The Derivative - Teams of Options to Tackle the Tails with Jerry Haworth of 36 South

Episode Date: July 22, 2021

We’re excited to have one of the pioneers of options trading on this episode, Jerry Haworth -  Founder and CIO of renowned option and tail risk firm 36 South. In this wide-ranging talk, we dive into Jerry’s roots in Zimbabwe, trading South African bonds, structuring derivatives, the point in his jazz career where talent and drive diverge, how 36 south got started, canoe marathons, why long term options rule, non-recourse leverage, Victoria Falls, swaptions, asymmetry, Chicago Blues bars, liquidity cascades, slow-moving south sea bubbles, leptokurtic curves, changing correlations and, of course - Teams of Options. Enjoy! Chapters: 00:00-02:19=Intro 02:20-18:31=Zimbabwe to Auckland to London 18:32-44:10=Positive, Neutral Carry & Teams of Options 44:11-56:16=Long-Term Options & Non Recourse Leverage 56:17-01:04:29=What’s changed in 30yrs of Option Trading 01:04:30-01:08:46=Favorites Learn more about 36 South at 36south.com  And last but not least, don't forget to subscribe to The Derivative, and follow us on Twitter, and our host Jeff at @AttainCap2 or LinkedIn, and Facebook, and sign-up for our blog digest. And visit our sponsor, the CME Group at www.cmegroup.com to learn more about futures and options. 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. The longer you go out in time, the more critical implied volatility or your forecast is, and the more leverage you get. So if you're buying an out-of-the-money option with a five-year option, roughly a delta 0.1, you're buying an out of the money option with a delta, five year option roughly, a delta 0.1, you're getting about 10 times implicit leverage. Now leverage, I love non-recourse

leverage. I don't like leverage for leverage sake. Non-recourse leverage is you put a dollar down, you can make 10, you can't lose 10, you can only lose a dollar i like that so it has the symmetry the asymmetry of payoff i love the fact that it is uh it has convexity so the linear fashion, it goes up exponentially. Hi, everyone. I'm excited to be sitting down today with one of the OGs of the derivative markets, options, tail hedging, and more. We've got Jerry Hayworth from 36 South joining us from somewhere in the south of France or England or both or one or the other to talk through all things tail hedging, out of the money, and whatnot. Welcome, Jerry. Yeah. Thanks for having me. Thanks for being here. So you're in England and not France at the moment? Yeah, I'm in London at the moment. Yeah.

And how much time do you roughly split between the two? I go down to France when I can. I take my holidays down there. So when I can, I take my holidays down there so when I can I get down there I spend a bit of time uh you know obviously working remotely it's made a lot easier uh so I spent a bit of time there last year and I spent a month there earlier on this year very pleasant yeah what what part of France I'm a big Tour de France fan so I anything i know about it is all from watching the tour de france it's quite close to saint million okay so it's a lovely area lovely part of france as well yeah good wine down there yeah good wine always helps you ever seen the tour come by do you ever watch any of that um not really no no yeah and there's big i i can respect what they what they're doing but that's about all right um yeah they're like a right tail event

right like the unbelievable they can go up those mountains so fast yeah that's true some would argue it's because they're uh chemically enhanced but we'll leave that for another podcast. Yeah. Yeah. That could take up the whole hour. Exactly. And you're South African originally, right? Zimbabwean, which is close enough. Yeah. So Southern Africa. Yeah. I was born and raised in Zimbabwe. Yeah. Which was great place to be raised in Africa. you get a lot of black swans down there. Especially Zimbabwe. How did Zimbabwe get itself on the map?

It seems like it punches way above its weight in terms of economic importance and participation in the global derivatives markets. That's a good question. Yeah. I've got no idea what, why it would punch itself above its weight in the derivative markets for sure. Right, but like we were always talking about Zimbabwean bonds and it's always kind of in the financial news.

Oh, yeah. Well, I suppose the hyperinflation is a good example of hyperinflation for a start. And yeah, it was a really interesting time to live through as well. And amazing that people survived it. And I remember watching an arts and crafts guy selling his wares and offering prices in five different currencies. Really?

Yeah, including gold dust. And it's mainly a gold-based economy? Like the main... No, mainly agricultural. I think tobacco is their biggest crop. Okay. Yeah. And you ever get back there?

Yeah, occasionally. There's some great fishing to be done there. I get back to Southern Africa once a year uh mainly to see the wildlife and there's who's that uh there was a good uh zimbabwean golfer i'm trying to remember his name yeah nick price nick price right yeah he he's a great friend of mine and amazing guy yeah all right what's he up to these days he's he's kind of past his his playing days are he still playing no i think he's i think he stopped playing i think he's he's with the pga board now if i if i i'm correct which is you couldn't find a nicer guy and with more integrity so i think it's

really good for the game um so how did you make your way from Zimbabwe up to London into the derivatives markets? So I left Zimbabwe to go to uni after military service and there I did my thesis on the viability of an options exchange in South Africa. So I'd already kind of, from the moment I saw options, I thought these are really interesting. At that time, I didn't even think there was a financial model. That's how far back we're going. Yeah, I worked around, ended up working at Investec, which I think I was the 55th person at Investec, a bank down there that's grown to, you know, five, six, 7,000 people now. And I got a job trading bonds.

I actually left Investec, got a job trading bonds. I actually left investing, got a job trading bonds. I worked for the local stock exchange, trying to set up their futures and options exchange and positioned myself in the options market very early on when literally there wasn't much software. I remember we wrote down our positions on a whiteboard. And the one day we came and we found that the cleaner had wiped all our positions off the whiteboard. We had to try and reconstruct what we had. So it was very much sort of cowboy style trading. And we muddled through that.

What year is this roughly it's got to be about 85 oh no it's got to be about 88 89 um and then uh yeah i joined joined back at investec um and became the head of equity derivatives. Left there, started my own shop, which was basically structuring derivative strategies for institutions. That did really well. I IPO'd sort of early 90s. And then I moved to New Zealand and did, well, attempted a music degree for a couple of years oh fun um so a bunch to unpack there but uh I was thinking back to the old board of trade days where they're like putting the market prices on the chalkboard remember yeah yeah I'm sure that happened at some point someone wiped the chalkboard and nobody knew what the last price was.

Yeah, yeah. And then, so structuring the, well, I wanted to first, so you're trading government bonds, that's across the world? What was the main thing you traded? No, they were just South African bonds and they were very volatile. Yeah. very volatile um yeah i remembered uh ltcm crisis i got offered 100 million bonds at 21.65 yield to maturity oh yeah which i should have taken them i didn't take them i was too fearful yeah and who was calling up to do the trades hedge funds from across the world or other central banks? Yeah, banks. Everyone was liquidating pretty much everything at that stage.

Yeah. Yeah. That's exciting. And then structuring these derivatives for corporations. Give us a little quick background. Yeah. So designing strategies, zero cost strategies. We also designed structured notes and were very successful at doing

that. There was such a great tailwind for the products. I mean, we had 16% interest rates. So on a five-year structured note, you could get a zero coupon bond at a very small percentage of the capital required which left you a lot of a lot of finance to buy some really great long-dated options so yeah we designed some great product um yeah that was fun and so these were mainly south african companies restructuring these for across the across the Yeah. Mainly South African companies. Yeah. And they were trying to, they were doing complex hedges or trying to create alpha. Yeah. There were all varieties of different strategies.

A lot of them, you know, like the zero cost collars were quite popular. We were, we were trying trying to design around what they, we were trying to give them a better solution to what they were trying to achieve. We had equity-linked bonds as well into the mix. It was quite advanced for its day, I must say. And kind of the predecessor for what a lot of big banks do now. Yeah. Yeah.

Of their structured notes and yeah. Which a lot of times I was seeing like their short vol for the bank, right? The bank might offset that, but. Yeah. We never designed yeah we always went and got the exact uh product that we wanted to fit into the structured product but i understand the way banks do it now and to be honest i wouldn't want to manage the residual risk to be honest yeah it wouldn't yeah and there's some funds we talked to whose main alpha is like going out to those banks and trying to take the other side of those, right? Yeah, yeah, yeah.

We see quite a bit of flow currently from those kind of products as well. Good. And now, so then how did, or so no, I wanted to also ask on the music degree. So you go to new zealand have you ever been before you said i i'd been there once i'd followed a rugby tour and i phoned my wife that night and said this is this is god's country we're coming to live here and when i haven't changed my view on that yeah she said okay let's do it yeah so we packed up ourselves and three small children and headed off to new zealand um yeah great country great and so how many years there and what was the music

degree all that uh yeah i did a i did i was attempting a bachelor of music and jazz performance. But like my vocal teacher said, I'm the exact point in the universe where talent and passion don't meet. So, but it was fun and I, it was interesting. Yeah. And what's your passion? Jazz? Jazz. Yeah. Yeah. Any specific type or just all the above? All kinds, really. How do you feel about our Chicago blues?

I love it. You ever been here? Been to some of the... Yeah, I have been to some blues bars in Chicago. I can't think of the names offhand, but I have. Yeah, it's good. Yeah. And that's always, Chicago has always been a big jazz city, hasn't it? Yeah.

Yeah. And they kind of went to the blues side, but you were probably a blues, BW, B period, L period, U period, UES, or buddy guys down on the south side or the one that just went bankrupt during COVID or they closed during COVID, Kingston Mines, unfortunately. Okay. Yeah. Those are some of the best. I haven't been for a while.

So now somewhere in there, you're sitting with your music career in New Zealand and said, all right, let's start this hedge fund 36 out? Well, actually we were just trading our own capital. A university friend and I just got together and we were trading our own capital. And it was sort of 98, sort of 98, 99. We were busy trying to short the NASDAQ in one of the biggest bull markets of the time and nearly got our faces ripped off. And realized that actually I'm not that good of a classic trader. Both our careers were in options. So we said, why don't we just,

you know, if this is going to, if it is, if eight out of 10 internet companies are going to go down, why don't we just use long dated options or equity leaps? So we took a lead portfolio that worked pretty well. And then we started thinking about, we now wanted to do cross asset class because we thought long-dated options, there's definitely an edge. And we probably would need to do cross all asset classes. So we need ISDAs. And the banks wouldn't give us ISDAs unless we had a fund.

So we literally started a fund in order to get the ISDAs. And we got friends and family involved, and we kicked off from there. We started in 2001. It was a classic Nassim Taleb strategy, 25% in options and 75% in cash. And we trundled along nicely until 2008. We made sort of 20% plus for that time, which only risking 25% of the assets, good risk reward. Yeah.

And then 2008 hit and two things happened firstly our black swan funded really well and our the fund as i just previously described uh made i think was 73 percent and that was a bit of a turning point for us because we realized that long-dated options not only great in their own right for a couple of reasons they've got characteristics that make them suitable for risk mitigation. 2008 really showed that. Who's the we in this scenario? Rich Hollington, my lifelong friend, partner.

We've been partners for over 20 years now. And yeah, I couldn't wish for a better partner to be honest you haven't strangled each other yet over 20 years not at all we've we've done a couple of canoe marathons together been around the world together and run this business together well now we're getting to the good stuff what's a canoe marathon it It was a marathon down in South Africa that I think was 120 kilometers running and canoeing over three days. Wow. Yeah, it was pretty brutal but yeah. How did you place? No, mediocre. Yeah, you finished the goal. Yeah, goal is to finish. To finish is a win. You have to be worried

about wildlife and whatnot? Not really, no. Just drowning yourself, I suppose. Great. Let's dig into the strategy a little more or sorry what where did the name come from 36 south it's the latitude of auckland oh i was thinking the latitude of south africa and then i looked it up i'm like no i'm off yeah i'm off yeah so it's a latitude of auckland and

yeah in the absence of any other I definitely didn't want to name it after a Greek god that's for sure well yeah you the typicals are some Greek word or Hayworth asset management right yeah yeah yeah it's a nice neutral name and it has

the benefit of appearing at the top of every list maybe it's a dubious benefit but um so yeah it appears at the top of every list right it's pre pre-alphabetical yeah um yeah one year my uh my sister got married in uruguay and we took that trip and went down to the glacier in the very tip of South Africa and Califet, Argentina, excuse me. So and then later that was in, you know, January, their summer. And then in our summer here in the US, I did the Mackinac race and ended up in Mackinac Island, which is at the top of Lake Michigan. That same year, I'd been above the 45th parallel and below the,

in that same year, which was fun. Excellent. Excellent. So let's talk a little bit. So give me the quick elevator pitch on what you're doing. You mentioned tail risk, you mentioned long dated options. So, you know, your website says pan asset, long-dated options. What's the quick elevator pitch on what you guys are trying to do? Yeah. So firstly, long-dated options tend to be extremely undervalued or overvalued. And if we can... Sorry, what's your theory on why that is? Well, if you go back to first principles,

if you look at an option pricing model, there's only one real variable and that's implied volatility. So you plug in implied volatility into a model. And in fact, I did it just before I came, I spoke to you. A Google five-year option priced 100% out of the money, Alphabet, Google, priced 100% out of the money. Its current vol is about 26. It's valued at $163. If it went down at 20%, implied volatility, it'd be valued at $59. So that's about a 70% reduction.

If it goes down to 10% implied volatility, it goes down to 63 cents. And if the market really, in vol really took off and it went to 100% applied volatility would be worth $1,734. Now, I mean, I know we've got physics envy, but if I was to design bolts for a bridge that had tolerances like this,

it would have the consistency of wax or titanium. So which is it right so on that premise we believe if we buy what we consider are inexpensive options and warehouse them with appropriate profit stops it has expected positive return we We will make money over time. If we include both right tail and left tail, the left tail element is very important for risk mitigation. There's very few things that display the characteristics of long dated options that display the characteristic for tail hedge, i.e. they have convexity, they can go exponential,

they display a symmetry, you can put down a small amount of money and make a big amount of money. It's investable, it's a huge market. And they make them, so it's a perfect risk mitigator. And of course, it's negatively correlated. So when the market goes down, you can rely on volatility go up.

And that's also really important. In fact, funny enough, having a convex curve like a big U has the ideal correlation profile. It's positively correlated with a bull market and negatively correlated with the bear market, which is exactly that. That's what investors want. Yeah. That's a perfect,

that's the only problem with that is that there's a cost to it. That's the only problem with that. That is the perfect correlation profile for any portfolio. Yeah, and I was going to, on your example there with the Google, right? My mind thinks of it as, so what did you say it was? $163? $163, yeah. So, right, in my mind, like,

and I don't know exactly what you mean by a hundred percent out of the money. How can it be a hundred percent out of the money? So if Google's now or alphabet is 2,600 would be double that. So 5,200. Okay. Got it. So right. Maybe there's one in a thousand chance of it happening in the next five years, probably lower than that. Right. But call it happening in the next five years probably lower than that right but call it one in a thousand my mind that's what i said in the last five years i used to do this example when

it was 1200 just there you go uh but right in my mind it's kind of a terminal break-even trade no matter how where where you put that maybe it's one in a hundred chance. So I spent that $163 99 times and then I get back $1,630 or whatever that math is and it's terminal break even. So how do you kind of approach that math? We more look at it as if we buy a five-year option, what are the chances if we bought it say at 20 say 20 dollars so we're buying it when the market's really cheap for ball we buy it for 20 dollars

what are the chances of it reaching 60 dollars in its life yeah so we we look at it as a continual horse race for five years we don't look at it as a terminal value so if and if say there's a bold spike in year two and it goes to 80 dollars we would have put a proper stop under it and if it falls back down we'll be out so so a disproportionate number of wins by using that methodology even though it is might be a thousand to one chance or a hundred to one chance the chance of retiring it profitably is a lot less than that because it's it's predicated on volatility right Right. And you won't bite if the bleed is too much. If you think that the gain you'll get from volatility doesn't

cover the bleed you'll suffer, then you pass. Yeah. I think it was one of the guys at Hedge Fund Windsor said the biggest edge you can have is not to do the trade. Yeah. I think.

So by the end of 2008, I think we were 95% in cash. There was just not much left to buy. And the same thing here in March of 2020 or no? Funny, well, there were still currencies which hadn't participated. They didn't express the level of crisis that equities did. So I would say there were still things to buy for a, if it hadn't turned around like it did, there were still tail hedges you could buy by proxy. But equity left tail, there was pretty much nothing left to buy. Right. And so let's dig into that a little bit. You're not just playing in Google or single stock names or S&P options, right? You're what you call pan

asset. But talk to us about what that includes. What's the universe of potential trades? Commodities, currencies, mainly receiver and payer swaptions, but we do Euro dollar as well. So interest rates, currencies, commodities, and equities. And there's good reason for that. I mean, often the opportunities don't necessarily exist at any one point in time in one asset class. Yet in a systemic crisis, correlation between asset class volatility tends to one.

So the proxies, if they cheap enough, tend to outperform the direct hedges. And I would say from April onwards to the end of last year, that would be the case for equities. S&P skew was very steep and they were expensive. And so you'll seek out proxies to cover that yeah yeah because I won't just buy a direct hedge just because we need to mitigate the risk if it's not worth buying and vice versa on that will you buy something that provides the risk if it's not worth buying.

Vice versa on that, will you buy something that provides no hedge just because it's a great value? Yeah, we also buy right tail options. So we will buy idiosyncratic right tail options that are not necessarily a hedge to a left tail event. And the reason for that is that, A, we're looking always to mitigate the cost of the left tail. And if the market runs up strongly, we want to still be relevant.

So like last year, the markets run so hard, you've got to almost reinstate your left tail positions to be remotely relevant. Yeah. And we find the right tail is useful for that. But it wouldn't be something like Coco calls or something, right? Like, could it be something totally out of left field? Yeah.

Okay. It can be totally out of left field, if it fulfills our metrics, if it passes all our filters, we'll look at it. But still you view the total as a tail hedge product, right? That would just kind of come in to provide some positive carry? Yeah.

We found over the years, we've run dedicated left tail product um like i said we had this black swan that did really well in 2008 we did a managed account after that that did really well as well over 2011 but dedicated left tail tends to be uh more expensive than twin tails. Yeah, for sure. And then the new, you have a new program, right? The Kuhn or neutral carrying. Yeah. Which is, this is our best. This is the result of our best thinking. Cause obviously you're right. We always running long volatility and being long volatility generally is going to cost you. And over the years, more so the last 10 years, we've come across options that whilst they're still decaying away, they tend to accrue positively for various reasons, and it might be bold, skew, normally the forward differential, and we can position strikes such that if nothing happens, they will improve in value over their life. dedicated a fair bit of time to understanding how and why and when that occurs and how to mix them

in a portfolio. And we feel confident now that we can run a portfolio of positively accruing options and blend it with convex options. So if something happens, the convex options kick in. And if nothing happens, the positively accruing options kick in. So this fund is, it's really, it's probably a tail hedge fund on training wheels. That's the way I would tug and cheat describe it because we look to carry neutrally over a rolling five-year period. So if nothing happens, we don't expect to have lost money. If something happens, we expect to make a certain percentage, which is quite reasonable, actually. So it allows even traditional

funds to get some risk mitigation into their portfolio. And it compares with bonds are slow. It compares very favorably as a risk mitigator to bonds, which I don't, I believe are losing their effectiveness near the zero bound as a risk mitigator. So yeah, I think it's, it's a product. It's, it's got a lot of appeal. We had a very good launch. So, yeah. Yeah, I mean, to me, it fits well with investor behavioral issues, right?

Like, it's hard to hold that tail hedge for year after year and see the negative print. Yeah. In fact, one of the behavioral biases is the tendency to sell it just before an event. And when, when I get a cluster of clients redeeming, you know, it's coming, I get quite excited because it's, it's, it's the best tell I've got. Right. Well, CalPERS famously ditched their tail hedge right before March, right?

Yeah. In January or February. Yeah. But so it's not selling ball to provide that carry we do spreads uh to take advantage of ball skew but we don't net sell ball um because a lot of people are solving the same problem by doing that right they're going to sell the belly and have wings on and capture the wings. Yeah. Another way to do it. I totally get that. It's another way to do it. We just find by doing it cross assets and looking at the correlation, different market regimes, we can get very good carry up, positively accruing options and very good convex options, not necessarily in the same market.

Whereas if you're trying to do it in the same product, a lot of the banks, they're very good at arbing away those differences. So yeah, the moment you go cross-asset, you've got chasms difference in potential pricing pricing and so let's dig into that some so yeah i was assuming you were talking there's you found an option and i'm going to use the coco example for some reason i must have uh hot chocolate on my mind or something but um yeah right and you're not finding some option spread in coco that has this positive carry. You're creating basically a synthetic market between asset classes.

No, it could be in Cocoa. Okay. But it now depends on the correlation between Cocoa and S&P in up to 10 different market regimes. Okay. So if Cocoa reliably is negatively correlated to the S&P when the market's down 30 plus, we would definitely consider it as one of our positively accruing options. You know, probably the best example we had is receiver swaptions.

It's got to be a few years ago now, probably about eight years. We observed that you could position strikes and receiver swaptions on a call spread on the US receiver swaption. So it's a very liquid market. And if nothing happens, they would accrue hundreds of percent. And they will also, you can generally state that interest rates will go down if the equity market falls over. So you can comfortably lump them, excluding risk parity blow up in a left tail scenario. So now you're having a left tail option that positively accrues. That is worth its weight in gold.

Yeah. So for listeners and maybe myself, explain a swaption if you could real quick. So it's just an option to enter into a swap, either as a receiver of the fixed price or a payer of the fixed price. So in this example, you're buying the swaptions? Yeah. So we were buying the swaption for, I think it was 10 basis points.

And if it was on the two year rate and if the two year rate stayed exactly the same, it would accrue multiples. I think it was four times its original price if nothing happened. So if rates went up, we'd lose the 10 base points. If rates went down, which was what you expect on an equity meltdown, then we'd still make the multiples.

So if you look at the bell curve, the whole section from the middle of the bell curve right to the left you're going to make uh multiples of your original investment that's a valuable carry that's a very valuable option to have in a uh tail hedge fund and so are you are you using um any machine learning or ai are you you data crunching to find these opportunities now? Yeah, we've gone a long way down that because it's one thing to find the right option. Yeah.

It's quite another to put two, three, four, five together and see how they behave. Running an option portfolio, as you're probably aware, is like trying to herd cats. And so we've gone a long way. And the critical element that we've really sharpened our expertise on is the correlation in different market regimes. So it's not enough to have a constant correlation number for where we are now, because if we're in a late stage bull market, the correlations will differ when the market's down 10, 20, 30, 40, 50. So we model it over all different market regimes. And to date, I haven't

come across a better way to do it. and that's and so that's the risk to the whole thing right of that correlations are unstable and the correlation you're relying on doesn't hold in the future that's kind of the basis risk but it might be unstable in your favor yeah yeah yeah so there's one currency uh which will remain unnamed that has a very good negative correlation in crises and pretty low vol um so yeah it is it's quite fairly reliable as a left tail option and is there sort of a reality check on all this so So if it shot out, like I had this pet theory that natural gas was so low, it became a flight to safety asset for a long time. Yeah.

If it shoots out, Hey, you should own a bunch of natural gas because in the crisis people might put money in there. Cause it can't go any lower. Yeah. Classic example of that. Right.

But yeah, if it shot out natural gas, you're going to be like, hold on a second. That doesn't quite make sense fundamentally. Well, we put it into our engine and it busy recombines roughly by Monte Carlo. I mean, we just brute force it. And it comes up with teams and options that perform in every market environment.

So even if the market's up 10, up 10, 20, up 30 or down, the team tends to perform well and it has a left tail. And it comes up with some really interesting teams that I wouldn't have picked. I would never have guessed. And it's also, it's a great way for us to then go and have a look and say, yeah, let's have a look at this team.

You know, much like Moneyball, the best team on the pitch is not necessarily the most glamorous players. I think Chris Cole has used this analogy widely and it holds true. Yeah. So I love this teams of options i think you that we can add that to the options lexicon now so in that in our examples right maybe cocoa by itself's not good maybe natural gas by itself's no good but those together plus some dollar options now we have a team that performs has the profile we want yeah yeah so we broadly put it into two if you look as you've

got your attacking attackers and you've got your defenders pretty much every sport so the positively accruing options are the defenders uh and your convex options are your attackers and that's roughly how we view it so we're looking so like in the carry neutral fund we're looking to be neutral i.e pay for the negative carry that the convex options provide in uh in normal times and we look to the convex options to score the goals when it's opportune for them except Except for canoe marathon doesn't have attackers and defenders, right? No, it just has that.

It has one thing that you need and that's persistence and patience. Pain and suffering. Will the computer, so A, would this have been possible before kind of advances in machine learning and stuff? Would this have taken an army of room full of people to crunch the data? Yeah. I don't think it would be feasible 10 years ago even, I don't think.

Yeah. And then B, my mind's going to, all right, I have this team of like, what's the limit on how many options can be in a team? Because in my mind, like, all right, I've got this team of four, but if I add this one, it makes it better. If I add this one, it makes that one better, right? It seems like you could lose control of. Yeah, exactly.

Yeah, I don't think you want to, I don't think you, I suppose you could try and micromanage it, but I think you want to get the broad principles right and for it roughly to do what you expect it to do and then have some uncommon common sense overlaid on the top of that. Uncommon common sense. I like that. So it's more just going to be kind of a, it's like in the old days, you're calling the trade desk and they're saying, hey, have you looked at these swaptions? There's a really good rate on them.

And now it's just the machine saying, hey, take a look at these teams. They fit our risk profile, decide which ones you want. Maybe one day we'll get to the point where we rely on it a hundred percent, but we're a long way from that. Yeah.

I appreciate that. It scares me a little when it's 100%. Yeah, yeah. Especially in the options world, because sometimes the data is not necessarily even clean. So I don't know. 100%. How do you approach that problem?

Do you create your own option prices or rely on the exchange prices? Look, we've been around the market so long, I think we've got a natural cynicism and skepticism that gets us through most through most issues in terms of pricing. You know, it's when we're looking to buy an option. It's not really that the pricing isn't critical. If we know, you know, going back to that Google option, if it's, if it's trading at $2 and we know that it could be worth anywhere from 63 cents to $1,700,

$2 or $2.20 or $1.80 is not really going to make a difference on the five year result. Even if you bought it at $3. That's what makes a market, right? A mismatched time horizons, right? So somebody's super excited to sell that to you for $2.20. Yeah. The trader at the bank books his profit, gets his bonus that year. That's fine.

You know, we bought 25- options, a really good vol. And honestly, I would not be the one to manage that option for 25 years. Yeah. Right. That seems like a So let's talk about that a little bit, go backwards to their kind of overall philosophy of why the, tell us some of those properties of these long-term options that get you excited and what exactly you mean. I didn't know you're going to go out 25 years. That's amazing. Yeah. That's like the hundred year Austrian, hundred year bonds, right? Like at some point there seems to be a limit on the duration of these,

but I guess not. Yeah, yeah. Well, Warren Buffett, I think when he bought Geico, had a sleepless night because it had 100-year electricity options they had written inside Geico. I think I've got the details right. I might have them wrong. But the longer you go out in time, the more critical implied volatility or your forecast is, and the more leverage you get.

Yeah. So if you're buying an out-of-the-money option with a five-year option, roughly a delta 0.1, you're getting about 10 times implicit leverage. Now, leverage, I love non-recourse leverage. I don't like leverage for leverage's sake. Non-recourse leverage is you put a dollar down, you can make 10, you can't lose 10, you can only lose a dollar. I like that. So it has the asymmetry of payoff I love.

The fact that it has convexity. So the more implied ball goes up the the price your premium price doesn't go up in a linear fashion goes up exponentially that convexity is also lovely to have in a portfolio uh it is investable it's it's a huge market um it's negative you can get negatively correlated to the traditional markets so all those characteristics are similar to what if you wanted to ensure portfolio and you could get if you could go and buy insurance from an insurance company and ensure your portfolio against losses they would be offering a product with those characteristics yeah and what kind of do you have any idea on the average in that scenario like what

the average yield you have to pay per year so if i'm holding it for five years what's my annual burn it varies so much yeah yeah you know you're looking at the currency market versus every yeah which is is quite weird because uh an option is just really a bet on how much something jiggles and you know what the the default assumptions for how much something jiggles in the currency market is totally different to the equity market. And Tesla is totally different to Facebook. Yeah, yeah. So that's quite interesting in itself. There's no hard and fast rule. And I think the only way to look at it is to look at its own,

look at an asset with reference to its own volatility history and its asset classes, volatility history. Got it. But you, and for your portfolio, you're not going to buy something and lose, right. That would cost the fund 40% of the fund's value or something. If it, if it declines to zero right if the no no yeah well we design the funds with different uh theta burns and rot in mind like our high octane fund we have built in a 15 percent uh burn a year but that's designed

to give that level of octane convexity that's that's extremely high octane fund but it's designed to give that level of octane convexity. That's extremely high octane fun, but it's designed with that in mind. And like the carry neutral, we design it for it to be around zero in that kind of time. And I'm sure there's people just like, right? The classic option seller loves that you're willing to pay and hold this thing for 10 years

and they'll say great i can take that uh take that income in today yeah well and there's a lot of structured product issuance around the five-year area as well currency is precious you can get out to 10 years quite easily um it is fairly deep markets in those what I've just mentioned. And equity tends to be a bit shorter, but sometimes you can get longer. And so you're still doing these ISDAs, or is it all exchange traded? It's ISDAs, but it has changed quite a lot since 2008 in that a lot of them are margin now. And I think it's due to become... It's due... Basically, every ODC will be margined.

Yeah. So, you know, it really has blurred the distinction between traded and ODC. Traders, they're clearing members of the exchange or the banks anyway. Yeah. So you've got the same counterparties underpinning both. And so in your scenario, you're buying the long-dated option. The seller has to put up margin to cover you in case you win on the trade.

Yeah. Has that ever been a problem in the past where you were, you killed it on an option and the counterparty disappeared? No. Yeah. Fortunately we, I think we just got a bit lucky in 2008. We don't hold more than 25% in any one counterparty anyway in any fund. So even if we did have a big counterparty go down, in that environment, the rest of the fund,

I'm sure would have covered that and some change. And if more than two counterparties go down, I think we were definitely in the wrong business anyway. Yeah. Well, I mean, that was driving the increase in prices in 08, right? Yeah. At AIG, perhaps the ultimate counterparty was going to not be there. Yeah.

Which leads me to how do you view this kind of Fed put environment we've been in for quite some time now and central banks across the world kind of putting a floor on markets. Does that, do you model that in? Like that seems to me that that truncates or puts a cap on the amount that these long dated options can pay out. Well, my best analogy is that imagine a vaccine that we've never tried before. We rush to market and we vaccinate everyone and suddenly we find it doesn't work.

Yeah. As we thought. This central bank experiment has never been done on a global scale. It's been done by third world dictators. Yeah. And almost probably 100% as they ended badly. So while we think we're going to dodge a bullet here

and this is all going to work out well, I'm not so sure. And you have Perthville, Zimbabwean experience with that, right? Yeah. I suppose I am a bit old school because I have experienced hyperinflation. It's a terrible thing to inflict on society.

And I don't know why they would risk it, especially when you don't need to. It drives wealth. Central bank interventions are driving wealth inequality. I don't see the, I think the rewards are not outweighed by how much it's harming. So yeah, I'm a bit skeptical about it. But it could work for 50 years and fail in the 51st year, right? And you have to live through those next 50

before it fails. A hundred percent. Yeah, 50 might be a bit too long, I think, for this experiment. And so what do you think, when it fails, in your opinion, what happens? What does that look like? I suspect that if inflation does emerge, and it is a function of the velocity of money, so we definitely got the mass of money, but we've had in recent history declining velocity. That's why the apparent inflation is not there. If the velocity of money picks up and starts accelerating, I think the velocity of

money is a bit like kinetic energy. It's MV squared or MV cubed. It's not a linear function to the mass of money. And that's just straight off the top of my head. But what I'm saying is that inflation will start to rise exponentially. It'll be some sort of exponential function or power law function. So if that starts to happen and you think the central banks have got an eight-year average rate, this is like a trader at a big bank saying, I trade mean reversion and the closer it gets to the top of the band, the more I sell. What happens when it breaks that band? We know what happens.

The risk manager steps in and says, close the portfolio down. And then for the central banks, that'll mean they will have to play catch up with their interest rates. And that will be very ugly. Yeah, it just seems to me they'll pull every stop out of the book then, right? Of just, hey, they'll wipe out debts they'll forgive each other debts it seems it as long as they're coordinated it'll take one person to step out of line once once one does then the dominoes could fall but if they stay coordinated they can kind of keep the shell game going indefinitely yeah well that's firstly will they stay coordinated and be uh if one raises rates

yeah that'll probably be enough yeah um and then the u.s in that example do you feel like they're the least at risk of all this right would they be or be, or the most, or somewhere in between? Well, I think the whole Western world, I think probably the least at risk is the less complex financial economies. I mean, if the discount rate goes up, say 10%, where would the property market be? And where would the equity market be yeah well property market would right if mortgage rates go up if the payments go up 10 the prices are coming down 10 like you see yeah i'd say if well i'm talking about if the interest rates you know move to 10 oh wow wow yeah the property market would be down 90 oh yeah huge yeah so and at the moment they say we've got it we can't we won't raise interest rates and if we do it we'll do it slowly but inflation might have other ideas i certainly hope it doesn't happen

but it is an experiment and i think uh they're running unnatural risks from where i can see yeah and at the same time you you're not, your models, your program doesn't really care what happens. I mean, right. You're not betting the farm on, on this blowing up next month, next week. You know, our duration of our fund is over five years and we keep it rolling out. Evolument happens, you know, more or less every five years. If you go back to 1987, it was only between

2011 and 2020, we had nine years. And if it's not raising interest rates, it'll be something else. Yeah, I'm on board with you. I think the next crisis is definitely rates driven, right? The bond market leads us, which we just saw on Monday. So you've been at this game a while, 30 plus years, right? Yeah. Just broadly talk to us what's different, you know, from five years ago, 10 years ago, 30 years ago. Is it harder?

Are there more options pros out there? Are option prices tighter? You know, and just, you know, what are your thoughts? Yeah, well, the number of clearing banks, the number of banks active in derivatives has gone down since 2008. I think that's fair to say. And the liquidity is still there and it's getting taken more over by sort of non-bank shops.

And so the liquidity is still there. Fortunately for us, when we're buying options in a low vol environment, everybody wants to sell. And when we're selling options in a high vol environment, everybody wants to sell. And when we're selling options in a high vol environment, everyone wants to buy. So we're fortunate from a liquidity point of view, we get liquidity both sides. Yeah, you're a liquidity provider on both sides.

Yeah. But I think what has changed is the moats around the derivative businesses are definitely getting bigger, which now, once I have an established business, that's good for me, but it's not good for anyone trying to start a fund or trying to start a shop that might aid the market by providing liquidity. It's getting a lot more regulated. And the collateral requirements are something that's not talked about much at all. Since 2008, the posting margin for ODC contracts has put the market

at greater systemic risk, which sounds counterintuitive. Because what has happened now is when the market goes down like March, April, not only do the traded options get margin calls, so do the ODCs. In 2008, you just hoped and prayed that your counterparty didn't go down, but you didn't get trigger margining or collateral margining. So now you've got this, I don't know how big the OTC market is, but I think it's, you know, the total options market, according to biz.org, is 100 trillion, of which at least half of that is ODC.

Now, all of a sudden, you've got big margin calls on a daily basis on the whole 100 trillion. And that's just options. Now, expand it out to derivatives. So the collateral, the amount of collateral required required and i think they ran into a big problem in large last march and april is the reason why liquidity crisis we're probably more prone to liquidity crisis is not less yeah i think there's been a few uh i don't know if you know cory hofstein did a paper on that liquidity cascades. Yeah. Wellington or someone like that just kind of piled on there.

Similar thing of like, it's becoming, the structure is becoming more illiquid because everyone's going to have to meet margin calls and liquidate, which drives further liquidation. Yeah. Yeah. Part of me seems that's always been the case, but perhaps there's, there needs to be more Delta hedging and there needs to be more risk control. It just seems those banks and everyone involved has much tighter risk five years ago than 10 years ago, right?

So you can't go home with 100 million short open exposure. You got to hedge that at the end of the day. Which, if we're more prone to liquidity crises it's good for a long ball fund it's not going to be you know it just means the prices are going to be much deeper wider and you know downturns will be a much uh more exaggerated that than they would have been yeah i call it you need to be on the video for this one, people. Sorry, but you squeeze the distribution, right? So you're going to have taller heads and fatter tails,

but you're saying we're going to compress all this. Yeah, more leptokurtic. Yeah. Yeah, so that's where we had that 09 to 19 was that squeezing in, coiling the spring, and then boom. Yeah, yeah yeah exactly a taste in 18 and then a full taste in 2020 yeah do you have anything else you wanted to cover on the strategy yeah i know mike green talk has talked in the past a lot about passive investing

uh and the dangers of it. But I think that's also going to, if ever there was a gray swan sitting out there, that's get everyone to have identically correlated portfolios and then watch what happens when the market turns and they all run for the exits. Yeah, that feeds right into that liquidity, right? If you have more and more concentration, it seems bad for...

Yeah, yeah. And what are your thoughts on retail, all this retail options participation and record volumes and retail options and record options volumes overall? Well, it just looks like a slow-moving South Sea bubble, doesn't it? I mean, they've turned the market into one big meme stock, really. And so you either invest in the general market, and then as a sort of sideshow, you

take a punt in some of these meme stocks with no valuation metrics whatsoever that i can see so that yeah it's all good but it's it's just indicative of a late stage bull market it's slow moving um but i don't i think it's still a valid indicator yeah and i don't know if you've seen some of that on robin hood the app right of's basically, I think they may have changed it now, but before six months ago, it was like, if you think the stock's going up, buy a call. If you think it's going down, buy a put. It's much harder than that. Wouldn't you say? Yeah. I used to think it was that easy 30 years ago and

well that's who's buying these options i think the same yeah but that's great they buy a call on netflix and their earnings get they beat meet the earnings and then the you know the stock goes down or the vol comes in and they lose money on the option and they're like but this you know options are always accompanied uh in the tulip bubble there were options on tulips the explosion and in the derivatives is almost a natural follow-on from a late stage bull market so it's it's not surprising i don't think it'll end well but it's not surprising the phenomena and what what do you do personally if you mind sharing of just two right if you're waiting 30 years for this big crash for all these tail risk to pay out um

right what's your what's your right personal investment? Are you just long passive index funds or real estate or anything? Yeah. I now can say that I'm pretty much out the equity market. I have a small investment in the equity market. I have some properties. I like farmland. I am extremely conservative at this juncture. Yeah.

It's just always interesting to me of people who understand the left tail risk oftentimes ignore the ability to, there's a big opportunity cost of, I missed 300% up move in S&P. A hundred percent. I've called 10 of the last two recessions. Yeah.

Congrats. That's better than most, right? Awesome, Jerry. What I'm going to do, we'll finish up with some of your favorites and then we'll let you go enjoy. Looks like a beautiful english summer day there great thank you um so we'll just do quick fire favorites favorite jazz song um nancy with a

laughing face by john coltrane oh i love it and favorite jazz singer coltrane Well, he was a sax player, famous jazz performer. Performer, sorry, yes. Dexter Gordon. Dexter Gordon, all right. I know Coltrane, I don't know Dexter. Yeah.

Favorite French restaurant? Corniche in Cape Foray. All right, we'll check it out. How about favorite place in uh london there um oh that's a difficult one yeah probably alfred's alfred's all right yeah put it on the list um favorite investing book favorite investing book uh charlie munger's um almanac all right love it um have you ever written a book no any design on it no um no i'd love team how to win with teams of options. That'd be a good time. Yeah, yeah, yeah. And favorite tourist spot in Zimbabwe or South Africa?

When I go to the world. Victoria Falls. It's one of the natural wonders of the world. And I think it only has 1,400 bed nights in it. Oh, really? In the whole town. But it is definitely worth seeing yeah yeah i had a buddy who did a whitewater rafting below there what's the river's name i don't know the river uh the zambesi the zambesi yeah but he said i guess it's super deep it's like 80 feet deep or

something yeah yeah so he was pretty pretty hectic that that i believe. Yeah, he said they capsized. He went under and it pinned him like 30 feet under for longer than he would have liked before he popped up. It was a little scary. And then finally, favorite Star Wars character. I don't know if you're a fan or not, but we asked Alex. Yeah, I would say it's got to be Yoda. I mean, because he thinks his way through things and then he has access to higher power,

which was always useful. I love it. Yeah. He would have for sure been a long ball guy, right? He'd have been like, it's, it's out of the force.

Yeah. Yeah. Well, maybe with that amount of knowledge, he might've been a short player. He would have been a market timer. I think with that amount of knowledge, he might have been a short player. He would have been a market timer, I think, with that amount of prescience. Right. And if it didn't go his way, he could just force it the other way.

All right, Jerry. It's been great talking to you. Hopefully. Awesome. COVID opens things back up and we can see each other in person sometimes. That would be nice. That would be nice. And some blues bars here in Chicago.

That sounds wicked. All right, Jerry. Thanks so much. Go well. The Derivative is brought to you by CME Group. CME Group is the world's leading and most diverse futures and options exchange. For more information and educational resources

about futures and options, visit cmegroup.com. You've been listening to The Derivative. Links from this episode will be in the episode description of this channel. resources about futures and options, visit cmegroup.com.