurally long vall
Speaker 2: in there in parts of their portfolio or like the
Speaker 2: sort of the hedging aspect.
Speaker 3: Yeah, So for what we do, it's called carry neutral
Speaker 3: tail risk hedging, and this is more so a tactical approach. However,
Speaker 3: the majority of what you call strategic or solutions based
Speaker 3: long ball or tail risk hedging has done insanely poor
Speaker 3: over the last three to four years. It's been right,
Speaker 3: it's been obliteration. And we're you know, we're pretty outspoken
Speaker 3: that those type of applications don't work. Because what you'll
Speaker 3: see at an asset management firm, they'll say, okay, great,
Speaker 3: you have if you're a family office, you have five
Speaker 3: hundred million dollars in equities, Let's take one percent a
Speaker 3: year and allocate it to some long fall and then
Speaker 3: over the course of years you realize that, well, that's
Speaker 3: really destroying my portfolio. I can't just lose a percent
Speaker 3: a year. That's why you're seeing more sophisticated institutions go
Speaker 3: or lean towards tactical defensive hedging as opposed to the
Speaker 3: solutions based defensive hedging, because those just really do not
Speaker 3: work over the long run. So you just can't wake
Speaker 3: up and say, yeah, I'm gonna buy a put and
Speaker 3: just keep rolling it and rolling.
Speaker 2: It right, That eventually costs a lot of money.
Speaker 3: Exactly Who are the.
Speaker 1: Big winners from the explosion in shortfall and derivatives in general?
Speaker 1: I have to imagine that the CBOE would be in there,
Speaker 1: given that they're the ones selling the shorter dated options.
Speaker 1: Maybe some of the market makers who's making tons of
Speaker 1: money from this.
Speaker 3: Yeah, so definitely the exchanges are doing quite well. Market
Speaker 3: makers generally do quite well when you have big ball environments.
Speaker 3: For the most part, it's important to note, and I
Speaker 3: think that this goes over a lot of it goes
Speaker 3: over a lot of people's heads when they're going through
Speaker 3: the research. Se Bow is incentivized to make sure that
Speaker 3: the data that they're showing you is pretty right. So
Speaker 3: Sebow's never really going to come out and say, hey,
Speaker 3: all these options traded is a hazard because it just
Speaker 3: goes against what they're trying to do as a business.
Speaker 3: And for what it's where I like the guys at SEBO,
Speaker 3: respect them clearly doing extremely well from a business standpoint,
Speaker 3: But yeah, the exchanges are doing quite well. Market makers
Speaker 3: are doing quite well. But when whenever you're reading research
Speaker 3: or data about these options or zero DT, it's important
Speaker 3: to take it with a grain of salt. When you're
Speaker 3: getting the research from people who have been doing well.
Speaker 2: I just have one more question, and it kind of
Speaker 2: goes back to what I was saying, like, how you
Speaker 2: know I understood the value of in come generating strategies
Speaker 2: through derivatives, particularly in the zurb era when there was
Speaker 2: not many sources of just sort of like income. You know,
Speaker 2: the market complexion is obviously changed quite a bit because
Speaker 2: although now you know there's yield, but also like traditional
Speaker 2: like sort of natural hedges in the market don't work anymore.
Speaker 2: So if you had you know this, the old sixty
Speaker 2: forty portfolio, at least for a while, was like terrible
Speaker 2: and so like this idea like, oh, a hedge by
Speaker 2: having a little bit along here and long here, and
Speaker 2: they do differently like that doesn't work. How has that
Speaker 2: changed the vault trading business, These sort of reversals of
Speaker 2: some long standing just sort of correlations of bread and
Speaker 2: butter assets.
Speaker 3: Yeah, I think it's it's for the good of the
Speaker 3: ecosystem because I think it is cycled out. The bad managers,
Speaker 3: the managers who have not been able to navigate this
Speaker 3: environment have been really taken to the woodshed, And I
Speaker 3: think that's important. You need a healthy cycle out of
Speaker 3: those bad products and those bad managers, because look, everybody's
Speaker 3: a hedge fund these days. Everybody manages some sort of
Speaker 3: assets these days, and the reality is that that alpha
Speaker 3: doesn't exist everywhere. So when you have poor products, after
Speaker 3: a while, people start realizing just how poor they are,
Speaker 3: and then those participants get cycled out. So I think
Speaker 3: it's healthy that this sort of stuff has come to light,
Speaker 3: because yeah, you shouldn't just be able to put somebody
Speaker 3: in some generic put buying program you charge twenty five
Speaker 3: basis points and you know five percent CENTI fee on that.
Speaker 3: That doesn't just jibe. Well.
Speaker 1: I have one more question, which is, how do you
Speaker 1: prove that the explosion and options is having an impact
Speaker 1: in the market, because so far, the observable pattern that
Speaker 1: I have seen is that something like a December twenty
Speaker 1: first happens where the market falls. JP Morgan publishes a
Speaker 1: note saying part of this was because of short dated options,
Speaker 1: and then the CBOE comes out and says, no, no, no,
Speaker 1: we didn't see any evidence of that, and you have
Speaker 1: all this polarized commentary. It feels like in something as
Speaker 1: mathematical as options trading and finance, we should be able
Speaker 1: to point to concrete evidence, but we are still having
Speaker 1: this debate about the overall impact. So what do you
Speaker 1: look at to prove that this is happening.
Speaker 3: So the way how we trade is literally a second
Speaker 3: by second basis, and I think unless you're trading like that,
Speaker 3: you won't be able to have a good picture as
Speaker 3: to what's going on. So we have certain agency desks
Speaker 3: and market makers that cover our flow, and you talk
Speaker 3: to these guys, you go out to eat with them,
Speaker 3: you build relationships with them, and there's an ongoing joke
Speaker 3: that we have with one of them, and they say, listen,
Speaker 3: every time volatility spikes, we have five clients that will
Speaker 3: come in and fight with each other to sell it.
Speaker 3: They are jumping over one another to sell volatility. Now,
Speaker 3: it's hard when you don't have that color or you're
Speaker 3: only seeing a price on screens, But when you understand
Speaker 3: the ecosystem and what's transpiring under the hood, it paints
Speaker 3: a cleaner mosaic to understand that we've only seen one
Speaker 3: side of the equation, which is yeah, volatility being stabilizing
Speaker 3: and just not really performing endorment markets. But there will
Speaker 3: come a day when there's a catalyst that pushes this
Speaker 3: thing through. And it's very similar to like Vallmageddon, where
Speaker 3: everybody who was trading vault during that time understood the
Speaker 3: exposures were baked into the etpis, and then after it
Speaker 3: occurs they'll say, oh, yeah, it was so obvious. Didn't
Speaker 3: you know that everybody was short volatility in the ETPs H.
Speaker 1: I swear to god, it was not obvious to everyone.
Speaker 1: Chris sid You'll thank you so much again for me
Speaker 1: back on all thoughts that was a fantastic explanation of
Speaker 1: you know, a pretty technical change in the markets, but
Speaker 1: an important one. So thank you.
Speaker 2: Yeah, that was great, Thank you so much.
Speaker 1: Joe. That was so good. That was really interesting. I
Speaker 1: have a joke. It's not as good as Chris's joke,
Speaker 1: though maybe I shouldn't tell it.
Speaker 2: Tell it, tell it, tell it.
Speaker 1: What is a risk manager with a science degree at
Speaker 1: a large market maker say when he wants a salary increase?
Speaker 1: Tell me he asks for a Gamma raise.
Speaker 2: That's good. Yeah, it's good.
Speaker 1: That's good, Gama raise.
Speaker 3: It's good.
Speaker 1: It's good for Gamma raise. I'll work a workshop.
Speaker 2: No.
Speaker 1: I thought that was really interesting. He's sort of Chris crystallized. Oh,
Speaker 1: Chris crystallized something in my head which was about the
Speaker 1: exact mechanism of the feedback loop. Because I had assumed
Speaker 1: that as the market moves around, like people are lessening
Speaker 1: their exposure, but as he put it, like the thing
Speaker 1: they're doing to lessen the exposure can also lead to
Speaker 1: market maker behavior that is not ideal. In the stock's
Speaker 1: going down, everyone scrambling all together a scenario.
Speaker 2: Yeah, I thought that was very interesting. I also just
Speaker 2: thought like the sort of big picture if you have
Speaker 2: a lot of money, you just cannot buy insurance trivially.
Speaker 2: It's not like he's like, oh, I'm just gonna like,
Speaker 2: as you pointed out, like you know, you take one
Speaker 2: percent of your assets a year and roll it into
Speaker 2: some fun that supposedly is going to deliver major returns
Speaker 2: every time there's a pandemic or some major thing, like
Speaker 2: you're just gonna lose too much money that way. And
Speaker 2: so then the idea of like, okay, well, like these
Speaker 2: institutions take the other side and see opportunities in shorting
Speaker 2: vall and so you sort of see how how this
Speaker 2: trade can just get so large on one side.
Speaker 1: I also like the point that, okay, this is not nothing.
Speaker 1: It's not a trivial evolution of the market. But at
Speaker 1: the same time, it's not a black Monday black shoals
Speaker 1: reducts where this is going to lead to like a
Speaker 1: massive crash because at the end of the day one
Speaker 1: day options expire. At the end of the day, the
Speaker 1: options are ended. The end day options end. Okay, I
Speaker 1: need to.
Speaker 2: Work that work, thank you, But there's something there.
Speaker 1: But no, I like that point. I thought it was
Speaker 1: a very clear description of the ecosystem. Yeah, and it
Speaker 1: is amazing to me, given everything that's sort of gone on,
Speaker 1: how much the vault trading environment has changed, because you
Speaker 1: would have thought after twenty eighteen, after the wildness of
Speaker 1: the post pandemic period, that things would have gone in
Speaker 1: the other direction, but nope, no.
Speaker 2: And also we knew because of you know, we took
Speaker 2: in twenty twenty one. We talked a lot about retail obviously,
Speaker 2: but it really is telling and then that fell off,
Speaker 2: and then you know, you could see, you know, Cibo
Speaker 2: as a stock kind of peaked at the end of
Speaker 2: twenty twenty one for a while and then fell and everything.
Speaker 2: But obviously there's just so much more than retail. And
Speaker 2: so when we're talking, you know, I think if people
Speaker 2: hear zero day options or any of these options, you know,
Speaker 2: they just sort of think about people like on their
Speaker 2: apps gambling. But the idea that it's not necessarily gambling,
Speaker 2: but there's sort of like very dynamic intentional hedging participation
Speaker 2: in these markets from big money is pretty astounding.
Speaker 1: Sometimes it is gambling though, and there's gambling all right, well,
Speaker 1: at the end of the day, one day options expire,
Speaker 1: that's what it is. But the conversation and the controversy
Speaker 1: over them certainly does not. It goes on forever.
Speaker 2: Sounds good.
Speaker 1: Shall we leave it there?
Speaker 2: Let's leave it there.
Speaker 1: This has been another episode of the All Thoughts podcast.
Speaker 1: I'm Tracy Alloway. You can follow me at Tracy Alloway.
Speaker 2: And I'm Jill Wisenthal. You could have followed me at
Speaker 2: the Stalwart. Follow our guest Chris Sidiel, He's at CA
Speaker 2: sid I. I Hello our producers Kerman Rodriguez at Kerman
Speaker 2: armand dash Ol Bennett at Dashbot and Kelbrooks at Kelbrooks.
Speaker 2: Thank you to our producer Moses Ondem. For more Oddlots content,
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