The Derivative - Market Up/Vol Up, Market Down/Vol Down…WTF Episode

Episode Date: September 10, 2020

So – what’s happening in the wide world of volatility? The market moved to new all time highs and the VIX actually went UP. The market then mini-crashed lower and VIX barely budged?  WTF indeed? Is it Robinhood traders?  It is market makers?  Is it sustainable?  To break it down we’re doing another of our WTF episodes, and are joined by two VOL pros, Matt Thompson – Managing Partner at Thompson Capital Management, and Pat Hennessy – Head Trader at IPS Strategic Capital to talk about volatility, VIX, and options trading inside the market dislocation. Chapters: 00:00-01:36 = Intro 01:37-31:46 = The VIX in the past month 31:47-46:11 = The Elevating of the VIX & The reasons behind the curve 46:12-54:47 = Strategy Impacts 54:48-1:00:05 = Where do we go from here? Follow along with Matt(@dynamicvol) and Pat(@pat_hennessy) on Twitter, and check out their websites for more info on their strategies at Thompson Capital Managementand IPS Strategic Capital. And last but not least, don't forget to subscribe to The Derivative, and follow us on Twitter, or LinkedIn, and Facebook, and sign-up for our blog digest. Disclaimer: This podcast is provided for informational purposes only and should not be relied upon as legal, business, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations, nor reference past or potential profits. And listeners are reminded that managed futures, commodity trading, and other alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors. For more information, visit www.rcmalternatives.com/disclaimer

Thanks for listening to The Derivative. This podcast is provided for informational purposes only and should not be relied upon as legal, business, investment, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations nor reference past or potential profits, and listeners are reminded that managed futures, commodity trading, and other alternative investments are complex and carry a risk

of substantial losses. As such, they are not suitable for all investors. Welcome to The Derivative by RCM Alternatives, where we dive into what makes alternative investments go, analyze the strategies of unique hedge fund managers, and chat with interesting guests from across the investment world. You know, those trades that have a longer dated tenor, those options, especially when structured as a call spread, there really isn't a lot of gamma exposure on those trades. Obviously, the sizes were massive. But the you know, I would imagine that the bid for volatility and the bid for, you know, Vega as the market was ripping higher was more influenced by those longer dated stock

replacement trades, while the, you know, short dated kind of consistent retail call black buying flow would have had a more disproportionate effect in the movement of the underlying stock itself. All right, welcome everybody. We've got a fun day to talk volatility and VIX and option trading with the NASDAQ down about 4% today. It's Tuesday, September 8th. Now close to down about 10% from all-time highs. But the reason we're here is that volatility and VIX haven't quite been playing along with this move lower.

They haven't spiked to new highs. And in fact, before we started selling off, we were seeing some days of higher VIX and a higher market especially in the Nasdaq. So what is all happening? We've grabbed two option VIX pros to talk it all through and to add to the discussion. Right on Pat Hennessy head trader at IPS strategic capital and Matt, managing partner at Thompson Capital Management. So thanks, guys. Welcome. Thanks.

Thanks for having us. Thank you. So Pat, you previously joined us quickly on the TVIX Gets Terminated pod, which was fun. Go check that out, listeners, if you haven't already. So some of our listeners will know you from that, but why don't you give us a quick elevator pitch of who you are and what you do? Sure. How do you get all that nice SIBO swag you're wearing?

I know. Allie had pointed out that I think I was wearing almost the exact same outfit as the last podcast. So I swear I have more clothing. It just kind of lined up that way. So I am the head trader at IPS Strategic Capital. IPS is an independent registered investment advisor. We've been in business since 1993. Our specialty is in providing our clients with hedged equity solutions. Those come in a variety of flavors. We manage a 40-act mutual fund. The ticker is IPSAX.

And that is kind of a all-in-one product that will provide upside market exposure combined with a downside hedge built into it. The goal there is to outperform the market over the course of a full market cycle, which seems like we've seen almost three full market cycles in the last three years. And we also provide custom tailored hedging solutions and we run a long volatility strategy, not really a tail risk strategy, but more of a long volatility overlay that can be put directly into someone's equity portfolio. And we manage that as a separately managed account, as well as a few other separately managed account solutions that are focused on providing asymmetry to the equity markets. Perfect, good.

A longish elevator, but it was pretty good. And Matt, thank you for joining us on your first episode of The Derivative. What do you got going in the fish tank back there? Oh, those are my freshwater sharks. Freshwater sharks. Yeah, right. I feel like a Bond villain or something.

I need to have a cat that I'm stroking here. Sharks with laser beams on their heads. That's right. So give us, you and your brother Mike started Thompson Capital Management. We've known each other for a long time in this space but give us a quick background of where you started and how you guys formed your company. Sure so my brother Mike and I have been born and raised in the Chicago suburbs and you know started on the traditional buy side that you know big big firms in Chicago and then along the way buy side, big firms in Chicago, and then along the way have worked our way into more volatility specialists,

next derivatives, and then started Thompson Capital in 2019, just last year, for an RAA, and we do risk-managed strategies for other advisors generally. Perfect. And you're pretty active on Twitter, both of you talking VIX and all things volatility. So thanks for sharing all your thoughts. So yeah, I want to dive right in here and just get your guys' thoughts on what we've been seeing in the past month, it seems, you know, starting with the NASDAQ kept making all-time highs and the VIX wasn't falling. It's been kind of staying right at this 27 to 32 range. So we'll start with you, Matt, just of your overall thoughts on what kind of environment we're in and what's happening there.

Yeah, it's been goofy really since, I would say, really since the August VIX expiration. So kind of middle of August forward even to today. You know, point to point, I guess it's been about the normal relationship, you know, S&P's down a little, VIX is up a little, but the path has been strange where you've had a lot of this positive correlation, especially in the back half of August. We had, I think, three or four days when VXX, the long-volume ETF was up, you know, multiple percents as S&P was just chugging along to the upside. You usually don't see that even one day, let alone four.

And now then the market really starts to turn south and VXX is down and the market's down two and a half. So it's just some real unusual, consistently positive correlation between two indexes that are supposed to be negatively correlated. Pat, how about you? Yeah, so, you know, one of the things that I flagged on Twitter and was, you know, really a theme in late August was the persistent bid for both index volatility, as well as, you know, the bid for the underlying equity. I think the market was up something like five and a half percent, while the VIX was up about 20% in the same time frame,

from August 20, to the beginning of September. And, you know, there's, there's no way to know for certain what exactly is driving these things. And I think a lot of the narratives that come out, um, trying to place a, you know, why behind the moves that happened, um, you know, it's just doing our best to try and figure out what could be driving this. But I think it was pretty well documented that there was, uh, an exorbitant amount of both retail trading, um, very short dated call options and large cap, single name, you know, tech stocks, as well as a, you know, a large player, potentially multiple large players that were implementing stock replacement programs in the same names. And,

you know, what you see and how that kind of translates into the index products is that you know there there was a lot of optionality gamma and Vega that was being purchased in these single names that can be extremely challenging to hedge within those same single names and so you saw dealers and market makers start to reach into the index products where there's a little bit more liquidity to try to help hedge off some of their risk. And I think we can go into the difference

between those two styles of trades and how each, you know, the retail trader as well as the stock replacement traders have influenced both the price of the underlying as well as the volatility replacement traders have influenced both the price of the underlying as well as the volatility of the underlying. But needless to say, when the correlation between SPX and VIX tends to break down, whether it's on the upside or the downside, it's always something that tends to be very important and market moving. And so let's unpack that a little. So we talked about offline, Ben Eifer put out a nice thread on Twitter of talking through what's happening. What you just said, there's two pieces

to it. One, this retail flow. Two, everyone was saying SoftBank bought 40 billion in option call options. It later sounded like maybe that wasn't necessarily the case. It was kind of a covered calls or not covered calls, but buy rights. What was it? Stock replacement. Stock replacement. Wait, let's someone explain stock replacement for me and the listeners. Sure.

I'll, I'll, I'll bite on that. So stock replacement is a strategy where you are, you know, long, let's just say for the sake of an example, your long portfolio that resembles the S&P 500, what you might do in a situation where you wanted to actually take some risk off of the table is you would replace that position, that underlying stock position, with call options. So what we saw in, large cap single name space within a lot of these large tech stocks is you were seeing, you know, these massive call spreads and risk reversals trading. But these trades were being done against an underlying stock position, which

just means that if I'm, you know'm buying a call spread, which is giving me long exposure to the underlying, at the same time, I'm selling my stock against that. Meaning that the effect on the underlying security is very minimal. And so I think that a lot of the you know chatter after hearing about these large trades was that you know Softbank is pulling a page out of the Wall Street that's you know trading manual and trying to you know take on a crazy amount of risk when in reality you know these trades are actually far more risk averse than owning the underlying stock. And it's it's freeing up cash for them if they want to, you know, look to repurchase the shares if there was a pullback.

So I think, you know, one of the things is that you should not immediately associate what happened in these stock replacement trades as some, you know, extremely erratic uh over leveraged overly bullish bet because that's you know generally not the case with stock replacement it's actually yeah it's the same group that funded we work into the ground it seems like they are risky right it seems like well if they did that no it was like yeah to have to be that that bank that institution everyone was like oh really these guys and so it lends i mean it makes the story just perfect then you could run with these big numbers from soft banks uh and make it into something that you know has a kernel of truth in there right but so stock replacement i've got a million dollars in stock i'm going to sell that i'm going to buy a million dollars worth of exposure quote unquote exposure for whatever say 250 grand yeah right and just my premium paid so i can just risk my premium

instead of my whole principal amount is the concept there right right yeah you can you're actually taking risk off the table in that with that with that approach and in theory not giving up an opportunity cost but if it just keeps chugging along, I'm going to give up my, my premium spent. So, right. All right. So that's one side of it, but we're saying probably not as big of an effect because it's a net zero. They're selling the securities in order to buy the premium. Would you think what in perhaps in the short term could have short term selling pressure on the securities or the arb there would immediately cover that with the option purchases yeah usually that would be done you know concurrently so you'd figure or right around the same time so you'd figure that the net effect in the market of that whole position shouldn't be too great um depending on all that how they liked into it and everything

but uh you know the the bigger the bigger think, push was this big tidal wave of these smaller lot options from presumably retail flowing into those big FANG names. Those were probably not as sophisticated as a stock replacement strategy. That's probably more like give me leverage to the upside and a few names that you know that i that go up every day um i could see that and being a bit more of a the directional kind of push let's talk about that so that's robin hood gets thrown around there but

it's come out that it's probably way more than rob just robin hood sure kind of across the board but the theory there is all these retail which means small investors buying less than 50 contracts or something, are buying up these call options because, let's get into the why. But for a second, just they're buying up the call options. The dealers that are selling them the call options don't want the exposure, especially now after seeing NASDAQ run up. So they're immediately delta hedging that by buying the underlying stock.

Who wants to dive into how all those mechanics work for a sec? Sure, I mean, I'll take a stab at it and Pat I'm sure can tell me where the holes in this explanation, but it's basically, it's a similar idea to the stock replacement, except you're not replacing any stock. So now get rid of that short component to that whole equation. And you've got this big flood of directional exposure that comes into the market.

And it's usually, if it's coming from that retail set, going to be smaller orders and it's going to be much shorter dated. So, you know, a couple of weeks to expiration. So it's the most leveraged kind of upside you can get out of calls. And it's coming all kind of in mass as these retail accounts go out and everyone can trade options these days. So you can go in to your Opinode account and hit the bid on a two-week option in Tesla. And that creates this negative exposure for the dealers, especially that real short-dated exposure in a real volatile name like Tesla or any of the FANG names. Those dealers want to lay that exposure off as quickly as possible

and so they're going to turn around and do what they have to offset that exposure, you know, buy the stock or as Pat mentioned, start buying the indexes, go buy vol products. And so so you know you have this uh un sort of unbalanced uh bid for that ball in those short short-term calls so why as a naively I would think putting myself in the listener's spot of like why not isn't there a big enough market where these retail traders can buy from other retail traders that are wanting to sell it? Or we're saying there's not a market out there, the dealers have to step in. Like it always confuses me of why are the dealers such a big player? Isn't there a market on both sides for all of this? Well, you know, the, the flow is, is very much one sided. Um, you know, there, there's very,

I can't imagine why any, you know, retail Robin hood trader would want to be selling calls on something like Tesla or Apple. Um, and so I think, you know, what, what you're seeing is that it's, it's extremely one sided flow or that the brokerage would even let them, they might say, you gotta have like, whatever, 20 million bucks up in order to sell a naked call right right um so i think that the the very short-dated trades you know matt said that they tend to be sub two weeks expiration um you know and and that's really where a lot of the gamma exposure you know options basically have more gamma the closer that they are to expiration and so a fancy way of saying they're going to react more to the closeness or to the strike price and they're basically they're all

price driven at that point instead of necessarily volatility driven. Sure. And so I think one of the important points to disentangle between the two is that, you know, these soft bank or, you know, if it was soft bank or whoever else was doing it, you know, those trades that have a longer dated tenor, those options, especially when structured as a call spread, there really isn't a lot of gamma exposure on those trades. Obviously the sizes were massive, but I would imagine that the bid for volatility and the bid for Vega as the market was ripping higher was more influenced by those longer dated stock replacement trades while the you know shorter dated kind of consistent retail call black buying flow

would have had a more disproportionate effect in the movement of the underlying stock itself um you know there there are two different components when we talk about the gamma has become such a hot topic in the markets. There is the effect of trades when they take place, meaning that there could be an imbalance between buyers and sellers. And then there's the ongoing hedging obligations of these market makers. And so I think what you saw is that, you know, these market makers were short, a lot of calls in these very short dated expiries on stocks that were going up, you know, five,

10% per day, and they were being forced to buy shares just to hedge their positions. One other thing that's very interesting about the way that the short dated call flow works out is if you look at a stock like Apple or Tesla and you look at the Bloomberg has a feature where you can look at the most active strikes on a given day, they're almost always the short-dated one to two weeks to expiry options. But if you look at the open interest, it's almost always still in the large quarterly expiration, September, December. Anecdotally, I've heard that these retail traders tend to go home flat.

They're day trading. It's not positions that they're holding overnight. And so, you know, what you're seeing, that effect there is basically causing larger intraday moves in these short dated options, which is, you which is effectively causing the stock to maybe trade somewhat erratically while the stock replacement strategies are not really swapping their exposure out too much like the retail traders are. Let's unpack for a little bit more of the, I want to get back to the market makers and basically why are they, this is their business, but are they making money when the market's ripping

higher like this? Are they making money hand over fist? Are they struggling? We have any idea on that? I think so. I don't think that there's much pain going on, especially if these retail traders are going home flat at the end of the day, that makes their job a whole lot easier. Where you could start to see pain is a position that's sitting on your book when a stocks going against you all is going against you your short calls or call spreads so what are they oh so then so to make money on that they have to be over quoting it right like selling it for more than its quote-unquote worth

but so what does that look like? The options? Yeah. So you can look at like the IV, the implied vols in, in, uh, Apple for, for instance, obviously a big, a big, uh, potential target for this whole scenario and, um, implied vols in Apple were rising. They're going, it went from like 40 to, um, I don't even know what they are today. 70 maybe. Um, as all that call demands coming in, the dealers are just raising the balls on them. So they're selling their products for a higher price, all else equal. And they know how to hedge. And there's plenty of liquidity to go out and hedge. It may move the stock around, yeah.

But they've already sold their high vol calls to these guys. That's how they're making their money. And so from the retail guy he's going to buy a let's just make up some numbers right say the the true vol of some options 10 he's going to buy the market maker is going to sell to them for 20 and then even if the stock moves up maybe the option settles at 18 yeah so they're trying to say hey we know it's volatile it's still moving but we're going to price it even beyond how much it's moving. Yeah, it tilts the edge to the market maker.

And they do enough of these transactions. They're going to make some money over time. And anecdotally, a lot of the Robinhood-type traders that I've talked with, usually it's a younger guy that might not even have tons of experience in trading options. He just wants to buy Tesla. He sees this call. He knows calls are for long positions and he just buys it. He has no idea what he's really paying for underneath there, other than Tesla up. So I feel like there's plenty of opportunity in there for a market maker to make a good living on that. Definitely. And to your point about how they price these options,

I remember towards the end of August and September, you were seeing a 25 Delta call on Apple traded a premium to a 25 Delta put. So you had an inverted skew where, you know, that shouldn't theoretically occur in something like an equity. It definitely shouldn't occur in an equity index. But that was the case. And that's a great example of how market makers will adjust the prices of options to accommodate for this. And in the past, wasn't it skewed the other way in the past because people were overpaid for downside insurance? Yeah. That's the typical shape of options skew. That's what I call a skew. It's usually to the put side just because typically equities have a larger

left tail than a right tail or at least that's the perception. And do we think these day traders getting run over? So are they losing billions en masse for the market makers gain? It seems like if that's the case and the market makers are kind of keep raising prices, raising prices, selling you more and more that someone's the net loser here and it's going to run out of money. Yeah, and probably wasn't the market makers in total. I think probably a lot of money

was pulled out of the Robin Hood set if we just were using them as a placeholder for retail. But it's probably US taxpayers, right? Like we gave everyone this free money, they're buying the calls with it and then it's yeah right it's kind of like yeah not my money anyways yeah right you know if they could put a put a couple hundred bucks in there that's that's you know some decent uh upside in tesla for a couple months and then so let's talk so everything

we said is causing i'm going to sell you this option, Mr. Retail Trader. I'm going to mark it up because you're so willing to buy it. I'm going to mark it up over what I think the option is going to move. So I'm going to make money if it doesn't move outside what we think it's going to move. And in turn, that's pushing the VIX or the NASDAQ VIX, which doesn't get quoted as much, but that's pushing both of those measures up

because it's measuring the prices of options, both on the call and put side. So make that connection for me that that's the last piece of the puzzle here. All this call buying, all the market makers hedging, but it's pushing VIX higher because it's pushing the option prices higher. Yeah, it's sort of a, just like positive feedback loop where you get the balls and the options lifting. The curve, the implied ball skew turns more to a smile or a U-shape. So you're getting lifted on the call and the put side in those names. At the same time, the hedging activity is pushing up the stocks 4% or 5% a day. There are already enormous market caps.

They're getting to be a bigger and bigger part of the S&P they're going to be an enormous part of the NASDAQ so now the indexes are looking more and more like these five names that are caught in this vortex and the indexes themselves start to get more volatile and everything sort of just can lift at the same time like that I think that's essentially what we saw at the end of August and actually you're seeing the opposite in September maybe. And so it's this, can we go back to the blow off top in 99? Is it similar dynamics here or no? You know, I don't have any specific.

There wasn't Robinhood or probably nearly as much retail. Right, you know what a new thing in the 90s, late 90s was like just electronic trading in general. So you get on an E-Trade account. It was harder to access the options market back then. But we did see, if you look back in the data, basically from 97 to late 98, you had VIX and S&P rising generally together. And then NASDAQ going through the roof.

So similar idea where balls were being lifted at the same time equity prices were. I guess the corollary in 99 would have been the SOCE bandits, right? Some of the online traders were retail platforms were marking the prices of the stocks themselves up. Being like, hey, if there's so much demand, I'm gonna market up above the price. And either their internal guys or so straighters could come in, buy it cheaper and quickly sell it to the new guy trying to get it high.

Sure, yeah, so now we just have a different access point and maybe more access to the options market. And we all just, we handed them a check for $1,200 a couple months ago and you've got the Fed out there basically pushing equity prices higher. So that's the mix. So two more things. So who are these market makers?

What are the names of these groups? So we're talking like Citadel, Susquehanna, groups like that? Those are the two biggest in that space. I think Citadel is pretty prevalent in that short-dated tech-related call flow. And they've been on record of Robinhood's statements of buying their order flow. And that's the other piece here, which has been well covered in the news. But the market makers are actually buying, Robin Hood paying these firms in order to get those orders in order to trade against them do they pay they pay just to see it or they paid to basically be

the market maker on the trade they pay to internalize that. So basically to be able to completely be on the other side of that order. In addition, there is information contained within that order trader, potentially the size of the account, you know, a variety of information that clearly, you know, if they're willing to pay 35 cents or 50 cents a contract, there's some value to them to be willing to pay that much money to, it's really, really you know access to information um because there's still the robin hood platform itself has a duty to give right put an offer out to the whole world right they can't just sell the orders themselves right to you know sure i i believe and you know this is not my expertise but there's my name some type of auctioning mechanism where it you know this is not my expertise but there's my name some type of auctioning mechanism where it you know here's what we're willing to fill the trade at and here's the payment for the order

flow that will be associated with that and then they need to act in their client's best interest they can't act in what we get the most from citadel so we're going to give them the trade it always has to be based on the net execution cost to the client. We want to allow the client to buy it as cheaply as possible. We're going to get four or five different quotes or whatnot. But I wonder if any of these Robinhood traders

even know one-tenth of everything that's going on behind the scenes there. It's been well covered that there's payment for order flow but do they know that the dealers right they barely know what the option price entails in terms of volatility and and time decay and everything do they know that it's also being marked up by these market makers uh i don't think i would say i'm doubtful well and and let's let's remember it's not, you know, these are still public markets. So it's being marked up by, you know,

like an institution is free to come in and try and knock that price down if they think that it's so out of whack. You know, it's not like they're specifically marking the trade up just on Robinhood traders. You know, these are publicly traded markets. And so anyone can react on that information. You know, it is interesting to see the concentration of, you know, the Robinhood traders tend to focus on a very specific set of stocks and a very specific timeframe. And I think that, you know, that, that tells you what you need to know about what they're interested in. You know, they want leverage cheap bets on upside

and stocks that they know that they think can go up. And, you know, I, I, I do feel that the, the payment for order flow you know, some of the negative connotations around that. Yes, you know, there is a very gambling mentality within the Robinhood traders. But, you know, it's also given people access to trade at the cheapest prices in history with, you know, minimal to no slippage. And for your typical investor or trader who's not worried about making you know oh i lost a penny on that execution or whatever like it i think that it ultimately benefits the end user fair good point um i just feel bad for that kid who killed himself because he thought he was down 200 grand or something so i feel like they've gamified it perhaps a little too much. Yeah. That it's actually real money and real people's futures. But I'd agree that payment for order flow is not necessarily evil.

And one day we'll probably see it in futures markets as well. It's just a different form of commission. You're moving it, you're moving it elsewhere. It's not, you're paying a ticket charge. You are paying it just in a different form so let's move on we talked so this is spiked the vix but the vix coming into this period

here in september october when the election was already elevated um We've had a really weird looking curve where it was sharpened to October and then falling off, but the whole thing's been rather elevated since March. So Matt, why don't you give us a little insight into what the curve currently looks like in the VIX and reasons for that? Sure. In my view, pretty straightforward. It's like everything kind of centers around that October contract. The October VIX contract looks 30 days forward. That covers the election ball. So the October contract all year has had this big bump in it.

And really since, I guess, that August expiration period, you'll see that October contract is kind of consistently lifting up. And the whole curve is kind of, you know sloping down around it so then the September contract has been dragged up a little but the contango from September to October is about as steep as it's ever been you know it was over 20 percent for a little while which is it's pretty outrageous so it's a big roll there up and then after October you get this big slope back down. Obviously the market is pricing in some volatility around the election and the prices in general are just super high.

Even out into like next year, next spring, you have prices, I'm just gonna look at it here, 20, you know, over 27 in the March contract, 28 today in the March contract. In the next spring. In the next spring. So that VIX market is like looking at major volatility around the election that persists for a long time.

So some of these scenarios people are drawing up where we're not going to have a clear winner for, who knows how long, could be another Bush score scenario or worse, depending on how you look. That seems to be what's being priced in right now. And then that's always weird to me because the October contract is looking forward 30 days. So it's the November option prices, right? So people are paying up for November protections, driving

that higher. But if I'm a VIX trader, if I'm trading the VIX futures themselves, I'm not going to get the real-time action in the october contract as soon as unfolding election night it's already expired right at the board should be in both contracts maybe right yeah and so i mean november is still trading 3190 right now so it's way up there too yeah a normal november at this time of year in in like type market, you know, November would be 18. You know, so you're talking, you know, way higher than average here. So, and I don't remember it being anywhere near this close in 2016.

And typically we have, we're in, what's the typical curve? We have backwardation? Typical curve is contango. So, you know, if vol's low today, the VIX is probably, you know, an average VIX would be like 13 something like that yeah sorry we always think there's going to be some event in the future yeah right the future versus the present yeah so you know in that in that aspect

vix spot vix september and october are kind of contained or they're contango but at a high level after that it gets all weird and it looks like a market crash basically after October has been priced in by bix. And then the typical trade and the typical right is harvesting that roll premium, selling front month, buying back months. What does that look like with this weird up and down curve? Yeah it's been a tricky I mean a tricky, I mean, a tricky trade really since, again, that August period,

because you've had this nasty contango in the front months, which generally that's where most of the action is the first couple months. You've had this enormous roll down that should be occurring in all, all else equal between October and September and September down to spot. And that has just stayed like that in that steep upward slope.

And the whole curve has been lifting up. So the signal, you know, look by the curve is like short vol for the roll down. But it's not happening. It's getting steeper and lifting higher. So the vol deck has just been raising over and over again. Do we think that's partly a result of less and less VIX ETF products, VIX index products? That's part of it. I mean, all the inverse exposure went away. A lot of leverage came out with T-VIX being delisted. So now you have just way less leverage in all those products.

VXX is the big game in town. There's no leverage there. It just owns the VIX futures and rolls them. SVIX is a fraction of its former self. Is it a quarter or something? Yeah. I mean, it's like 90% lower than it was at its peak. I think at its peak, it's probably over $2 billion. I think it's about $200 million a day. But then what do you guys hear about even the non-ETF, like via swaps or whatnot, or even not necessarily call replacement, but yield enhancing strategy of just selling vols, seems like those have gone away since March as well.

Yeah, it seems like the positioning was definitely kind of of cleansed and you had a lot of the over leveraged players in that space we talked a lot about this on the last podcast but um you know i think that the reduction of the amount of assets being allocated to explicitly short volatility strategies that are either selling fixed futures or playing the term structure or variance swaps. Those types of strategies definitely took a hit in their AUM. And in some cases, you know, are no longer around and won't be coming back. And I think that, you know, at the end of the day, volatility markets are just like any other market where they're going to be driven by supply and demand. And so I think, you know, one of the reasons why you saw such a high, you know, volatility risk premium

or the difference between, you know, implied volatility and realized is in part because there are just less people out there that are interested in selling volatility. It was interesting that for the first time in quite some time, there was a nice three-month run where your typical short volatility indicators actually did a pretty good job of getting you short vol at the right time. Where it started to get wacky is when a lot of getting you short ball at the right time. Where it started to get wacky is when a lot of these indicators that look at the front two-month futures, you know, when they started to incorporate some of this election volatility, you know, one of the I think more popular indicators is

looking at the spread between UX1 and UX2, the front two months. And you know, you can just get out of the way if it backwardates and that'll keep you out of a lot of the major equity sell-offs in the past. But unfortunately, if you're not accounting for the event risk that's inherent in the second month fixed future right now, that's not a good indicator to be using.

I think that a four and a half point spread right now between September and October is not at all indicative of the overarching volatility regime and how options market and other volatility traders are looking at the potential risks on the horizon. So I think that it's always important to remember that just like any other market, volatility is supply and demand driven. In 2017, you saw the extremes of just ridiculous supply and no realized vol. And now you're seeing a lack of supply combined with more risk on the horizon, increased realized volatility. So it's certainly possible that some of these indicators and things that were consistent and worked in the past may not work as well in the future. And so it sounds like you're saying we're in a new vol regime based on the new supply

and demand of what has transpired. We're in a new vol regime. Don't expect every spike to have VIX go back to 13 sure yeah well the and the proof's in the pudding we've been above 20 for how long now since february yeah probably one of the longer streaks i can recall for sure and look at this year too um there's the buy right index that sebo puts out and the put right index so selling ball in that format both of those are down over 10% this year so that just goes to show how tough that's been and I think it goes all the way back

to 2018 like February 2018 when XIB unwound and that sucked the life out of you know that that ball selling trade and the realizes have been so high since that point you've had these big 20 and you just had almost 40 correction peak to drop in s&p so you start to see that

amplitude coming up and it's actually paid since 2018 to actually own ball in total like buy options instead of sell options so that's i think it goes all the way back to 2018. But if implied stays above realized this much right now, right? Where I kind of, I don't know if it's record highs, but especially in the NASDAQ, it seems that spread is huge. That would tell me to sell vol, right? Yeah. All these retail traders are going to be like, dude, I keep getting the direction right, but I lose money.

Eventually they might say like, oh, I get it. Like there's all this volatility, but priced in that I'm not getting, I'm only getting the price move. And they might start saying, oh, I should start selling it. Well, and so one of the things is that, you know, I, when we had scheduled this call, I think, you know, at the time we were going to talk about the BRP and how, you know, the fix was so high, but the market isn't realizing a lot of volatility. But, you know, since then you have seen realized volatility start to catch up towards implied. So that spread is narrowed a lot. And one of the things that's worth pointing out is, you know, when that was basically

last Friday and today, right. I've like of like the nest down basically 5% each day mm-hmm and so you know and one of the things that you can kind of back in without getting too fancy with math you can look at a ratio of the VIX to something like volley which measures the 30-day at the money volatility whereas VIX to something like Volley, which measures the 30-day at-the-money volatility, whereas VIX is basically the strike price of a variance swap with the same maturity one month. And that'll give you a metric that will tell you how much convexity premium is being priced into the S&P 500. And, you know, that tends to sort of track something that looks like, you know, skew in the S&P 500. And what you saw was ahead of, you know, the market sell off,

the VIX was trading at almost a 35% premium to what at the money volatility was. And so, you know, when you're comparing, you know, at the money volatility to realize, that spread was much smaller. But at the end of the day, the VIX is very heavily influenced by these far out of the money options, which rightfully are very bid up. And as you said, that's where a lot of the open interest is. So. Right. And, and, and primarily in the S and P 500, you know, the NASDAQ single names, they have a very different open interest and, you know, just dynamic of where people want to trade options. And so I guess, you know, one of the points there is that because the market was pricing in a tremendous amount of downside risk as we were rising, you know, as the S&P was rallying in late August, you know, that explains to me that people were also going out of their way to hedge and that, you know, people were kind of ready and

expecting a drop like this. And that's the exact reason why you see days like today where the market falls by almost 3% and the majority of the VIX futures are down a percent or, you know, one and a half to two points spot VIX was up, you know, not even a full point, quite an underreaction compared to what you would expect based on the move in the market and i think that it speaks to the fact that you know people were anticipating something along these lines which explains why the vix was so persistently high coming into the you know right so it's like hey if we had market up vix up in mid-august it's not surprising here to have market

down vix down exactly like matt you said in the beginning, point to point, we're about where we should be. Yeah. It got weird then and it's weird now. Yeah. Yeah, which leads to, is this going to normalize? Are we going to see some back to kind of what we would expect the relationship to be, or is this the new normal?

I would expect, I mean, it's got to normalize or else, you know, downside protection is going to start to get way too cheap, essentially, or I guess upside participation, the way you look at it, depending on how you look at it. So you got to figure that the market forces are going to come in here at some point and things are going to stabilize out or, you know, the market will move in a way that catches more people off guard uh one way or the other and get where you think realize it's going to catch up with implied you're saying yeah that's another way to put it yeah that's that's a cleaner way to put it yep or vice versa or they'll it'll come back down to reality but then that goes against what you're saying. This is all driven by this kind of like artificial call by.

Right. Yeah. I mean, that could be another, a second factor would be whatever gets people, maybe the next stimulus check comes out and it's another thousand bucks or whatever. I mean, and we start getting back into this. Hey, I'm a, I just got some more house money back in my account and started loading up the calls again. Possible. We start seeing this thing persist a little longer than we thought.

How does this work for your guys' strategies? Is it a non-event or is it worrisome? Is it exciting? You know, for us's it makes it tricky because you know we use a lot of the same indicators that Pat was mentioning you know like the shape of the term structure is important to us in terms of signaling what the ball how the VIX market feels about risk and when when things get turned on their head like they have been in the last few weeks that message can kind of just can be confusing it can almost be the opposite so it changes the way you know

we're getting like this stress you know in August we got these stress like signals while everything was going great in the S&P so it it puts us in this weird unique spot where we're starting to put on hedges when the markets make an all-time highs and we're just watching what's happening in the next and putting the edges on it now the markets started to drop and we're backing away from the hedges so for a lot of our investors it's like what you guys are doing this backwards here yeah the Vix is doing it backwards yeah yeah uh for us you know we actually the the mutual fund that we use um the way that we implement that hedged equity approach is um you know in a sense

stock replacement and so we are long call options in a conceptual sense, maybe not in a literal sense. So follow-up spot-up is very good. We love follow-up spot-up. Our up capture was very good in that situation. And, you know, our models try to adjust, but they recognize the fact that that is a temporary phenomenon, that follow-up spot-up, you know, shouldn't persist for months at a time. That's not to say that, you know, generally, like in the 1990s, the VIX and the S&P trended higher together. But if you look on a day-to-day basis, the correlation was still negative between those two. And so, you know, in general, our portfolio is long gamma and it's long vega. So we love when the market moves.

And, you know, we've actually, one of the trades that we've liked, given how, you know, steep index skew was, was putting on put ratio spreads to hedge the downside. You know, we understood that performance is good when vol and spot go up together. But how do you hedge against that? And how do you kind of lock in some of those gains without taking all your chips off the table? And so our preferred way of doing that is by trading put ratio spreads on the S&P 500 instead of doing something like just buying a put because when you're buying a put you know on a day like today um despite the fact that the VIX was up across the board S&P options you know on a fixed strike basis implied volatility got creamed um and especially so in some of these longer dated expirations and so the way that you know that is the biggest risk to our core positions and so the way that we hedge that is through using put ratio spreads to effectively get somewhat shorter volatility and shorter gamma as the market comes down.

And it can, you know, they do very well on days like today. How do you square what you said with vol up, spot up? It would seem you're buying these call options, but they're overpriced is what we kind of talked about before. You're nimble enough to get them for not overpriced. Well, I think that it's a bit of a generalization to say that they're all overpriced. I mean, there's 12,000 options on the S&P. If you look at the NASDAQ too, you know, remember the BRP and looking at, you know, the implied volatility you pay versus what is realized. That is relevant if you're, you know, delta hedging and trying to remove all the price risk from that option. But at the end of the day, our investors hire us to, you know, they want market exposure. They just don't want that nasty 35% pullback.

And so if you have the propensity to actually own that Delta, you can use some of these nuances like skew, like the term structure to kind of optimally structure a long delta or bullish position, but that will still give you asymmetry to the overall market. And so, you know, there is, I think options tend to be very well covered in the very vanilla sense, covered calls, iron condors, put selling. And they're also very well covered on the, you know, volatility arbitrage side, which is, you know, just what market makers are doing and what, know proprietary traders are doing they don't want price risk there's a gray area in between um that we feel you know that's where our edge is and that's where there's opportunity price risk some vol risk yeah right and and you can use things like

skew to give you asymmetry to these markets and so um you know i i think that overall if you're willing to stomach that price risk that you know calls are not as expensive as they may appear um and then what coming back to the market makers for a second do we think some of these this environment is because there's too few market makers now like there's been some downsizing the banks have got the aim like if there's only right if makers now. Like there's been some downsizing. The banks have gotten out of the game. Like if there's only, right, if it was only Citadel, they could mark whatever price they want. So if you take that to its logical conclusion,

the fewer they are, the fewer there are, the worse it is for kind of, for a market. And the more this feedback loop could feed on itself. Yeah, I mean, I think the overall space has shrunk and balance sheets are a little tighter and so that that all feeds into that how willing they are to take any kind of directional risk and how incentive they are to go out and hedge that book very tightly and that kind of feeds into this kind of thing in the in the right scenario and these big mega cap names you know maybe that

leads to what we've seen in the last couple weeks and then you also have the dynamic at the same time the winner take all in the markets themselves of apple right the fang or the biggest wasn't apple worth more than the whole russell 2000 i think yeah last week or something right so you have this winner take all scenario going in the individual names plus the market makers kind of carving out their niche. Yeah. My brother, my brother said he had the best comment. He said that it's the winner's pool is like a hot tub now. Just a couple of guys sitting in there.

But in theory it makes it more fragile, right. And more susceptible to some systemic risk of one of those pieces breaks. Yeah. You know, in the other people on, you know, on the way up in August, looking at the breadth, we kept seeing these terrible breadth numbers in the NASDAQ in particular, but all over the place as the market's making new highs, it's breadth's getting worse and worse.

And the argument is, well, it doesn't really matter because these five names represent most of the index. So who cares what the other 495 are doing in the S&P. And then the inverse is happening potentially now. You had, I think, 70% of the NASDAQ opponents today were outperforming the index. It's just that the 30 that were getting creamed

are 55% of the index. So, you know, that works both ways. Yep. And so let's talk that quickly would this feedback loop happen on the downside as well or there would need to be mass retail buying and institutional buying of puts and whatnot and then the dealers are gamma hedging on the downside yeah i think in theory and pat can probably speak to better than i could but in theory the the demand for those two week tesla calls evaporated today.

Tesla was down 21% today. You know, probably people are pulling away from that market rather than charging into it. And then that creates the opposite. If there's still, you know, that inventory on dealers' books, now the delta's moving the completely opposite way. And they need to go, in theory, go reverse to hedge out those deltas. And especially on a 20 20 move in that name today yeah um maybe it would have been 10 if you know x all this this call overhang on their books he's i think he just right they uh they announced the split he raised that new uh new offering

then they didn't get in the s&p but they're like hey we got our money out of the thing that's right maybe they should split again i don't know then they didn't get in the S&P, but they're like, hey, we got our money out of the thing. That's right. Maybe they should split again. I don't know. Good, guys. I think we've covered all. Any other nuance pieces that we've missed? Where do we go from here? Well, we get the Fed next week. Maybe they'll right the ship here. And then, obviously, we're getting into election season pretty hot and heavy.

So I think it's all just going to depend on, unfortunately, polls and the latest tweet. And you mentioned, Matt, you thought that what's being priced in is there's like a dispute dispute of the election is that what you were getting at i mean it seems to be so the the october contract the election itself you know you're at 35 i've traded almost 40 uh which is you know previous to this year was pretty unheard of so the election itself but very volatile and then afterwards you had your upper 20s uh lower 30s upper 20s all the way out till upper 20s, all the way out until March. And if the market was really just worried about the election night itself and then, you know, we have a winner and we move on with life, I think you'd see those farther out contracts a little more at a discount. So if this thing drags on for, you know, if it's January and we don't know who the president is,

yeah, mid-20s fall is going to seem on the low side, I would imagine. I hadn't heard that take before. My thought was just people are thinking it's going to be Biden and he's going to tank the market and introduce new taxes or regulation or whatnot. Yeah, you know, maybe that was part of it, like early on in the year when there was that bump in October and it's been there throughout the whole time but now it's a bump on top of a bump this thing's close to 40 I mean right it's a bump on the whole curve is elevated right yeah right so now there's like this big systemic kind of thing being priced in I think and then what if we get a vaccine tomorrow you think the whole curve comes down 10 points or what yeah Yeah, you've got to figure. And that would take a big part of that left tail out, I think, especially on obviously the GDP and earnings and everything. And you can start painting in some better scenarios for earnings next year.

The market got quite a bit the way they are already, I think. But yeah, the vaccine would definitely help, especially if the vaccine was announced on like November 10th or something, or shortly after the election. Oh, it will be. They'll time that perfectly. That's right. And what else? Oil, dollar, anything? Any thoughts on those guys?

Who cares? Your volatilities? Right. I mean, we look at, I like to look at jump bonds and corporate credit in general, because that seems to be the linchpin of this whole, of the Fed's focus this year is let's shore up that corporate bond market. So we've been watching LQD and JNK are pretty easy proxies. And LQD is quite a bit off its highs.

And it's actually trading back down almost to where when the Fed said they were going to start buying that debt. So that's interesting for me to watch. I don't see all equities go up and volatiles down. It's LQD and that junk bond market or the investment grade corporate bond market is having trouble. So we're watching that. I think there's over the last few days, your traditional portfolio 60, 40 or, you know,

risk parity strategies have not fared too well um and i think that you know at the end of the day that's how 99 of people are invested in the market so that's always a good gauge for uh you know where is their pain and how much pain are people feeling yeah i think i tweeted out i can't remember what day it was, Thursday or Friday of like market down, gold down, bonds down, BICs down. Nowhere to hide. Nowhere to hide.

Bitcoin. Bitcoin might've been down too. All right, guys. This has been fun. Matt, why don't you tell everyone where they can see you on Twitter and whatnot? Oh, sure. So Twitter, I'm at Dynamic Ball

and Thompson Capital's website is thompsoncm.com, like capital management. And Pat, in case people didn't write it down last time you were on. Yeah, my Twitter is pat underscore Hennessy. And if they want to check out the firm, the website is investps.com.

If you have any questions, just reach out, send me an email. I'm always happy to, you know, talk shop, talk volatility. It's always exciting. It's fun. All right, guys, it's been fun. We'll reconvene when VIX is at 110 or something and a general gets appointed president or some weird scenario. All right. You got scenario. All right.

You got it. All right. Thanks, Jeff. Thanks, Jeff. You've been listening to The Derivative. Links from this episode will be in the episode description of this channel follow us on twitter at rcm alt and visit our website to read our blog or subscribe to our newsletter at rcmalt.com if you liked our show introduce a friend and show them how to subscribe and be sure to leave comments we'd love to hear from you