The Derivative - Sequencing, Skew, and (Option) Strikes with Hari Krishnan

Episode Date: September 24, 2020

We’re joined by option guru and author of ‘The Second Leg Down’ in this episode to talk through the real-time test of market crashes and volatility dynamics we’ve witnessed since February. Is our guest’s theory on volatility sequencing proving its worth in this environment of bigger VIX spikes, oil going negative, and retail trader flow? Hari Krishnan has all the insight on how to survive during volatile periods. Our conversation with Hari also includes: hobby jogging marathoning, basic income options trading checks, gamma driving prices, San Sebastian, selling unlimited retail, the gamma phenomenon, window dressing/skew/& monetization inside Hari’s strategies, Hari Krishnan cult movement, the new effects of VIX spikes, a broken fly, chaos theory,  panic options trading, if we actually saw a second leg, option selling accessibility for everyone, the temptation of selling options, hedge funds bailing on office real estate, fractals, and market crisis in stages rather than single events. Chapters: 00:00-02:01 = Intro 02:02-17:24 = Background 17:25-36:34 = The Rotation of Hedges 36:35-54:13 = Real-time Thesis Test & Broken Fly’s 54:14-1:07:44 = Is This the Golden Age of Options? 1:07:45-1:12:45 = Favorites Follow along with Hari on the SCT Capital Management website & LinkedIn, and read his book Second Leg Down. 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. But if conditions continue to get bad and we sort of start looking like we're going into a bear market, then the entire term structure picks up and options become more expensive across maturities. And so there the market is saying effectively, we want to price heightened risk over longer realizes.

And so you basically get stages in the process. Now, if the market does quiet down and there's a reversal and realized ball comes down, then the short end starts dropping again. The long end remains elevated until finally the cycle repeats they have stages in where risk is repriced and the way i thought about it in the book that i wrote and various speeches that i i blab on about this um is that if that is the case, if that volatility cycle is fairly sequentially predictable, you might not be able to predict what happens, but you can predict the order. The right strategy for hedging should involve rotating from one type of hedge to another as the surface changes. Hello, everybody. I'm excited to have with us today the author of The Second Leg Down, which I was sad to learn isn't about an athlete who loses his legs and

goes on to compete in the Olympics, but instead everyone's favorite dinnertime topic, options. We have Hari Krishnan with us today, who is exactly the person I would want at the front of the lecture hall if I was taking a course on option pricing and volatility dynamics during market crashes, with that great sounding voice and soothing cadence when explaining very complex topics. So welcome, Hari. Thank you very much. What do you think of my course title, Option Pricing and Volatility Dynamics During Market Crashes? Well, that's a mouthful. I'm not sure I can deliver on that. Should we pitch that to a college to offer some students virtually? Yes, but I'm going to make the recommendation that you teach that course. I've had my fill of university life.

That's what I was going to ask. Have you ever been in front of the classroom like that? I have. I have. And it's a challenge because some people are trying too hard to impress and the others are falling asleep. So it's a bit of a, it's a tough crowd. Among the students? So where was that? Where did you teach? I took for one semester as an adjunct at the University of Chicago. Okay. Know it.

And I've done the odd lecture here and there. And that's about it. Okay. So it was never a profession, really? No, no, no. You do not teach, right? Those who can't do teach? those who can't teach do. Does that work or no? I love it, yeah. I think you do both. So where are you joining us from?

You're usually in New York, but you've been a little COVID retreat? I am in a beach shack, for lack of a better word, in Duxbury, Massachusetts. Okay. Is that the Cape or no? Sort of a smack dab in between Boston and the Cape. It's right on the coast. All right. Nice. It's about to start getting nasty with some Nor'easters coming in there, right? Well, that's always the fear and we haven't had our generator serviced, so I think I need to do some hedging there. Exactly. And outside of writing books and running hedge products for investors, you're also a hobby jogging marathon traveler. What does that mean exactly?

Well, I used to trade, Sock Jen used to be our main prime broker when I was in London and I had a friend who was into marathoning and he was also into finding the best hotels that were close to the finish of the marathon. It just sort of hang out, drink some beer and eat really well. And the food and drink never tasted as good as at the end of a marathon. Maybe that's too much punishment to take on the way. But we did several European marathons, not earth shattering times. You know, I think I was running in the mid to high 320s.

But it was a great time going out there, getting nervous before the race and then really enjoying our food at the end. Mid-320, that's good. I'd take it. It's okay, yeah. And they were only European. Have you done them back in the States? I haven't done anything. I haven't run any of the big marathons in the U.S. yet. You're retired. Not for now, yeah. Yeah so so give us a little background on uh how you got into this crazy world of options and you mentioned london and sock gen and so give us a little personal background yeah well i've been around the block and um so i have a phd in chaos theory which we could talk about over a beer or something but i was up there then i

started working in um the option space basically i worked for a market making firm that wanted to establish an off-floor presence and so basically what we did was we developed models that allowed them to lay off the risk in individual options positions using index options so they wouldn't have to unwind intraday. And so it was basically looking at the correlation between implied volatility for individual stocks versus indices. That's a thorny topic. So they'd have a bunch of Microsoft to hedge and you would tell them like, okay, we need to do X index puts in order to do that or buy the X number of index futures in order

to hedge that? Exactly. Yeah. I mean, typically we did options versus options. Okay. And so I might be different from some of your guests, especially guests who have a lot of sell side experience. We think a lot about Delta 1 hedging, hedging using futures or the underlying.

I never really focused on that, but that's a really thorny topic as well. Everyone wants to talk about that right now with the gamma is driving prices higher, driving prices lower. I've been trying to get on some current market maker or dealer and see, like, is that what's actually happening or not? It seems a little too simplistic of a explanation to me. Well, it is. It is actually. The nice thing about it, though, is that, you know, as I've been in this space long, you know, over time, as I've been in the markets for a longer period of time, I've realized how at were credits and positioning. I kind of learned that when I was doing global macro in London, which is kind of another add-on to my bio.

But, you know, if I had to go back and look at 2008 versus today, 2008 was a credit problem. 2020, aside from the huge exogenous shock, which I'm sure you can get other experts to talk about, has been a real issue of positioning. And so some of the stuff, you know, the squeeze metric stuff or the overload of single name calls that dealers may have been short based on client demand, which forced them to hedge, that's been one issue. Clearly, that's been an issue. Has it been the only issue? Probably

not. Dynamics are very complex. That's been one issue. Clearly, that's been an issue. Has it been the only issue? Probably the last. Yeah. Dynamics are very complex. And do you feel there's an unlimited supply of dealer supply on those options? It seems that is a missing piece, too. I'm just like, yeah, the dealers will just sell retail as many options as they desire. They'll sell a lot at a price. I mean, there will be an adjustment in the skew as a function of that. And the skew adjustment isn't just because, say, Tesla has had some big returns historically. It's also because the flow is so heavy on, let's say, on Tesla or some other name,

some other name, the dealers have to jack up the implied vol numbers that they close to at least collect a fat risk premium for taking on the added risk. So to a degree, yes, I mean, you can create as many contracts as you want. But there are natural limits to how much supply is really, really available. Right. Got it. So sorry, I derailed your bio there. So you're in line in your market making option desk. Well, then I did global macro for eight years. I ran an FX strategy.

I ran hedging overlays and I also ran a diversified absolute return strategy. So I did that for nine years. I had the classic issue that many of us face where we have a very large sticky investor who turns out not to be all that sticky for seven or eight years. And so at some point, I moved back with my family to the US,

probably for a lifestyle change, and got back into an options-focused way of doing things. So the way I'm trying to hit people nowadays is to say, well, look, I'm someone who can help in terms of interpreting the macro perspective in certain very specific ways. I don't cover everything. I'm not a pundit, not a media personality per se, but also someone who knows the intricacies of trading options from the buy side. So that's kind of where I'm trying to hit people. I don't think you should be hitting people at all, but I get what you're saying. That's why I strike them hard, you know? Right. And so there's some news, right? You just recently joined a new firm?

Yes. I mean, I've known the folks at SCT for a long time. And given that my existing firm, that Bob Darcy decided to basically move on and do something else. I've taken over his business and then plugged it into the infrastructure of a more well-established, operationally sound hedge fund. So I continue to run an independent business line, but within a larger hedge fund. And I hate to use too much corporate speak,

but there's some good synergies there. Some good synergies. Yeah, some fine synergies where they are experts in machine learning. They've been doing it for over 20 years. And they are well aware of the strengths and weaknesses of ML. They have an honest approach where they say the real danger in machine learning is that the algorithms get too greedy. They start latching onto what's been going on recently and they're vulnerable to a sharp

shift in sentiments, like a jump in the regime. And that's exactly what I try to do with some of the hedging strategies that I love to account for that. I just saw today some zero hedge posts and they had a screenshot of JP Morgan's algo on the vol space of like dollar vols cheap and this is expensive and buy this sell this. It made me cringe for a second of like this this is a little worrisome but then I was like that's fine get get more and more into that space because I think the humans might have a edge there. Yeah. Yeah. I mean, humans are pretty good at saying, I don't know what's happened, but something has changed. Yeah. Machines are less good. I mean,

the old speech that I used to hear that I think is pretty valid is machines might be more emotionless, but that has some negative attributes too a machine doesn't worry about trading a million lots instead of a hundred yeah and we'll start sweating if they you know they trade the wrong size or they feel the pain of a position going against them and in a way that's a good response yeah they won't know if they get turned off, right? They don't know they get fired. Yeah, exactly. Exactly. So, in SCTs there in New York? Yep, they're on, they're in Greenwich Village. I wonder, I'm curious to see how this all shakes out and whether these hedge funds in New York all bail on the expense of real estate and have everyone remote and see what that looks like.

Yeah, that's a great question. You know, it's really a question of also how important culture is. Does culture breed more success at the trading desk? I really don't know. Back in the day, people assume that was the case. In the same way people assumed the variations in volume on the trading floor was an important signal of liquidity and things like that. That's all changed. It remains to be seen how this will evolve.

Yeah, I was speaking with, I'm'm gonna forget where he works but it's one of the big uh mutual fund or asset managers in chicago he was a buddy and he was saying that that's what they're most worried about the culture how do you bring in the new people get them plugged into the culture that they built up um like we'll see over zoom over zoom wow yeah doesn't work doesn't work as well um yeah and then i've done a couple sorry sorry to interrupt i've done a couple zoom happy hours that does not work no that was a big thing right in the beginning right i don't think i've done one since april but they were like two three a week in the beginning. So I was about to say, I have to ask on the name and being a child of the 70s of the Hare Krishna cult, would you call it? Religious

movement? I don't know if it's a cult, but any relation there? What's going on there? Just coincidence? Okay, that's a good question. Well, first of all, I'll say I have nothing to do with the movement or cult or whatever. Cult's probably too strong. Let's just call them a movement. Well, you know, I mean, it's a matter of perspective. I've never been involved in it. I don't know much about it. I'm speaking a little off-piste, but I've never been one in favor of conversion into any religion and um really the origin of my name is there are not

that many traditional south indian names for people of my caste there are probably five or ten with various variations and they're the names of gods you know tradition do gods and krishnan is or Krishna is one of those gods one of the one of the important ones and so my first name and my last name are very traditional names it's a bit like what people in India say no one ever has the name Wolf or Clint or Cliff. All the names have religious meanings, whether you like it or not. I mean, it's just tradition. And that's about it, really. And you know, it's funny, because as I was telling you

before the call, I was born around the time of Woodstock, and my parents weren't really hippies. They were blissfully unaware of the, not the ridicule, but the difficulty it would cause me in my early years. But you know, I saw no need to change it. It sticks in people's mind and should finance go south on me, as I've told other people, I can always shave my head and use my soothing voice, hopefully. Yeah. And, you know, make podcasts about inner peace and serenity. Done. I'd listen to at least one.

Yeah. Yeah. Great. Well, sorry if that was insensitive, but I was curious. I needed to know. So let's get into your strategy a bit. A lot of us in the investing world are worried quite simply about protecting our portfolios from a market crisis. I'll use air quotes there. But it seems you don't really see a market crisis as a singularity.

Kind of see it as having different stages and profiles. So yeah, tell us what you see as these stages and how your strategy deals with those different looks, so to speak. Okay, well, you know, there's an economic cycle that people talk about. There's a credit cycle. And, you know and as people are

increasingly become aware of, there's a volatility cycle as well. And the vol cycle, you can start it in the late stages of a bull market where investors are complacent. And when investors are complacent, the prices of options are low. The premiums are small. And the reason they're small is because people don't really feel they need to buy insurance over any horizon. So short-dated options are relatively cheap. Long-dated options are cheap. And the skew isn't that steep in terms of points.

It might be in percentage terms because at-the-money vol is so low. But it's not particularly be in percentage terms because at the money vol is so low, but it's not particularly steep in absolute terms. Now, as things get worse, if there's a crack in the market, let's say a little flash crash, and I'll just use equities for now, equity indices, because it's common fodder for most people. The first thing that happens is the short end of the vol surface picks up. So investors are now saying, oh, there is some risk in the short term, but we're not going to adjust our risk estimates for long horizon. And short end, you mean short term? Yeah, you know, options with a month to go. Yeah. Two months to go, something like that, or further in. But if conditions continue to get bad

and we sort of start looking like we're going into a bear market, then the entire term structure picks up and options become more expensive across maturities. And so there the market is saying, effectively, we want to price heightened risk over longer horizons. And so you basically get stages in the process. Now, if the market does quiet down and there's a reversal and realized fall comes down,

then the short end starts dropping again. The long end remains elevated until finally the cycle repeats. They have stages in where risk is repriced. And the way I thought about it in the book that I wrote and various speeches that I blab on about this is that if that is the case, if that volatility cycle is fairly sequentially predictable, you might not be able to predict what happens, but you can predict the order. The right strategy for hedging should involve rotating from one type of hedge to another as the surface changes. So if all options are cheap, go out and buy some long-dated ones and sit and wait, like a game where you collect some,

you get some investors to come in and you say, bear with me, I'm going to buy two-year options, three-year options, whatever. Kind of a Universa-tallid model, would you say? Yeah, Universa probably does some of that. 36 South specializes in that. Yeah. And it's basically a game where they're saying volatility is cheap from a valuation perspective

So why not buy it in a setup where you your Vega divided by theta ratio is pretty high in other words Every day that goes by you don't lose much in time decay But for every point that risk is repriced up you get a big bang Yeah is repriced up you get a big bang for the buck yeah makes sense and then people will say well okay that's that's nice but how do you take profits you can get in nice and quietly nicely quietly but how do you take profits in my view over time evolved to one where i basically argued that you don't want to be taking profits where you say, here, client, one day you're hedged, and the next day you're not hedged. You don't have to roll with this unless the client wants to do that.

And a little better way to put that might be, or for my brain at least, would be how do you monetize it, right? Like taking profit seems like you have a profit motive, but if this is a hedge, you have a kind of a different motive of it's supposed to be covering some piece of a another piece of the portfolio that i need to monetize the insurance right you don't your insurance you mentioned you're uh generating your hurricane insurance you don't have to decide when to monetize it right you get paid out if there's a problem if not you don't correct whereas these things can lose value quickly too very quick quickly, right. Very quickly, yeah. And yeah, monetization is the right word. And so basically, the client may have various triggers for monetizing hedges, which is based on what they're doing in the rest of their portfolio. That's fine.

But assuming that you're hedging all the time, and you don't have those sorts of external constraints, what can you do? And my argument was basically, why not rotate from one type of hedge to another type so that you always have some downside protection in place, but you're not overpaying for stuff that is rich and by a factor of 10 or something. If you buy a 10 delta put at 10 bucks,

then it goes to 110, 100, whatever. Probably at some point, it's no longer offering good value as a hedge. Either because implied vol has gone up so much, or you really don't have any convexity left in the position. It's just trading like a futures contract or something. So basically, the way I thought about it was, why not show what the best hedge is at least based on the combination of experiences and tests

given the regime. And on the put side also you have a zero bound, right? Like it can't go below zero. Like in theory you can only have the put can only go up as much as the zero bound, right? As much as you would make if it went to zero. Yeah. I mean, of course, crude oil, people will pull that out of the hat. Yes. In general, that's absolutely true.

Sorry, I broke you off. So you have this monetization. Then what do you roll into next? Some kind of a spread. So, you know, if the skew gets very steep at the short end, you might want to buy put spreads or even put ratio spreads if the skew is very steep, where you're putting on a defensive position.

You've got bounded risk, at least in the context of your entire hedging portfolio, but you're also monetizing some value out of the skew. So if the market doesn't race down from the point you put the trade on, you're actually building a downside protective strategy that where time is more on your side. And speak through a few of those terms there. So the skew you're talking about in that case,

which one's more expensive that's causing that skew? Well, typically, again, I'll focus on equity indices to keep it easy for now. When the S&P 500 or whatever sells off, typically the implied volatility for out-of-the-money options rises more quickly or radically than the implied vol for out-the-money options. Now, if you believe that the speed of the sell-off will not be maintained at that rate, then you're well served to buy some puts that are closer to out-the-money and buy some puts that are closer to at the money and sell some puts that are further away, simply because even though the puts you're buying might be a little more

expensive than they were, the puts you're selling are much more expensive than they were. So from a relative value standpoint, you've got a little bit of edge in the trade, but you're still expressing the downside view. Right. And if that, if it's wrong wrong if it accelerates out of that move if it gets faster you're you're only you want you're not going to lose an unbounded amount you still only have the difference in the spread right correct yeah i mean i'm not suggesting you

go in and you buy one at the money put and sell three out of the monies. That's a really different trade, right? I've seen that one get taken to the cleaners. Uh-huh more on the upside than the downside but oh Absolutely, I digress Okay, so what's next so that SKU SKU is high you're gonna sell those spread or you're gonna you're basically buying spreads right it's still a net debit Yeah, it's still in that debit. Yeah, so you're buying that spread so long protection and you're basically just trying to Skim all skim off a little bit of edge from selling the SKU, but you're building a downside protective structure Then if conditions get even worse it becomes more difficult. basically what you have to do is either trade delta one or go into very short-dated gamma hedges i've skipped a few intermediate steps

but those are the main ones so why what are short-dated gamma hedges well you can buy things like weekly options weekly options are very expensive from a time decay standpoint, as many of your viewers will know. If you try and plot theta against time to maturity for a fixed delta option, the theta tends to be very rapid, close to expiration. But the good thing about these sorts of options is that you're not really paying up for implied volatility, even though it's spiked. You're more paying a fixed cost to have a well-defined downside protective strategy in place over a short horizon. That's a mouthful. Basically, what I'm saying is you're not paying up for implied vol when people are afraid. You don't have long-dated protection,

but you get tons of implied convexity if the market shacks from there. Well, it's kind of like rates, right? Like if the curve is flat, go shorten your duration. Because basically you don't know what's going to happen, so get into the short end of the curve and live to fight another day. Yeah, that's a great example yeah

yeah and delta one just meaning you would go outright short you chase the move you're the you try and chase downside momentum in a disciplined way usually that's a systematic strategy at least in the modern age but it basically relies upon looking for what effectively amount to breakouts on the downside, where the signal to noise ratio isn't too bad. I mean, if you're thinking in kind of filtering or statistical terms, typically when you're looking for breakouts on the upper downside across markets, you're looking for setups um the quality of the breakout is high so there isn't too much choppiness going in now in risk off regimes you tend to get a lot of choppiness so there are various things you have to do to try and minimize uh the risk of being taken to

the cleaners if there's a squeeze but i'm fixing the down couldn't you argue that the uh the implied vol is there in the short futures trade as well it's just there in the range of the trade in the right you if you had a systematic strategy the stops would probably need to be wider because there'd be a lot of noise on the opening range or whatnot like so i could argue that that volatility is still there But I guess it's not a sunk cost. It's just a kind of an opportunity cost Whereas if you're buying the puts with that high IV, it's it's a sunk cost. You don't get it back Yeah, what are your thoughts on some costs for some reason? I mean I'm for obvious reasons But but you're right there is an implied cost to having a wide stop and then having the stop taken out in a market with high intraday vol. Right, and that delta one just kind of scares me

because you could also have, and you see this at bottoms especially, right? Like it might rip higher 3%, 4%, 5% someday, and then the next week it goes another 10 percent lower but you were going to get you're going to take a lot of that big rip higher loss but i get what you're saying it has to be very structured and very uh asymmetric in the amount it can make versus the amount it can lose but seems a little problem and is that actually part of your strategy or is that just i've never done that piece I've only done weekly options and I've done weekly options um I hate to sort of shoot myself in the foot here but

I had this idea where um this was not originally mine but at my old firm we were talking about how some people sort of call you up when they're in dire straits with the rest of their portfolio maybe they're allocated to some hedge funds or lockups or whatever and they're very worried about mark-to-market losses or just permanent losses and so they want you to hedge at the final moment what can you do and so we sort of thought well we're kind of like people who go around in an ambulance we realize we can't give people the best hedge, but we try and figure out what we can do that isn't too expensive. We'll block out the downside. And weekly options used to feature in that strategy.

So in other words, if there were some liquidity mismatches between when an investor could get out and the risk they'd be exposed to in the meantime and so on. We'd go into the shorter dated expirations and try and find highly convex trades that would at least protect them if the market went down significantly from there. So you're not, this wasn't pure window dressing. This was actually served a function. It did. It's not the best job though. I mean, the reason I said I'm shooting myself in the foot is because the core of this business, I hate to put it crassly, is.

Running a sustainable business with recurring revenue and to just wait until somebody pulls you up on the back from. Yeah, it's tough. Yeah, that's tough. It's a business that no one else did, probably because no one else wanted to do it but it was also quite an interesting one right well you'd be the ultimate poker player of like a leather ass as they call it right just sitting around for years and years waiting for that phone ring then you're in high demand right so you're waiting for the right hand but might take a while to get that hand uh so that's interesting so. But would that be part of the actual strategy as it exists today,

the Delta 1 futures? Just to block out, just to sort of create highly convex outcomes if the market is ripping down. And the basic idea there is that there is some statistical evidence that supports doing this in certain setups. And I'll give you the intuition first, which is that, you know, a lot of people say that, you know, markets, it's good to buy the dips. And that's generally true in the average case. Yeah. Or Tesla's case. Yeah. Yeah.

But the danger is if the market goes down, let's say 10%, intra-week, it could really melt down in the next few days. The odds of a very significant liquidation actually increase because people can sequentially get flushed out of the market. And there is a lot of statistical evidence that suggests that markets have the fattest tails over horizons of a week or less.

And so if you're seeing a fat tail sort of dynamic emerge, buying a weekly option at a fixed cost, probably a sunk cost, but not necessarily, is a good way to play it. And I sort of think that the markets don't really understand that because I've tested it. And even though weekly options have steeper SKUs and higher implied vols, I don't think actually, in general, that the markets adjust enough to it. They don't realize how fat the tails really are over short horizons.

And, you know, this is one of the early things that was done in this field called econophysics, where people would just tabulate returns. And so they take like a series of prices for natural gas or S&&P or 10 years, 10 year notes or whatever, the futures or whatever. And they would say, well, let's slice up the prices into one minute intervals, 10 minute intervals, one hour intervals, one day, two days, and so on out to weeks and months. And they basically built a different distribution each time. And they found the tails were fattest relative to the standard deviation. So they normalize these distributions for short horizon price action.

Like all the way across the timeframe down to the minute or was in this hourly or daily or weekly? One minute you get tons of four plus standard deviation moves. I think anyone who's traded bond futures will have seen that. Mega moves on macro announcements or liquidations or whatever risk off events quite often. For equities it's a little less common, but the same pattern persists. Where the frequency of high standard deviation moves, especially down for equities, is much higher

than over short horizons than it is over say monthly horizons, where the returns actually look pretty normal. So that seems to make sense, right? Like the longer the timeframe, it's going to smooth out more. Yeah. Right? Yeah, exactly. The shorter the timeframe,

the more apt you are to have just a run of, you know, in statistics speak, you're going to have a run of bad luck, a run of you're flipping the coin. You're going to have a run of tails, so to speak versus on the whole 10,000 flips, you're going to see it smoothed out. Which also made me think,

you think we'll ever see like daily or hourly options for that, right? If that plays out, the exchanges will be like, Hey, look at all the volume we got with weeklies. Let's, let's offer up some dailies, see what happens. Well, once a week you do get a daily one. Yeah, true. So they are out there, but just not every day. I mean, I suppose you could set the flex options pretty varied too,

but I don't know if you'd find a market for that. So let's talk a little. We just came through kind of a real-time test of your thesis here and of your book and what's going on. So how did it play out as you expected? Any different pieces? Did we actually see a second leg, or was that kind of just a one-legged monster there?

What are your thoughts on all that? Well, since I wrote the first book, some things have changed. And that makes the book a little bit dated in one or two ways. Generally, I think thesis is still very valid. But something that I've noticed since 2015, let's say, but more prevalent, it's been more prevalent since 2018 has been the risk of them of the VIX spiking Pretty by a large amount from a low level it used to be that you didn't get ten-point spikes for me a little 15 Yeah, I know there was a flash crash in 2010 where that sort of thing happened, but things like the Volmageddon in February 2018. Even that, it crept up a few points before the big spike, but yeah, I get what you're saying.

But the handle was below 20 when it just blew out. And we have the same thing here, where the VIX wasn't very high in Feb, and then just blew out completely going into March. And so this makes life a little bit more difficult from the standpoint of looking at hedges sequentially. The other problem with it, the other thing that's changed in the markets quite a bit, although it hasn't happened as much this go around, has been the tendency for the VIX to get slammed or volatility to get slammed as soon as things settle down.

There would be a scramble for people to short ball as soon as they thought the coast was clear. And you could look at something like the half-life of volatility across markets, and it had clearly shrunk. So in other words, you said, let's measure the spikes in the VIX, or the TY VIX before it got discontinued, or a currency VIX, and then let's see how long it takes to go down from the peak to 50% of the way from the initial level to the peak. And that is much shorter than it used to be, at least until this go around. Right think this people are expecting it to snap back a

lot quicker in April and May they did and in other markets it did kind of come down more yeah in treasuries if you look at the move index it's trading at a very low level now it's just equity seemed credit spreads have come in quite a bit. Equity seemed to be the outlier there. And the other thing that's quite interesting about now, again, I don't want to focus too much on the negative in terms of predictability, is that as others have remarked, I'm sure people on your show have, and you have as well, there's a strange kink in the term structure of volatility with a huge loading in October and November,

probably based around the election, but almost certainly. But that's pretty unusual, too. Usually, curves are either upward sloping or downward sloping. Some of our guests have said it's based on a contested election, not just who wins it, but whether or not it gets verified or not. Yeah, that's a great insight. But if that were strictly the case, if everybody believed that, then Dak and Janvol should be higher than they are as well, because contested election means continued uncertainty into the further out months. I think Chris Cole, when Twitter was coming back with that exact point of like,

that doesn't make sense, then it would be elevated. He's actually saying if there is, that's all way under price. Yeah, well, it has actually ratcheted up a little bit, but yes, yes, he's right. Yeah, we've seen Oct kind of come down and the back months go up, much to the chagrin of a lot of Volarb guys that we work with. I'm not surprised. Yeah, so be it. But the other things have sort of held true.

The skew's gotten steeper. The correlation of Vol across markets was very high, which means that in Feb and March, it didn't matter where you hedged, you would have made a huge return. You didn't need to be a genius then. If you still had assets and you were still loaded in your positions and weren't getting queues, no matter what you had on, you'd probably make a huge return. So in terms of your thesis, Jan and Feb option, vol was cheap, so to speak. So you were just buying out of the money puts.

Then March and April, explain March and April. So it got, when would you have per your thesis, let's not talk actual trades, but per your- I'd say early March before the low in the market i would have been rotating into spreads i would say in at the end of the first week so i would have missed the full power of week two so when we were down 15 or 20 i can't remember yeah yeah by that by that point the skew was pretty steep so i would have been trading spreads at that point but spreads could have been pretty wide and there still would have been gains to be made. Probably by mid to late March,

I would have been in sort of broken flies and things like that. So I would have lost money moving forward through that, but at a much slower rate than people who didn't monetize their hedges. Explain a broken fly for people to think that's a zipper. It's a zipper as well. Well, you can think of a broken, well how do I explain it without being too technical? Yeah, well we got a butterfly so it's... Yeah, so you've got a butterfly which is uh you but let's say you buy one at the money put you sell two somewhat out of the money puts and you

cover all the downside risk by buying an equally spaced away out of the money put so you might buy one of the uh one put at the spot price sell two that are five percent below and buy one put at the spot price, sell two that are 5% below, and buy one that's 10% below. For a broken fly, the spacing is not equal. Got it. Yeah. Basically, what you're doing is you're taking as much as you can from the skew, but you're imposing the constraint that you want to make money all the way down.

So you make some amount of money all the way down by buying that far out of the money put a little closer than you otherwise would, just to make sure that you have a true, true hedge. But at the same time, you're trying to get it squeeze as much out of the skew as you can. So those sorts of trades would have been attractive at that point. But they would have been very wide. They wouldn't have been zero, five, minus five, minus 10, trades would have been attractive at that point, but they would have been very wide. They wouldn't have been 0, 5, minus 5, or minus 10. They might have been 0, minus 10, minus 20, or minus 15 type of hedges if they were broken.

There's a lot of space on the downside. Why do you think investors are still, in that March period, is it just panic? It's just right like why are they so willing to pay up for those options when they at some point it's just a losing bet right like at a vix of 80 is the market really going to get more volatile from there in theory no right but people operate under so many constraints. And it just takes one prime broker to panic. And to one senior risk manager at a major PB to panic and say, blow it all out. I don't care what it costs. And people just have to unwind. They're not able to sort of hang in there by trading a spread around the position or cutting by 10%.

They just have to buy vol at whatever level. I mean, there used to be an idea that I had, which is a bit like the no negative price idea for futures, which said that, well, the VIX can never go above, say, 150. Because if it went up and down, limit up or limit down every other day, realized vol could never get much higher than 150. So you would have to be a seller around that. Yeah.

In 2008, if you looked at the implied correlation of all the stocks in the S&P 100, let's say, which can be derived from the relative level of implied vol for the index versus the average implied vols for the stocks in the index, you could wind up, there was a time when you wound up with an average implied correlation above 100%, simply because the market was clamoring so much for just slapping on index protection, macro level protection. These absurdities can come when people are just forced to cut risk.

Is there a flip side to that, that the people aren't able to add risk at those same points? There's people who want to sell into that volatility, but maybe they're risk constrained by whoever's in control of their risk book, or they just don't purely don't have enough capital to put it on in size. That's a great point. I mean, it's a one sided market when that happens. Yeah, but but not necessarily just because of fear, but because of other economic factors as well yes um so a point everything we're talking about here and these people are buying that up to do a hedge like how do you conceptualize and how did you get into this world of direct hedges versus like you were in a global macro firm of like no just add this piece and it's non-correlated and it should do differently

in a crisis how How do you view that difference? Well, I mean, I think there are three ways to hedge. One is to say, I'm going to pay a fixed amount of premium every year and provide something like fire insurance on people's houses, you know, where there's no real edge in the strategy, but people know what they're getting going in. And if it's run efficiently and well, there won't be any unpleasant surprises. The second thing you can try and do is to say, well, I'm really a hedge fund that specializes in downside protection. Trust me, I'll do what I do. I've done it before and I'll do it again. That may give maximum flexibility in terms of cutting costs, but it also creates an open-ended

question as to what is really being achieved with the hedge. And the third thing is the other area that I actually do. So I don't do number two, but I do one and three which is to say how close how closely can i come to replicating a volatility index like vix while minimizing the carry costs associated with that so i do direct hedging and i also do volatility replication those are the two different things i don't do the stuff in between mainly because i think it's very hard to sell it to people who think in terms of insurance, people who want the more predefined payouts that an insurance policy would deliver. I mean, ultimately that's the most flexible way to do it, but I only do one and three.

Now in terms of direct hedging, even that requires a bit of finesse, as we have seen many times, which you understand as well as I do, which is that the cost of insurance is not static over time. It's not as though you can diversify across thousands of uncorrelated insurance policies and constantly price things in the same way. When the market's afraid, you simply cannot go out and buy as much insurance at the same levels as you can when the market is complacent. So it does require some finesse, but assuming that you do apply some reasonable hedge fund style techniques to supplying that, I think that's a very good strategy, just to avoid overspending. You made me think of a friend who worked at a cat bond reinsurance, some sort of hedge

fund. So they would be selling like hurricane insurance or buying the reselling of that hurricane insurance. But she would always be like, oh, we just want a small hurricane. We don't want anyone to get hurt. Don't want a lot of damage but if the pre if it can push premiums up a little on the insurance reprices uh the odds are still the same right of the next hurricane hitting the odds don't really change but when the one hurricane comes through it pushes up premium i guess they're allowed to sell it for more because people are fearful uh but the odds are that you made a very good living i think that's

a good business we need to analyze at some point but um and then another thought there so i hear everything saying about you personally but to me it's interesting of the investor side how do you see that split to me it's i think maybe 70 30 the other way of people just saying i don't want to do direct hedging I'm just going to do a add 40% bonds or buy some gold or right they're they're thinking sort of hedging but they're more thinking asset allocation and diversification so I guess the question is more do you how do you tell people there's a need for this direct hedging component instead of just relying on this nebulous concept of asset allocation and diversification? Well if someone issued a guarantee

that Treasury bonds or government bonds in general would rally in every crisis from now on to the end of time and also that the yield curve would be upward sloping from now until the end of time. There's a strong case to be made for just buying treasuries as a diversifier. I think if you go back far enough over time, maybe this is a Chris Cole type of thing again, you'll find that bonds haven't really provided reliable protection, say, over many decades, maybe since the 80s they have, but since the secular bull market in government debt, but not before that. And if that ever changed, and if you think of the risks purely in terms of where yields are vis-a-vis where they can go, then this whole idea that sort of riding that camel

until it falls over by diversifying into bonds, we're coming up with some clever-looking scheme using a bunch of fancy math that basically forces you to allocate a lot to bonds, may fail. I worry about what other people are doing in that regard. Was that a veiled nod to risk parity? It is, well, not so veiled.

Not so veiled as it turns out, okay. Not so veiled, but I mean, I understand why people do risk parity. It looks great in a back test. And if you operate under the assumption that bonds will rally in a flight to quality, fine. It's probably better than hedging, but that is a heroic assumption.

If the bills are globally close to zero, okay, maybe they can go negative. Maybe you can make some money on roll down. But at some point with a perfectly flat zero yielding curve, the risk has to be asymmetric to the downside, at least for prices. That's a wise go-to hedge in the medium-term future. So it seems as an investor that the calculus is the basis risk of those non-guaranteed diversifiers greater than the cost basis of doing the direct hedges right

yeah but i'm with you of bonds especially now when they're yielding nothing like in the past hey if they're wrong and they don't do a flight to quality at least i get this yield but now it's you know you you're just relying on that flight to quality aspect. Yeah. I mean, it's one of those things where, you know, if you had a yield curve, I wrote this in the first book that where the yield was zero for maturity, zero years to nine years, 364 days. And then the 10-year yield was one basis point. You'd still be able to buy bonds in the sense that you could buy a 10-year bond every so often. And then when it became less than a 10-year bond, it would reprice.

And you could dump it and then buy another 10-year bond and do it again, which is effectively what the futures do because they have been under... Growing up the curve. Yeah. So trading the curve is one way to make money without yields being high but even that becomes increasingly difficult when the short end is pinned at zero or near zero and the long end is vectoring down in there and uh so even that trade eventually gets squashed yeah and even managed futures last year and 19 made money in boons and a bunch of negative yielding debt because it basically got more negative yielding. So that can happen, but it seems an odd bet.

So back to options. We're seeing all this talk, which we touched on earlier, of the gamma hedging and Robinhood retail option flow. Do you kind of see this as a golden age of option trading? Anyone with an internet connection can trade an option? And if that's the case, or maybe golden age is the wrong word, but it seems as if there's more people in the world today than ever before that can trade an option. Is that a good thing for you, for market makers, for those people?

It's not good on average for those people. I think the reason they're trading options isn't just that they're ultra bullish and they want to load up with implied leverage on the upside. It's also because the places they're trading through, the platforms they're trading through probably won't allow them to build significant positions without trading options. So they're kind of forced into it if they really want to make a big return on their investment. Well, and or they offer free stock commissions you pay commission for option training they're incented to uh push you into options yeah to steer you in there that's right

and then the apps and everything are all gamified of like have you tried options yet you know so there's there's that component of it as well but i would agree like i don't think it's a net positive for society that a bunch of people are trading options and, oh, this is easy. I just buy a call. I don't have to put up much money. The Tesla goes up, cash out. And I feel very bad

because some of my favorite finance podcasts, they have commercials. They're interrupted by commercials. Maybe I should get the proper YouTube subscription, but they're interrupted by commercials. Maybe I should get the proper YouTube subscription, but yeah, by commercials where people are making outrageous claims. Oh yeah. In the middle of a perfectly good,

sensible, um, show. And that's why we don't have ads. You're a wise man. Well, I'm always like, and then,

or right. You have some, unless you can control not just who but also the content gets a little dicey um yeah so i i don't think it's a net positive for society i mean you know the fact that you can trade options with bounded risk doesn't mean that you don't have risk if you buy a lot of options right you can still burn all the premium. And, you know, if you're too regressive in spending, that can lead to problems as well. And I brought this up on our pod talking about this gamma phenomenon of if most of these people are losing money, like, is that eventually

going to dry up, right? If they're all buying and the dealers are marking them up because they have to protect their risk and they have to make money in theory if they're marking them up correctly then it's just a directional bet that 50-50 at best right it's a negative negative edge game for the the buyers yeah so those buyers are eventually gonna lose money so does that flow dry up Is there a never-ending flow of retail that's going to replace the ones that are losing money? No. In a word, no.

I don't see it. Not without basic income in the U.S., and maybe they need both basic income and option trading income. Like, here's your $800 check a month, and then here's your $200 check a month to buy options yeah you know it's funny because a lot of people are unwilling to take options in their career

discussions but they're more than happy to make um bets with negative expected returns in their retail accounts trading options and that's a bit unfortunate because they can get some of those options in their lives accounts trading auctions. And that's a bit unfortunate because they can get some of those options in their lives for free. And I feel sad that that's the case. But it's the same, it's like the gamblers, right? If on a craps table, they'll bet on the worst possible statistical odds

because it's a big payoff. It's 12 to one or 21 or whatever, even though the true odds are 100 to 1 or they'll do um and football they'll bet on a 16 parlay because it's 10 to 1 odds but the true odds of that happening are 50 to 1 i don't know the numbers exactly off the top of my head but right people just they're willing to do it because it's a small bet for a large return even though if they you know and then the lottery is the ultimate example of that, right? So I put in my dollar and I could win a billion dollars. But I always said, if you would you play the lottery in reverse? If the lottery sent you a dollar every day, but you have

a 0.0000 or whatever, six chance of eventually they could come and take everything you own away plus that of your ancestors and everyone right you'd say no way but in theory mathematically it has the same expected return right yeah absolutely right but no one would say yeah i want to take that dollar every day yeah that's a good one that's a good one which brings me to have you ever been tempted by the dark side i'll call it of selling options, which is kind of that same... I have. I've never been an outright seller, but I've done spreads that I've gotten burned on. About 10 years ago, I was doing calendar spreads in the Eurostox.

And basically, this was 2011, and the term structure had become very steep. There were all these solvency crisis-related issues. And so I had this notion of buying. So these were kind of deferred in the term structure. So I was buying front-month options and then selling twice as many further out-of-the- of the money back month options. And I got burned because nothing much happened until late in the expiration cycle. And then all of a sudden there was a shank.

And even though I was long gamma, I was short vega effectively. And the vega caused some problems. I was able to block out the risk by just buying some ridiculously low strike puts below, sinking the cost, and then taking a moderate loss on the short puts but not getting seriously damaged. But yes, I have ventured into the dark side in spreads, but never in leveraged naked shorts.

And what would you say to the mostly retail crowd that's out there selling those naked if they're allowed? I don't even know if they're allowed to do that anymore. I mean, I know regulatory-wise, but risk-wise? If they're allowed, just don't do it. It's worth it.

It's just life isn't worth that. You know, the stress is just amazing amazing if you have open-ended risk and you need the market to come back in very short order that's you know it's just simply not worth it or just buy and hold tesla or something right just buy and hold some stocks if you want that risk profile yeah buy penny stocks or something, right? Just buy and hold some stocks if you want that risk profile. Yeah, buy penny stocks or something. Or not even, but just the, which comes to me, like if everyone's trying to hedge, everyone's trying to do something, if you have this 50-year view, you'd be like, yeah, it goes down, it always comes back up, right? That's- Yeah, right. Penny stocks is the wrong example, but yeah, yeah. Your case is a good one.

But what do you say to that? People like why should I hedge it always comes back it does but people's tolerance for pain and their ability to keep the position going is not indefinite right it's a complex variation of the gambler's ruin type setup

yeah it only takes one time of it not coming back. Yeah, it could come back 99 times and then that hundredth time, you're out, you're done. So I wanted to ask you what you think is one of the most commonly misunderstood thing about options, both for retail traders and for professional traders.

Well, one subtlety I like to talk about is that if you buy a very long dated option, it doesn't matter really if you buy, if it's got a low delta, it doesn't really matter if you buy a call over put. And unless you take carry and interest rates into account, that's significant. That's something that a lot of people don't get. The other thing is that a lot of people worry about the wrong Greeks for certain maturities. I don't care about row interest rate sensitivity for a one-month auction. I don't care too much about it.

But I should care a lot about dividend yields and interest rates for longer dated stuff. So, you know, I often tell people that if you're trading a one month option versus a one year option you're actually trading two very different things even if they're both books and so looking along the surface you've really got a whole like panoply of different strategies embedded in there if you just take the time to take a look at it. The one other thing I'd say is that this every dog has its day type message is an important one. Any option strategy is going to have setups that work well for it, even the silliest one.

And even the best strategy is going to have gaps, holes in it, situations that won't play out. The question is, do you understand what those scenarios are? And are you playing the right strategy statistically or probabilistically or gambling-wise based on what the market is giving you now? That's what options trading is about.

It's a combined, potentially combined directional and vol bet with an emphasis on vol. And so you want to be doing the right sort of structure given what the market is providing for you and you see that in these chicago prop firms you know option backgrounds of they just go into those environments that are right for their strategy and they'll step aside

or they'll go into other markets where that's right for them don't don't don't force it yeah you should never force it i mean so for example we have a vix replication strategy and um basically it does well if the vix flatlines or if it explodes it doesn't do well if the vix trends up but you know the bet we're making is that the vix generally doesn't go up by one or two points every week in either spikes or flatlines or decays. And so if you can create those setups in your strategy or any of your strategy, that's the best you can hope for. And if you play consistently, you have good shot at success. And then I should ask earlier, but so your strategy,

are you offering one strategy to investors or you let them come in and create a bespoke product? Depends on the mandate. I do, as you have mentioned, we do sort of classical hedging where we have a somewhat constrained strategy of buying downside equity index books. We do the replication strategies and we also do customized bespoke stuff where if a client wants to hedge a single position or has a specific exposure to a

currency or something, we can, we can block out the risk efficiently there too. And for international clients, currency risk is very significant. So that's one of the things we have in our arsenal. And then I, for that, so if someone has a huge Apple position that's grown tens of millions of dollars or something and comes to you and you'll say, all right, here's how we can protect that, that kind of thing and what speaking of apple what do you think on just as the kind of winner takes all economy and

fang is just becoming larger and larger portion of the indices is that an issue for index option pricing or it all gets kind of baked into the prices it doesn't matter what are your thoughts on that um the s&p 500 is still pretty diversified the nasdaq less so uh it is a problem it's definitely a problem because aside from it's being a societal problem which i won't go into um it just naturally reduces the amount of diversification in the markets. And one of the problems that have been the case, it may still be the case, is people trading a small number of names actively, and then just passively going into everything else. That's not a healthy market. There's no relative value really to speak of in a market like that. It's just performance chasing plus passive investing. And in theory, the smaller the basket,

the more volatility it would have, right? Less of that smoothing effect. So in theory, you could see as if that becomes more and more of the case, it'll either be under the volatility of the index will be underpriced, or it's just going to reflect the volatility of those individual names.

Yeah, exactly. Which I'm sure there's tons of strategies out there right now doing that are between the, the, uh, the index vol and the single name vol, which brings us full circle to what you used to do at the, uh, back in London. That's a long, yeah. Well, it's been a long, long time since I've been doing that stuff great so i'm go through a few of your uh favorites here to end the pod so favorite marathon location uh copenhagen or san sebastian oh san sebastian that's the the northern coast of Spain there?

That's in the Basque country, yeah. Yeah, and they only have like four Michelin star restaurants or something. I think there's a lot of good spots there. Oh, it's fantastic for tapas and the whole thing. It's quite nice. It's a different culture from most of the rest of Spain, but fantastic. I'm going to go there. You can surf there, I think, too. There's some surfing, good restaurants.

I knew that, yeah. I'm not going to run a marathon, but I'll check out the rest. And best hotel in your marathon travels? I've never stayed at a fantastic hotel on the races, but the Radisson Blue in Copenhagen is nice. All right. I like it. Favorite, well, you have your PhD in chaos theories.

We could do a whole nother pod discussing that. My wife's cousin's husband is an artist and sculptor. He's a mathematician, but he's also an artist and sculptor and he will do mathematical formulas in art form so you've seen those those chaos uh fractals and stuff like that oh yeah the attract the lorenzo tracks are all that jazz yeah yeah but he's taken it to another level of like in different formulas instead of just those fractals of like here's i'm i don't know enough to tell you what he's painting or what he's sculpting but it's quite interesting um and to me that's that's about my level of expertise but yeah it's interesting and i was philosophy major to me the further you go in philosophy the closer you get to math

it might be the same way the further you go in math the closer you get to philosophy Yeah, that's get into logic agree with that yeah So that was a long way of saying favorite mathematician Well, I when I was an undergrad I like Cantor because he had all of these different levels of infinity. There could be various sets and they were all infinitely sized, but some were a whole lot bigger than other ones. That blew my mind. That just blew my mind. He went. That was the precursor for different stages of a crisis, different levels of infinity.

All right. That's far more sophisticated than anything. But yeah. So favorite city you've lived in. When I was a baby, I lived in Geneva, but I don't remember it too well. London was good. I lived in Chicago for a bit. That was great. When I was younger. I might, I'd either go with Chicago or London. All right.

Chicago was great back when I was there in the late 90s because it was a friendly city to just go around. Yeah, it looks worse on the news. It's still pretty friendly, but it's been looking pretty worse on the news it's still pretty friendly but it's been looking pretty bad on the news here like lately we've got a bit of some tax and finance and pension issues but we'll take it a lot of i think a lot of people just say chicago to not hurt my feelings but i appreciate it and favorite star wars character no i'll go with Chewbacca.

Chewie. All right. Can you do a Chewie? No. No. Won't you? We've had a few. I like it.

All right. All right. Well, thanks so much for your time. Look forward to seeing you in person one of these days when we get a vaccine or can go out, do whatever. But until then, good to see you. Tell people, you're rather anonymous on the internet, but you don't have Twitter or anything like that? I would, but you know, it's a question of just keeping myself under control.

I know you would be great on it. I'd look forward to that. But the sb1 website out on the show notes and whatnot you got it jeff all the best 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 RCMAlts and visit our website to read our blog or subscribe to our newsletter at RCMAlts.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. Thank you.