Odd Lots - What the Dramatic Boom in Zero-Day Options Means for Stocks

Episode Date: March 17, 2023

Zero- and one-day options give investors the ability to bet on the daily moves of the S&P 500. In recent months, both big institutional investors and retail traders have gotten in on the action, creating a boom in trading volumes of these short-lived contracts and sparking an intense debate over their effect on the market. So what exactly is driving their popularity and why are some Wall Street analysts so divided on whether such options will cause a rerun of the “volmageddon” that we saw back in early 2018 and that caused a big drop in stocks? Nomura Securities International Inc. strategist Charlie McElligott walks us through these new trading contracts, explaining how they work, why people are snapping them up, and what their impact on the market could be.See omnystudio.com/listener for privacy information.

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slash audio. That's vanguard.com slash audio. All investing is subject to risk vanguard marketing Corporation Distributor. Hello and welcome to another episode of the Oddlots podcast. I'm Tracy Allaway. And I'm Joe Wisenthal. Joe, do you remember Armageddon? Oh, wait, let me start over. Keep that in.

I cried. I cried. Keep that in. That's a great moment. Keep that in. Keep that in. Do you remember Volmageddon? Yeah.

If you asked me exactly when that was, I don't. 2018. Okay. I wouldn't have necessary. Maybe I would have said 2017 or something. something. But yeah, something crazy happened and like something with the VVIX and some ETN or something. I don't know. This is a moment in market. I'm still laughing. Sorry. This is a moment in market history that lives for free in my head. Because it was a lot of interesting things happened. So for those who

might not remember all the details, there were these two little volatility products to exchange traded notes that basically ended up having this huge impact on the market. and specifically the volatility index, the VIX. And so you had this kind of tail wagging the dog scenario where you had two products that ended up impacting the overall market. Yeah. And you know what was really notable about the post-2010s environment is that just keeping a steady short volatility trade on

was extremely profitable for years. And people sort of just get walled into it. Because, you know, by the dip was like this sort of dominant. thing. You had the Fed sort of on your side, typically playing some role of, you know, the Fed put and all of that. And you had the residual anxiety of the crisis. So people were paying a large premium for protection, volatility protection. So being a seller of that and sort of being implicitly short volatility was just great until the one day it wasn't. Well, this is why these two exchange traded notes came into being in the first place. It was because people wanted to be able to

sell volatility. And I remember they became very popular with a certain faction. of retail traders. There was even a subreddit called Trade XIV, which was the name of one of the notes. It's since, it has since rebranded to trading vault because we had this Volmageddon situation and both of these exchange traded notes ended up collapsing. So not only did they sort of spark this wider move in the market, but they ended up dying because of it. What's interesting in retrospect, and I hadn't really thought about this, but what's interesting in retrospect about this story is that, okay, in 2018, the retail move was like, okay, trade XIV or go long XIV, and that was sort of like how people played this. Post-2020, now you get the sense that retail is

playing derivatives more directly, particularly call options. And so rather than some note or instrument that implicitly did that, now, of course, the story of the Robin Hood and all that is lots of people just getting directly into options training. That's right. And the big story in options right now and the reason I brought up Volmageddon, not Armageddon, which thankfully hasn't happened yet, is because...

Well, we're recording this March 8th. Thank you for the caveat. You never know. All right. So the reason why we're talking about Volmageddon is because you have this new type of option on the scene. They're called one day or zero-day options, a zero-d-de-e or one-d-te-e.

And they've kind of exploded in volumes in recent years. And there's a lot of discussion about whether or not they are going to lead to a similar Volmageddon type scenario where you have, you know, this small thing, although they're not that small anymore, but you have this small instrument that ends up having a cascade effect on the market and leading to a bigger effect on the S&P 500, the benchmark index. Right. And as always, there are these concerns that any sort of derivative of instrument, which is, you know, might be used for hedging purposes, could have this feedback loop. And of course, the classic there is like 1987.

Black Shoals. Yeah, and the stock market insurance or whatever, they called it. Portfolio insurance, yeah. And the other thing you note, and this is sort of what's interesting to me and why we're talking about this, it's like, in 2021, I think we had a very good story for why there was so much of this sort of zero data expiry option trading, right? The story like, all these new degenerate gamblers and they're on Robin Hood and they're like trading these hyper volatile derivatives that, you know, they're short-term bets and they're just bringing swings. We've had this cooling off of speculative activity over the last year as clearly seen by prices, right? You know, Bitcoin and Arc and all these things have come way down from their high.

And yet the level of trading in these instruments is still very high, which complicates the story that, oh, it's just a bunch of like retail at home gamblers. I was about to say, I think it hints that maybe it's not just retail. And this is something that I've written about on Oblots, and you should all check it out. And speaking of what I wrote on Oblots on the blog recently, we were going to actually be speaking to the perfect guest. We're going to be speaking with Nomura Cross Asset Strategist Charlie McGilligate. He was the author of a very, very good research piece that I wrote up a couple months ago and

has been writing quite a lot about this topic. Charlie, thank you so much for coming on all thoughts. Excited to be here. A long time listener, first time call. Love it. Maybe just to begin with. Talk to us about what these options are exactly and how they came into being and also their intended purpose, because I think nowadays people talk about them as, oh, it's part of

this speculative betting frenzy, but I assume they're supposed to serve some sort of purpose. Absolutely. So, you know, I would almost start this conversation going backwards by saying, look at the stock chart of the CBO right now, right? Which is almost a proxy on the explosive growth and usage of options, you know, from the investing community, whether it's institutions or retail investors. And it does fit somewhat tidily with this larger kind of speculative excess boom of the past two and a half. half three years in that post-crisis period and the Wall Street bet stuff that you guys just spoke about, you know, the Stimmy checks and, you know, SPACs to crypto, you know, this kind of new world of leveraged, highly convex payouts is a place where flows and money followed. And this is the type of return profile that people are really looking to exploit in this day and age. And in that sense, that's the unspoken portion of why these have been rolled out and offered.

Now there's daily expirations. There's an expiration for every day of the week. And the zero DTE product is now almost one out of two options to trade with the spy ETF, for instance. And effectively there, too, for large S&P, which is almost exclusively an institutional product. So the demand is there. I think the official line probably from the exchanges, would be something to the effect of we want to offer the net end users more tools to manage their risk, manage their liquidity profile, things of that nature.

And look, that is not wrong either. When did CBO actually launch these? You know, kind of call it mid last year. Okay. Oh, okay. So they really have not been around very long. So options, right, hedge risk. That's what they're all about in theory.

And someone like maybe takes a more speculative position. Someone needs the hedging. they trade an option, et cetera. How do you go about trying to decompose how the instrument is actually used? And how much is it from, okay, you have a large portfolio manager that needs to hedge their downside, et cetera, versus how much of it is being driven by someone who wants to make a bet on what Tesla will do tomorrow? Right.

It's a great point. And I think that is where, you know, at this point, you know, myself, my colleagues, Anthony Antenucci and Joanna Wang have done some pretty quality work here. I think unpacking that exact idea. Like just looking at open interest, just looking at volumes themselves is not indicative of anything, right? We need to get a sense for, you know, are the net end users buying or selling these, right? It speaks to the macro regime. It speaks to the volatility regime, right? You could say it to a certain extent, looking back in the kind of QE era, let's say, where we did, or where Fed was an active suppression of volatility mode, large-scale asset purchases, zero percent or negative

interest rates. You know, that was part of this idea. You create a wealth effect. Financial conditions are easy. It's a growth tailwind, all that good stuff, virtuous stuff happens. The Fed was telling you to be leveraged long assets. So you had a need for hedges to a certain extent. So like a measure like skew, right, which is a measure of kind of downside demand relative to upside demand. Like the credits to a sphere barometer, right? Right. To a certain extent, right?

So or even, you know, specifically put skew, which is like demand for a tailier or crashier put relative to something closer to the money. Those measures were very high. Skew was very steep back then because you were long, leverage long assets. You needed downside protection. And this gets to the point, though, of why selling VALD XIV was so profitable because if you have so much demand, right, you have the same. structural demand for protection. Lots of buyers, a good market to be a seller. Exactly. And what it does,

I mean, the way that you look at volatility, it's kind of different from this, you know, what I've learned from being in the vol space specifically within the Nomura Equity Deriv's desk for the last five years, which is, you know, top three market share player in the U.S. option space, is that it's a consistent shuffling of your feet. You're trying to find value, you're trying to find highly convex payouts, right? which to a certain extent is why these options exist in the first place, why there's so much demand for them. You know, you have kind of a defined risk,

but a much larger kind of multiple times implicit leverage, you know, on the payout, right, if this thing, you know, strikes gold, you know, to a certain extent. So you're kind of range trading. When something is cheap or when vol is cheap is when you want to be adding protection, when vol is rich, that's typically when you want to, you know, flip positions and be, you know, kind of short volatility or short gamma. So those are all part of the calculus here. I think what matters then, however, in this QT era, right, where the Fed has their hands tied in light of the inflation overshoot, in light of this dynamic where, you know, they were clearly behind the curve.

I mean, it was just a year ago at this time. They only stopped buying bonds, mind you, right? Before they even began, you know, their first hike, they were still buying bonds. So they've needed to tighten financial conditions. They've needed to try everything they can in their limited tool. kit to address, you know, the wealth effect that was caused from these, you know, legacy 10-year-plus easy financial conditions. And that means cramping, you know, the demand side of inflation through tightening FCI. And in this case, what QT has meant was a very simple trade. And that's why, you know,

it was such a clear trend in 2022. It was kind of like long dollar and short assets. Right. That's why like CTAs, for instance, were up, you know, 30 some percent. Like, there was a very very clear defined trend. The Fed was effectively telling you to be short assets, right? What we saw then was this trade that still kind of exists to this day, even per the most recent Jerome Powell commentary, which was kind of this view that when you're in a, you know, kind of a stretched equities valuation, the Fed is de facto a seller of calls. At the low end of the equities valuation, they don't want to market crash per se either. Then they kind of talk you off the edge and they're a seller of put. So we're bouncing around this range. But in QT, right, in a QT era where

they're shrinking the balance sheet where they're jacking up rates, they're trying to tighten financial conditions, it kind of perversely creates this situation where you're being told to be short assets, you actually don't need as much hedge protection. So one of the big questions for the last year, like, why is VIX so low? And that's part of this idea. If you don't have a lot of exposure on. You're sitting in high cash. You're sitting in low nets. You don't need a lot of like crashing downside. This is such a, that clicks. This like finally feels like it clicks and answers like a big question. It makes so much sense, right? If you're, if the Fed is telling you hold more cash, don't be so leveraged, yeah, then you sort of have your built in hedge already.

Cash is and at the money put. Yeah. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients, consistent results year in and year out, go see the record for yourself at vanguard.com

slash audio. That's vanguard.com slash audio. All investing in subject to risk Vanguard Marketing Corporation distributor. On April 4th, 23, around two in the morning, a man was found stabbed multiple times on a sidewalk in downtown San Francisco. Hey, we did this to you. What happened next turned the story into a political firestorm. Reports have identified the victim as Bob Lee, the founder of Cash App. From Bloomberg Podcasts, this is Foundering, the Killing of Bob Lee, beginning April 16. So just a really basic question. I know you've done some research on this, but what does the split actually look like between

institutional versus retail usage right now? Well, I think that's part of some of the, you know, fuzzy assumption that makes this an uncomfortable discussion. I don't truly trust many, whether it's cash percentage of the overall cash equities universe or assumptions about options trading with regards of this idea of what is retail versus institutional. I think a lot of people do kind of a naive analysis looking at the size of, say, you know, as it pertains to the options discussion, looking at the size of options contracts. And then, you know, under a certain threshold, they will kind of label those as, okay, this is, you know, retail type

size and then you get this, you know, potentially false narrative. I think the issue is that particularly with this product, it's an electronic options product, which means it's a market maker is kind of the counterpart here. This is going to be my next question. We'll get into that. And who, you know, who are the saviest electronic options market makers with the best algorithms, the best risk tools? It's these entities that, you know, you know, no specific names necessarily I'll use, but are incredibly savvy with those algorithms, they're slicing and dicing up their risk all day. So you're not going to see huge blocky types of flows

that you could typically pinpoint and say, you know, obvious. Just because something is an odd lot does not necessarily mean it's retail. Correct. I mean, I trust me. Words to live by, Joe. Well, in my past career on a cash desk when I started out of college, I sat at a dot machine and I had a time schedule for every minute of the day on a VWOP order, a TWOP order, I had to send down 120 shares at 959. At 10 a.m., I had to send down 140 shares at, right?

I mean, that's how this thing worked. You're on this distribution curve. So that's kind of, imagine that now times like a much larger risk order that you have. So I have a hard time attributing retail institutional here. You know, one thing that I will say is that recently what you have seen, which proves out this idea that this clearly is an institutional. product by and large, is you have seen kind of upstairs size premium spent, right? So the amount of money that the net end user is spending up front to directionally buy. In this case, recently,

we've seen some large put buying. Right. This is, again, you're sort of like leading into all my next questions, but this is an unusual thing about these shorter dated options, which is that I think the split between put volume versus call volume, it's very skewed in one direction. Why is that? Well, I think the simplest thing I would say right now, and this will kind of go into some of the work that our team has done to kind of assign this idea and to kind of push back as it currently stands. This is an ever-evolving product. And look, each day I like to say is its own ecosystem now with these products. So there is not necessarily going to be a carryover of prior day trend. But generally... So you could have a day where it's mostly which it has been so far. And then you could have a day where it's mostly calls. Well, to a certain extent. But this is the deal.

This is kind of at core of how these things are trading right now by and large. There's an inherent, almost by definition, mean reversion flow from these things. Because whatever you're putting on intraday, ultimately then, if it's moving in your direction, ultimately then needs to be unwound and monetized. So the actual impact that you're getting, so let me walk you through kind of the way that, one, we're identifying these flows and trying to assign a buy or a sell. The CBO handles options flows, let's say, for kind of index and ETF options type stuff. And what we do is they assign kind of an end user tag, right? So there's kind of a broker-dealer traditional, let's say, like upstairs big bank options. Sorry, just before we go on, what is, I think it's the second time you've said upstairs.

What does that mean in this context? Sure, sure. So just speaking to actual high touch sales traders and risk takers, not necessarily on the floor of the exchanges, right, but more associated with large balance sheet banks. The big stuff. If we did a subscriber-only version of odd lots, we could call it upstairs. Yeah, I like that. That's kind of nice. So in this case, you know, the broker-dealer tag with these products is actually, there's no clear angle to these flows, right?

You can see everything that they're trading in these zero-d-te-e options, and some days they are long and some days they are short. Market makers, right, in this definition, are those electronic options entities that we're speaking to, right? the very tech savvy kind of newer players in the scene, I'll say. And they, by and large, are the net sellers, right? They are the sellers. They are the source of supply for the end users. And the final kind of category, because there is a broker-dealer prop, which is, I think, an antiquity kind of term when prop desks were a thing.

It's no longer really particularly relevant. But the net end user is actually a customer tag. So that to us, you know, are the people who are, you know, trading at home, you know, clients, you know, institutional clients, retail, et cetera. What we do is we take a kind of a trade pressure monitor. And you can do this with a, you know, a futures contract, but where you're looking at time and sales and what is transacting at that time versus the bidder offer. And what you then see is if something is kind of, you know, generically, you know, assumption-wise, if it's trading above the midpoint, right, doesn't even necessarily have to trade offer, but it's above the midpoint.

That's somebody typically who's lifting an offer. That's a buyer. Okay. Right. And vice versa, right? If it trades below the mids, it's somebody hitting a bid. It's a seller. And what we do is we net out all the trades over the course of the day.

And then we get the, and we look at buys of calls, sells of calls, right? Bies of puts, sales of puts. And what we end up seeing is a very clear pattern that market makers are almost always net sellers and customer flows are almost always net buyers. And that is core to this discussion right now because, you know, as it relates to this larger topic of Valmageddon, which we'll touch on a bit, you know, that's actually the setup that I am most comfortable with where the seemingly, you know, day trader, right? The seeming kind of the buyer of this is more into creating a gamma, a gamma flow in the market, a momentum flow in the market.

And we can kind of unpack that, you know, what that means. But they have a defined risk. They're spending the premium on the option. Most of these options are going to expire worthless as you kind of push out of the money. Wait, so before we get into sort of knocking the Valmageddon argument down, can you talk, like, what is the Volmageddon argument? Can you piece it together for us? And then I know you don't necessarily agree with some of the more extreme interpretations of it. And I know, for instance, there was a J.P. Morgan note recently where they said that a 5% drop in the S&P 500 could basically snowball into another 20% drop because of these options.

Talk to us about the dynamics that would drive that cascade effect in theory. So in, you know, to take it back to 2018 in that Vol-Megedin scenario and, you know, you guys kind of got the joke, right? There was very steep skew at the time. Vol was, you know, at times screening attractive as a sell because of this kind of fed macro suppression, right? And you had no yield in fixed income. So there was a lot of growth in Vol selling strategies and, you know, yield enhancement strategies. And this isn't necessarily from, you know, VAL, ARB, you know, hedge funds, you know,

and dark, opaque corners of the market. This was, you know, the largest asset managers in the world, you know, with overriding funds. Bill Gross stood up on stage and said sell volatility, right? I mean, that was, that's how he did it. Yeah. That's how he did it. He was, you know, the biggest Ray Vaughal guy out there, you know,

and just constantly mushing that stuff. You know, so this is more than just an equity's discussion. Right, right. So there was this buildup, an accumulation of short volatility in the market. And in particular with those products, their end-of-day hedging requirements, the larger that short-vault trade got,

which again, you know, everybody gets the joke, it's picking up pennies in front of a steamroller thing. You're just collecting premium. You're collecting income, you know, theta gang, all those kind of euphemisms,

that one day, and it happened to be that there was an actual macro catalyst over the course of that December and January, the Trump tax plan went from kind of zero delta, meaning like nobody thought it was going to get done to getting approved in like the House or the Senate by mid-December. And we were already at above-trend growth and above-trend inflation. And all of a sudden, now you had this big fiscal boom out of nowhere. Over the course of January, equities was spot up. So the market was up. But vol was going higher because people were

buying upside optionality like crazy. So a spot-up vol up, which is a kind of a known term for an unstable market, I guess you would say. And over the course of that month, we kept seeing, you know, prices paid beats, you know, from regional feds. There was a CPI release. And at the day, the Friday prior to, you know, Valmageddon, you know, February 5th, I believe, we had this average hourly earnings print, I believe. It was like a three standard deviation beat or something like that. And for the first time in that QE era, there was a holy smokes moment. There was a holy smokes moment. And there was an inflation scare. And all of a sudden, that seemingly very controlled forward path, invisibility of the Fed, keeping rates low forever,

was no longer a thing. And that morning, you know, so the S&P traded down two and a half percent, I think, that Friday, that morning we saw these things start to come unglued. And a lot of people were short these things. Right. And they had to turn by the end of the day. Well, the craziest thing is they were tied to fixed futures. And I think the week before you could see. the VIX curve start to invert. And everyone knew what inversion would mean for these products. And I remember, I will never stop bringing this up. But I remember tweeting about how VIX curve inversion would be really bad for, you know, these two ETS. And then it happened. And everyone was shocked. They were like, oh, I didn't expect, or at least, you know, a significant proportion of retail seemed to be shocked,

which was unfortunate, but you could see it coming. Right, right. I mean, I called it a for, you know, I think that at that time. Like, it was a neon swan. Yeah. We knew that you needed a catalyst. And it was probably as always, as we've seen with this most recent, you know, multi-year period as of, you know, the volatility catalyst was inflation because it shocks you out in this kind of lazy, you know, QE mentality, zero bound rate mentality.

Moving back to the present day, you know, what is it? So as you pointed out, there's good reason to believe this is heavy institutional or active buyers of these zero data expiry options. And clearly there's a lot of demand there. The demand is real for it. What is it, I guess what are they used for? And by that I mean specifically, what is it about the characteristics of current large scale institutional portfolios that the sort of like standard length, longer, I don't know, duration, maturity option? I don't know. to a term, just whatever, longer data expiry options are not as good for. Why do they need such short-term protection?

Well, so I think what you want to do is you look, you know, I spoke earlier about kind of the shifting VAL regime and a QE versus QT era, right? And then last year, skew flattened to like zero percentile, right? So that, what that tells you, right? And we said, it was because, you know, largely generally speaking without going into some really technical kind of flows in the structured product space, there was this general underpositioning that didn't require hedges. It was a crashless sell-off.

It was a grinding de-leveraging. But why did they need the zero? Like, why do they need such short-term activities to get that same, get the level of protection to say what? So that's the perversion here is that if you were, you know, so many tail funds stunk last year. Because typically tail funds are owning, you know, you're kind of, you're, we like to say,

you're short the meat and you're long the heat, you know, Like that's a kind of a generally, you know, assumption of what works. You need to finance paying for, you know, the hedges that you put on by, you know, being able to be short some volatility at the time, stuff that's going to, you know, you're going to be able to collect on and then you want to own like crashy stuff. Well, because we never crashed. Yeah. Like, you know, owning gamma into these event risks didn't pay out.

So an owning puts didn't really pay out because it was this grinding, spot down, VAL down environment. Skew was flat. The actual only days we really saw VAL perform were on crash ups because nobody had it on, right? Nobody was worried about a further sell-off because you had such low exposure or high cash, as we already said. You know, like if anything, you were hedging daily event risk. And that was a big thing. So much of the event risk last year was a CPI print, was an NFP, was an FOMC meeting, was an ECB meeting. So you wanted something that really looked a like and was going to be highly sensitive to that day's move, right? If you were a hedger, so people were buying like at the money same day puts. A one month put or a quarterly put

was not doing you any good. And owning like put spreads for some gamma or whatever, it was not doing you any good. So as the kind of the migration of the flow moved to these, to these, you know, each day, to that point early, each day became its own ecosystem. And if you are hedging those risks. If you are a market maker selling into this kind of end user who has demand to kind of push the market around either way, whether it's buying puts or buying calls, which we're seeing this, you know, the customer base due currently. They're, they should be agnostic, really, about the direction of the market, to be fair, right? What they were doing is they're buying this. If you're, if you're now short this stuff, you want something that's going to perform just like

those and owning a Friday option, a weekly option or a monthly option is not going to have the same oomph kind of in hedging your risk. So part of the volume proliferation that we have seen this year is the market makers and broker dealers themselves using these products to slice and dice their own risk profile. Right? It's symbiotic with the kind of the underlying demand. So just on this note, we have this environment where maybe you're worried about a big intraday move because of event risk. And so you're going to buy a short-dated option or a zero-or-one-day option versus a weekly or a monthly or something like that. What does that actually mean for the impact on the market?

Because the whole Valmageddon portfolio insurance doom loop theory is that you end up in a situation where the whole market is basically short gamma and what if it keeps declining and then market makers have to keep selling in order to hedge. but I'm assuming if you're talking about these ultra short options, I mean, maybe it could make the market volatile on more volatile on a one-day basis, but probably unless you get sustained selling for several days, probably not going to lead to, you know, a 1987 type situation. Right. So, you know, I think, you know, in one of my, you know, quasi-recent notes, there was a span, you know, at some point in February, I'd say, like over 10 days. seven days, I want to say seven days. I think we had 15 or 16, 1% moves in both directions in like a week and a half. It really was this?

I want to say it was like the first week and a half, save like February. Okay. When, you know, the velocity of mentions of this, you know, this became a very trending conversation. Yeah. And at that point, too, we were printing, you know, basically the high usage points of these options to date. You know, one out of every two options was a zero DT option. And what you were seeing then was kind of that example. point that you're bringing up, Tracy, it was like, you're getting this enhanced intraday volatility

because when these options were net bought by the customers, the dealers have to go on hedge that gamma. And what that means is that, you know, if I'm selling upside, if I'm selling upside to you, you're trying to induce a move in the market. You're trying to kind of push the market with this accelerant flow. That's the lesson that we learned with the Wall Street bets yolowing phenomenon. right? And, you know, this, it came part and parcel with the democratization of financial information, right? The democratization of trading and making it like a video game. This was that highly convex, you know, low risk, all you're doing is spending your premium, that lottery ticket phenomenon. Yeah. And this has become a powerful flow and people now get the joke from retail to former institutional folks that didn't think about options as a vehicle. Joe, you might remember I wrote about this in the newsletter, but this to me, is,

is like the legacy of crypto. Well, crypto's still here, but this is the big influence of crypto to me, which is that people bet on ever shorter term events. And they're kind of agnostic to price, right? It's like, does the market go this way or does it go that way? Actually, this leads perfectly to my next question. It was like, how big is that activity today in early 2023, in your view, relative to where it was in, say, middle of 2021?

And because obviously a lot of those people must be gone or wiped out or something. But it's clearly, I mean, there's like this cultural thing and there's a lot of people still doing it and talking about it, et cetera. So like in your sense, like the sort of yolo, gamma squeeze trades that we talked about we've had on the show multiple times. Like how much of a force is that today versus back then? So this is kind of the way I think about it. It's a very, it's a very option-centric phenomenon. Right. And I'm not just saying, oh, like zero-d-t-t-e options.

Like shocking. What I'm saying is that in the absence of a clear kind of macro message, and you were seeing that with Jerome Powell and the Fed and the market really trying to come to terms, you know, by getting ahead of itself and anticipating the end of the tightening cycle and trying to begin pricing that in and then bang, you know, hot inflation data or hot jobs data keeps, you know, the Fed having to readjust and the market repriced terminal rates and all that stuff. When the trade becomes very challenging like that, where again, on a daily to weekly. basis were, you know, we're completely held hostage by an individual new macro data point or a central bank meeting. I think there has almost been, I don't want to say a traitor boredom, but you need to exploit some other phenomenon where you're dealing with kind of binary outcomes. And what ends up happening, what we've seen is that if you are a market maker or, you know, to a lesser extent, as I said, a dealer, and you have clients looking to exploit these intraday

moves, which, by the way, there's also, you know, kind of a regulatory paper trail aside here as well, because, you know, if I'm, you know, sell, if I'm selling an option, let's say, okay. I don't, at the end of the day, if it's not on my prime broker's books, because that trade is gone, I don't have to, you know, do the kind of the, the margin, you know, requirement, right? The, the collateral, you know, kind of requirement. So, you know, there's, there's also this at, as opposed to using a, futures order, which by the way, you would put a, you know, like for a stop loss, a risk management

tool. So often in this type of world, you put your stop loss out here down at this level and, you know, the market goes there and you execute and you're out of your position even though you wanted to be long. And then by the end of the day, the thing is higher and you just killed yourself. These sit out there live until 4 o'clock. They give you a chance to not get knocked out. Oh, and I didn't realize that about the margin requirements. That's interesting. Yeah. I mean, so it's just, you know, those types of things are all part of this tailwind to these products. But the thing that I want to say is if you think about where a market maker is basically positioned, they're kind of, they're short a put and short a call on a daily basis. Our data shows per that customer tagging that almost every day by and large, particularly, and we look at, you know, moneyness buckets, right? So, and that sounds kind of intimidating perhaps, but just think about like calls in the up 1% to up 3% right, is almost, always a net customer buyer, trying to create that gamma squeeze. Okay.

But so are puts in the 97-99. So like down one, down 3%, almost always a customer buyer. You're trying to push these flows around. So just on this point, and you mentioned exploitation earlier, and one of the things about Valmageddon and those two exchange traded notes or products was that eventually market participants became very, very aware of their size and how they worked and sort of realized that they could influence those products so that the products in turn would influence the underlying, which in this case was VIX futures. Is there a chance that you could see something, or you're

already seeing something similar here where sophisticated market participants understand how these options work, the hedging activity that they generate, and they start to sort of game them. Yes, but what you're doing is you're kind of intraday gaming them because, again, the inherent mean reversion property of these things, if you're going to monetize, you got to do it by the close. And what you're getting, this is feeding into the intraday volatility expansion. Right. Right. The intraday acceleration flow. I'm lifting a guy on upside calls, you know, and out of the money upside calls and the market starts rallying. And then we get through a strike. He's short gamma, right? So the higher the market goes, the more they have to buy to stay.

they hedge, you're trying to help push. You're trying to get the ball rolling. Again, these are accelerant flows. Same thing to the downside. And that is, that is, you know, well within the kind of the bounds of fair play. It's the same thing. I have to go out and buy, you know, five yards of futures. You know, you're going to rip the market. It's going to leave a footprint. You know, you might be trying to do it kind of low profile. But, you know, these trades, we've seen futures on our options on futures trading of late, where people are doing this clearly on the screens where they're buying 20,000 options on futures down 50 points in the middle of the day and puts. And that was a big story a week or two ago where the market moved because there was two billion dollars of

Delta for sale. Everybody saw that. Everybody knew it. Actually, maybe just as a way to sort of help me conceptualize this and understand. The example that you just cited, like, Can you talk a little bit about payoff probabilities? Like, can you sort of walk through a sort of a specific, like, type of bet that someone would make in this type of situation? Like, what are they risking? What is the upside? Everyone wants that sort of like big lottery tickets type move, et cetera.

Can you sort of like walk through like a sort of theoretical trade or theoretical, like, math behind how an entity would enter and think about the upside and downside? Well, I mean, without even getting into like a complex option strategy, right? If you were just simply buying same-day call options, you know, kind of through the end of January, you just running a systematic strategy of, you know, of buying and closing. Like you were up, you know, say, you know, 5% just on, you know, that alone consistently. And you had, you know, an actual like positive sharp ratio too. Like that's not a normal kind of environment because January was a. like everything type of rally, even though, you know, there were times where we were rallying and

VAL was going higher. But it's more actually the view of why, in my mind, why market makers want to be, are willing to be short these. Okay. Right. And that is, you know, a critical part of this process, particularly in this VAL regime where, you know, VAL can't squeeze yesterday, you know, barely, barely ticking higher, right? Or excuse me, on yesterday, meaning referring to the Jerome Powell.

The first day of the Powell testimony on the Senate. But if you're looking at, you know, a sharp ratio, right? So a measure of kind of performance versus a risk unit, you know, it's really a marketing tool, right? You know, it's not an actual like risk calc. But shorting a daily straddle, which is what these market makers are doing, right? They're short a put and short a call to a client. Or you could say short a strangle as well, kind of depending on same strike or wider strikes. But you're talking about an S&P for the last 10 days.

That's a seven sharp selling that straddle systematically. On a 20 day, you know, it pushes up somewhere, you know, or it's still like a five or something like that in an S&P. So these, this is a big payout for these market makers. So, okay, so what is the regime shift scenario in which market makers could get run over? They're short puts and calls. So they're essentially making bets on not. big moves, right? Like, to a certain extent, yes, in a world where we haven't had any crash. And there is

not, so right, we've had declined, but not crashes. And part of that is perhaps, you know, due to the sort of like de-levering. People don't, people have more cash on the sideline, so they don't have to like sell in response to selling, et cetera. But talk like about like, what is the scenario in which a market maker with these, you know, short straddles could get run over? Well, so in this dynamic that we're talking about that has kind of been the setup for most days, right? Yeah. You know, where, you know, it's actually a good thing. I want the short vol, short gamma being managed by professionals with some sort of regulatory oversight.

Yeah. Capital, you know, oversight, you know, with more robust discipline kind of risk management process. Yeah. And not by the same day, intraday scalpers who are shorting tails for income. Yes. Right. That's critical to me. So when I'm speaking with regulators, which I am, you know, when I'm speaking with, you know, kind of oversight type of entities and, you know, things of that nature that want to know, is there a systemic risk? Yeah. This currently is the right setup to be, you know, well managed. The thing that would make me uncomfortable would very much come from what would almost require certainly a different macroeconomic regime, which would be a much more highly speculative environment. It would probably require, you know, a resumption of quantum. quantitative easing. It would be a very different world where there wouldn't be all this yield and sitting in cash.

And you had to go back to being risky by selling vol. Sorry, I don't want to keep pressing on this. But I'm trying to understand like, yeah, they're really smart and they're professionals. But smart professionals blow up too. Wait, wait, wait. So just on this point, I think like the biggest criticism of the Volmageddon scenario is that if your put went up like a thousand percent in a day, you would sell it. right, which would like start to decrease some of the hedging needs or bring in buyers, buying from market makers and that would ultimately support the market. That's my understanding of the sort of opposition to Volmageddon thing.

I think the sheer supply of short vol then versus this very tactical and then daisy chained hedged, you know, environment that we're currently in where part of these volumes, once dealers are short, some of these, you know, down to or up to types of scenarios? Are they themselves hedging out these scenarios and slicing and dicing their risk? Back then, that was the largest supply of kind of short vol that we had seen. And we knew mechanically it had to rebalance. That's why it was an extinction event. People began to shoot against it. Now, of course, that can still happen now. But again, due to this dynamic where if the trade is actually going your way, you are being incentivized to close it out. And that's why, so if classic realized volatility is a measure of close to close volatility, right? Right now, kind of sort of say, VIX, the VIX future at like around 20 is implying a 1.2 to 1.3% daily move in the S&P.

Like five of the last seven days, I know that's a random sampling, but have been like 50 bips or less. But what you're getting is 1% intraday moves. And this is the thing, right? What you're getting is like from a volatility measure that actually incorporates open to close or high to low, you're actually seeing vol expand at some times. But from a classic volatility perspective, because this mean reversion flow compresses from a daily change, right? That idea of an ecosystem, of each day its own ecosystem. On a close-to-close basis, these trades are actually helping to compress volatility and actually leaning into implied volatility is kind of grinding lower, which is very much where we're stuck right now. So I just have one more question, and it's kind of facetious, but not really.

Like the day-to-day takeaway from this is that the CBOE and the market makers must just be minting money from this. And secondly, does it mean that if you're an equities trader, like, you don't even have to be around for the full day? You could just be like around present for the open and the clothes. And those are the most important things now. Well, so we watch, you know, there's a ton of mythology and wheel spinning based on, you know, in recent years. And I've been, you know, part of this process for certain with regards to getting a sense for, you know, the aggregate options, landscape and where extreme long or short are the aggregate delta is across options, where dealers go short gamma versus spot and things like that, trying to find these

acceleration points in the market where things could go wrong or things could get slippery in either direction. What the proliferation of these tools is done, as we said, each day has its own kind of environment. And when we're looking at these things trading, these don't necessarily mean that it has to be an open and close. So as we've moved away from looking at the longer term impact of kind of the longer expiration options, and now it's so intraday based, we have a lot of tools internally where I am seeing whether or not premium is being spent or premium is being sold. And that's

meaning, so if I see Delta going higher and I see premium going up in a positive direction on these tools, I can assume that calls are being bought, right, spending premium, and thus the delta is going higher. On a day like this recent Jerome Powell, you know, hawkish kind of escalation yesterday what we saw, he comes out of the gates. There's a ton of puts bought. And then you get the down move. And this is a big theme in 2022 as well with the number of the big CPI upside surprise of seemingly hawkish data points. People would monetize that downside. it would immediately put in a floor in the market, right? Because now you sell those puts, you sell those hedges or directional puts.

It creates an impetus now for dealers to cover their short futures. And then people would even further exploit that by buying same-day calls to kind of create a further squeeze of that impact. So all day, it was buy puts, sell puts, buy calls, rally, and then we got that. And we snapped back. And then we sold off again. It is a, you can do it as much as you want, right? And you're not held to close, you know, you can close them out midday. If you got your 200% return and a far out of the money thing that went in the money and that's happened on multiple occasions intraday, you know, you're good.

But the overall point is absolutely not every day are we closing back to flat. You know, I'm not trying to say that with regards to this mean reversion dynamic. We have had a number of days, certainly after the rates repricing and some of the volatility in February, the policy of volatility in February and the rate volatility in February, where we actually did look kind of short gamma, meaning we either closed on the low or closed on a high at the end of the day. You know, when I say we looked short gamma, it speaks to that dynamic where market makers or dealers are needing to buy something the higher it goes or sell something the lower it goes, particularly at that end-of-day hedging period.

Now you're getting this intraday hedging period and intraday unwind period. So by and large, again, with the customers being the buyers and the kind of the dealers and the market makers being the managers of the options Greeks risks and the second order Greeks, that is a far safer place to be in my eyes. it's when we see that resumption of selling tails intraday that my spidey senses will go up and say, I don't like how this could go. Then you very well could have a situation

where they don't know how to manage their, you know, their gamma risk, right? The sensitivity of their delta to a move in the underlying, the sensitivity of their delta to a move involved or Vanner risk, right? All those things. These things have a shelf life of six and a half hours best. They're super sensitive. That's the reason that they're attractive

because they're, you know, lottery tickets on steroids. And again, with a defined risk, you can spend 80 bucks to make 11,000 or whatever it is. Well, I want to do that. You know, that's the kind of setup. No, I do. You've learned nothing from this podcast. Spidey Sense for Spy Impact is also very good. Charlie, we're going to have to leave it there.

Thank you so much. That was a fantastic explanation. Really appreciate you coming on. Thank you guys for having me. So, Joe, I found that conversation fascinating. And I think whenever you do have an explosion in volume of a new type of product, it does warrant some caution and additional scrutiny. But for me, the big takeaway there was this idea of every day is kind of a new ecosystem. And this idea that more and more people, and I thought Charlie did an excellent job of sort of crystallizing a lot of these ideas, this idea that if you don't have a defined macro environment or macro trend, then why not trade on a sort of day to day basis?

on things going up or down. There was a, yeah, I found that conversation to be very clarifying. The big picture, like, sort of aha moment for me is that, you know, when portfolios are less levered, because the Fed is sort of telling you to, you know, use less leverage, the raising the cost of borrowing, et cetera. Like, you don't need as much long-term structural protection because you have a volatility hedge already, which is the amount of cash that you're holding. but, you know, you still have these one-day moves. So you have the less big macro crash risk,

but you still have these one-day moves around CPI releases or around Fed speeches. And so, yeah, intuitively you think, okay, short-term options, this must be all just people who like to gamble, betting that $80 for, you know, $11,000 payoff. But if the story is really about one-day moves and one-day risk, then you can see why institutional portfolios would like to trade these instruments. Yeah. Well, I think there's definitely a rationality behind it, especially on the institutional side. But I also think we can't ignore that just over the past few years, you know, with the advent of crypto and then the Wall Street Betts phenomenon and all of that is we've kind of normalized the tokenization of everything or the lottery ticket idea. And, you know, I can just

treat this as go up or down and make a lot of money. No, I mean, like that's obviously like, such a thing. I mean, it's like such a part of the culture, the gambling culture, the sort of like take risks, the sort of like shoot for the moon. Like that is like a real thing that I don't think we felt to nearly the same degree five years ago or whenever it was, you know, even Volumageddon, all that stuff. It feels like sort of like a quaint era now within how people treat markets. But yeah, no, I think that was fascinating. And then also I do think Charlie's explanation of like the sort of natural mean reversion of the people who participate in these markets was helpful. And again, sort of like reasons to think that even with a lot of speculative activity,

that the nature of them is more towards curbing large moves rather than accelerating large moves. Well, it's kind of like the bad news is, you know, one or zero day options might add to intraday volatility. But the good news is it's intraday volatility. Yeah, right. It's only a day. Well, that was so fascinating. like the idea that's like, okay, something bad happened. So like everyone starts buying puts, that pushes it down.

People immediately want to start monetizing their profits on that. It's like, oh, let's do the call squeeze now because we know that everyone's going to be monetizing. So you do sort of get that sort of like it's volatile, but it's sort of also dampening at the same time it sounds like. Exactly. Shall we leave it there? Let's leave it there. This has been another episode of the Oddlots podcast. I'm Tracy Alloway.

You can follow me on Twitter at Tracy Alloway. And I'm Joe Wisenthall. you can follow me on Twitter at the stalwart. Follow our producers, Carmen Rodriguez at Kerman Armin and Dash Bennett at Dashbot. Follow all of the Bloomberg podcasts under the handle at podcasts. And for more Oddlots content, go to Bloomberg.com slash oddlots where we post transcripts.

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