The Derivative - Vol Curves and Vanna Charm with Cem Karsan

Episode Date: October 15, 2020

Today’s pod is all about word play playing into alternative investment. How does Jam Croissant relate to Cem Karsan? What about Vanna Charm and options definitions? Or the forever popular “there��s no such thing as a free lunch” evolving to “nothing is ever risk free”? To get together the definitions, explanations, and educated facts on all these nuances, we have FinTwit VIP & Founder and Senior Managing Partner of Aegea Capital Management, Cem Karsan. On top of alternative investment word witticism we’re also talking with Cem about how to actually pronounce Cem Karsan starting out as a market maker, Hagia Sophia, vanna informing trend following, buying options, twitter debates, Cem’s favorite jam & croissant, active to passive moves, the election pushing October, November, and December higher, how nothing is ever risk free, winner takes all mentality for market makers, market down/vol down market up/vol up, volatility retail call buying growth versus value, and all of the Greek/options definitions. Follow along with Cem on Twitter (@jam_croissant) and LinkedIn and check out Aegea Capital Management’swebsite. Chapters: 00:00-01:50 = Intro 01:51-14:04 =  A Globetrotting Background and the road to Aegea 14:05-30:06 = Market Makers Business Models 30:07-41:22 = Delta, Gamma, Vega, Vanna, Charm 41:23-52:55 = Playing the Players, Loving the Game 52:56-1:00:22 = Talking Aegea Capital & Getting an Edge 1:00:23-1:16:25 = Momentum vs Value, ProfPlum vs Jam 1:16:26-1:27:04 = Vol Surface & the Election 1:27:05-1:32:24 = Favorites 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. It is a second order derivative. Mana is the change in delta per change in vol, per change in implied volatility. Yeah. in vol ever change in implied volatility yeah so as uh implied volatility decreases by i'm sorry let's say increases by one it's the amount of deltas that change of your options

position um another important one that kind of goes hand in hand with it which i talk a lot about um is charm charm is a bit more commonly looked at and used, but still, you know, second order derivative, that is per change in time. So per back talking French baked goods today, because if you've been anywhere on VaultWit or FinTwit as of late, you've been hard-pressed not to see the wide-ranging and increasingly popular opinion of the vaguely mysterious handle at Jem Carson. And we've got the man behind the handle on today's pod, Jem Carson. See what he did there? Who's founder and senior managing partner at Aegea Capital Management. So we're excited to talk about some of our favorite Twitter and non-Twitter topics with Jem, including volatility, retail call buying, growth versus value, just how complex

trying to trade an uncertain election is and more. So welcome, Jem. Thanks for having me. Thanks for being here. So it looks like you're in the office. Yeah. So about two months ago, got back in the office. The other tenant we share space with left, so we have twice the space and perfect we're all spread out so it's twice the space half the price exactly me um and where are you you you just mentioned off on your river north to just north of the loop here in chicago yeah 401 west superior so right uh right in the heart of river north uh easy commute for me from Bucktown. Perfect. So that's Superior and what?

LaSalle? Superior and Sedgwick. So just south of Chicago here. They're right in the heart. Cool. So first question I alluded to in the intro there. Your name is spelled C-E-M but it's pronounced more like

with a J. Jim, that's the handle. So give us the background on the name and the pronunciation. Yeah, it's Turkish. I was born in London, lived in Turkey as a child, grew up speaking Turkish and English at the same time, and then moved to Texas. And as you might imagine, that's quite a change, you know, from Istanbul to Houston.

But so people had a hard time with it. So I get all kinds of jam, Jim, Jim Bob, Joey, Jeff, respond to anything at this point. So I figured the handle Jam Croissant might help you. That's kind of a joke that's come around. My wife's last name is Barry, actually. So we're kind of the jamberry croissants so all right so her middle name is Barry and her last name is and you can well her last name is Barry but she she hyphenated it uh she's Barry Croissant

I love it uh so born in London or you you said lived in London, born in Turkey? Born in London. Born in London. Actually have three passports, a British because I was born there, Turkish because my parents were Turkish and lived there as a child and then became an American citizen, naturalized when my parents did when I was, I think, six or seven. So great. And then citizen of the world.

Boston is in there as well in Chicago. Yeah. So my parents lived in Norway when I was at the end of junior high. And my dad's, there wasn't, you know, good American schools in Norway. So my dad's company paid for me to go to prep school on the East coast. Very, you know, amazing experience changed my life. I went to, went to Andover outside of Boston. So what I think we lost to them in lacrosse down in Florida.

They would come down for their spring breaks and beat us. We played football with sticks, but they were playing a different game. Andover might have been the one. Andover's got a great lacrosse program. I played there actually. I started late compared to most of those kids, but I actually made the varsity team by my senior year. It was a lot of fun. Great sport. Wait, what was the dad's company that they paid for you to go to Northeast Prep School? ConocoPhillips. So my dad was a structural engineer, PhD designs, offshore oil platform.

So hence all the connection between London, Turkey, Texas, Oklahoma, and Norway. Have you ever been on one of those platforms? I have. I have taken a helicopter out with my dad. I mean, these are a $6 billion, you know, plus projects that last, take four or five years to build. Don't break even for 50 years, right? They have like a hundred year life to them.

You know, a thousand people on a floating uh city in the middle of kind of the north sea for example tethered to the bottom you know miles down to the ocean so pizza you know it's like going to space it's they're crazy feats of engineering so and super technical right don't they're like the jets keep them about center and all that stuff absolutely absolutely i mean each one's different they have all kinds of different kinds you know i'll leave my father to kind of give you the specifics but i grew up around that it's pretty pretty cool and so what was your favorite accent at all those places it sounds like you haven't really adopted one do you flow in and out of them well my daughter and i speak with a british accent often, just to play around. But for the most part, no.

I mean, I grew up speaking Turkish and English. Actually, there's another country in there. I lived in South America in Chile for a year in college. That was supposed to be a one semester thing. And I met a girl and kind of stayed a little longer, but did live in South America. So I speak Spanish as well. When's the book coming out this is all this is all good stuff for a bit yeah one of these days when i can find time i'm uh it's a lot a lot a lot of not to write about so got it and so now in chicago office and you said

live over in bucktown which is just a little west of the city so cool um yeah so give us a little west of the city. So cool. Yeah. So give us a little background on work-wise and what you were doing in all those places up until Aegean. Yeah. So believe it or not, I've been here in Chicago now 20 years or more, 22 years, but never lived longer than four years anywhere before here. So my whole career has been here in Chicago. I came out of here, out here from Rice in Houston, was hired by a gentleman who had a trading operation out here who was a Rice grad. And there's actually a bunch of us, kind of a whole lineage of guys that have started their own shops out here. There's a big pop shop called Belvedere Trading here in Chicago. The head of that, Tom Hutchinson, hired me in the business, basically.

I worked under him early on. We were still very close friends. We knew each other at Rice. He played rugby. I played lacrosse. We were kind of friends. There's a whole bunch of guys, like I said, in the business, like I've come up that way. It was a bunch of old O'Connor associates guys who, who started a group for the Royal Bank of Canada. And so we kind of came from that lineage, learned kind of the right way how to do things. Trial by fire, it came in late in late 98 99 right before the bubble burst and uh really

kind of learned uh sorry with uh jim kleinhops who had been o'connor somewhere we were talking to o'connor and i'm like that would be a great book of just detailing the right it's kind of like the tiger cubs and just the amount of managers and pros that have come out of the o'connor tree is huge. I think it's even more important than the Tiger Cubs. From the derivatives space, I mean, they pretty much wrote every single model that's out there. Every model is pretty much based on it. Every prop firm in Chicago, not every, but I'd say 85% of them primarily use the same model

that comes from, at least the original roots come from there. Definitely 85% of the ones who've survived. Correct. Correct. Yeah. So no, it's an amazing story. I agree.

It'd be an amazing book. Somebody should write it. All right. We'll do that. That'll be a separate pod and or book at some point down the line. So I cut you out of there. So somewhere in there you were a market maker. Yeah i came out here as a market maker um and uh trial by fire you know moved up the ranks quickly i mentioned tom hutchinson he and some other guys left to

start belvedere i moved up very quickly to kind of fill the void i I was right as, you know, 2000 came around and, you know, made a lot of money for the firm. In our, you know, in our world, it's a very black and white world. You either make money and you're good at it or you're not. And, you know, I happen to have the capacity to, you know, to excel at it.

And, you know, my background was in that econ. And so it was well suited for the business. it was well-suited for the business. And you were making a market for the prop firm, like for their own money, not for a bank desk. Correct. Correct. I mean, it was a division of the Royal Bank of Canada, so it was backed by the Royal Bank of Canada, but it was a separate kind of deal, basically. The economics were 80-20 to the…

Yeah, they basically bought it in order 80, 80, 20 to the, they basically bought it in order to get the profit stream. Correct. Correct. So anyway, so learn there, moved up quickly as one is prone to do as they gain confidence and, you know, start seeing how much money they're making for who they work for. They start saying, Hey, maybe I can do this, you know, for myself and get my own economics. And that's essentially what I did. I went and started a group for Bear Wagner Specialists, a specialist firm that was

in New York in decline, as all specialist firms were in 2003, 2004. And they were looking to diversify into the market-making business. They were talking to CTC, Wolverine, a couple other big firms here in Chicago to potentially acquire them. A gentleman and I approached them to create the firm from scratch for them. And we did that. We built that out to a significant number of traders on and off the trading floor. And- What was the decline from more trading going to the screen? Yeah, exactly. The specialist business was basically, you know, stock specialists at the time were, you know, up until that point where it was a very lucrative bid-ask spread business and

everything just went electronic and, you know, the writing was on the wall. Like a business, right? Like I'm here if you want access to the stock, pay the toll. Right. And if you think about it, market making, making you know on the option side is same idea but much more quantitative and much harder to kind of completely automate um so just because the number of strikes and the complexity um and so it was a natural you know he john mulhern he's actually quite famous he's the gentleman who hired me to um to start the group for them.

You know, he had been a options trader early on in the 80s. So he had a good understanding of the space and knew he wanted to get diversified. It was the right idea. It was just a little too late because by the time we were two, three years in and building the business, I think their market cap had dropped from over a billion to like $500 million. But you were tasked with building an option market maker unit. Correct. Correct. And, and we did so successfully.

The problem was the, you know, the economics, we were supposed to scale it to, you know, a hundred million dollars in equity and leverage that. And you know, they had capital constraints on their end. And then John Mulhern passed away. And so it just did end up being quite, you know, as big as we hoped. It was a great operation. We learned a lot, built a great business. But, you know, I amicably split, took five of the gentlemen with me in 2006

and started my own group back to myself with one outside investor. And, you know, that's really what I kind of made my name in the business. We grew that to one of the biggest market-making groups in the indexes. We were 13% of SPX volume at our peak during the financial crisis. So 2007, 2008, we were one of the biggest market-making groups on the floor and off the floor and uh you know left that uh in 2010 after crazy run we took you know several million dollars and turned it into you know 25 times that basically um over the course of three years and uh you know i had 95 of my net worth in the business and was

just ready to kind of take a break after a crazy run. Yeah. So, and we can get into this a little later, but just talk through real quick the, cause it's so prevalent in the headlines in the news that market makers are doing this market. And I don't think most people really understand what the business model is there. So talk through just quickly what the economics look like, what they're actually trying to do. Yeah, absolutely. So market makers, as most people know, are kind of the gel that keeps the market together, right? Without a

bid-ask spread, there's nobody to sell 90% of the time there's nobody to buy because you're not going to match exact orders all the time so somebody's got to provide that infrastructure and they're the infrastructure of markets at its basis there's nothing nefarious about it it's very it's a very useful an important part of the business. I feel like most retail traders, especially believe there's another retail trader on the other side of their trade. Yeah. I mean, in equities, a lot of times that's the case, right?

There's a, you're talking about one equity buy and sell order is kind of hitting, but you know, in options you have tens of thousands of strikes for every, you know, for every series. And you have a million different stocks and products. So it's an important thing to have a good market maker on the other side to provide liquidity, especially during times of stress

and when volatility markets are probably at their most important. That having been said, sorry, go ahead. I was saying are probably at their most important, you know, that hasn't been said. Sorry, go ahead. So at the base level is, hey, I want to buy this option on Krispy Kreme donuts three years out. There's no one else on the other side of that trade. I'm the only one in the world who has this view. The market maker steps in and is like, cool, I'll sell that to you. But I'm going to analyze the risk and add some spread in there basically

to cover what I believe is the risk. And the successful market maker correctly analyzes that risk and prices it. Correct. And actually, yeah, correct. And in order to be a market maker, you actually commit to the exchange that you remember at to provide a certain width market at a certain time. And they can widen that out, tighten it. But for the most part, that's your commitment to the business.

Now, how much you trade there and how liquid it is will depend on the risk that the market will bear. And risk is broadly not measured in just general waving of hands. The market makers, you know, market makers see the world in a, in a, you know, multi-dimensional matrix matrix and every risk is related to everything. And you, you model, you know, every risk as it relates to wherever other things are trading in the market.

So you're able to perfect market maker world. You've hedged it all out and you're just making a market with no risk. Correct. Yeah. I mean, a great example is, you know, when you trade an option, particularly a role, you have interest rate risk, right. You know, or something that's in the money and, you know, the first thing you do is you go fire out your Euro dollar, you know, bootleg strip to hedge out that risk, right. And your pricing model is based on where that's trading at any given time. Obviously, your underlying as well as, you know, another component. And, you know, all these things are, you know, are now automated, automatically hedged

into a central book for most market makers. And, you know, the real trade is being, you know, the edge is being generated off of implied volatilities and directional components if you have some directional edge based on the flow that you see. And it seems like a winner take all market for a market maker. That's why Citadel's gotten so big and things like that, right? The more capital you have, the more strikes you can cover. Increasingly. Yeah. Yeah, absolutely. I mean, look uh there's a lot of data involved there's a lot of execution involved uh there's a lot of volume involved and uh at the end of the

day if you can get economies of scale and lower your uh trading costs and increase your informational flows by getting more flow right uh and, you know, improve your technology and execution, which itself is an arms race, you know, you're going to come out ahead. And it's a very profitable business. The information, especially in this day and age, the information that you gain is probably the most valuable thing of all. That wasn't always the case. But now know just by seeing flows you have an incredible edge to kind of get ahead of where things are going and and make money on on that side of the trend and that's a directional trend a directional directional yeah right yeah directional always directional right yeah directional for ball directional for the for the underlying stock

directional for the implied volatility right stock is directional for the implied volatility right there's a lot of components so it's a multi-dimensional space right is that is that flow allowing them to hedge it better or is it allowing them to trade basically opposite it or with it in order to make a profit yeah so if you imagine the system, yeah, both imagine, imagine a system where you have in real time the quickest systems and you're able to make a market to knowing that you're, that somebody is coming in to buy something, they're showing you're in their hand that they're a buyer, right? What are you going to do instantaneously?

You're going to go sweep any implied volatility you can elsewhere right now not necessarily in that that but uh elsewhere to uh you know if it has interest rate exposure had your interest rate risk or whatever right um if it has directional underlying risk to kind of go take that um and your offer that you give them to begin with is firm and it's instantaneous and they they may come and buy it but if they decide to kind of walk it up and kind of slowly keep upping their bid, right, then the market's going to move against them. And that's true for the stock market. You know, it's true for all products, but it's particularly because the options and volatility world is so complex and has so many factors. There are a lot more opportunities to take advantage of it

and would you so the broad brush is painted a lot of that stuff's nefarious and kind of a bad actor what would you say to that i don't think that's true at all i mean the reality is it's uh the most sophisticated players out there are going to win and That's true pretty much in every business. And the most sophisticated players here have seen more information. They have economy scale. They have better technology. They're faster. They're smarter. They got better models. And they benefit from it. I don't think, you know, nothing here is illegal or, you know, I think the term front running gets, you know, gets thrown out there a lot. I don't, I don't, I don't see it as, you know, front running. It's,

it's essentially making a market saying I will buy here and I will sell here based on the risk in the market. Right. Somebody's got to provide that service. And, you know, as they make that market and they market and the trade comes in, they hedge it out. And if they have the opportunity to then they see a big trade is coming to take advantage of the informational flows they have, they do. And that's probably true for any individual out there. See, they see information, you know, correlation, information, basis, risk, other things. Right. They're going to act on it on a more macro scale. And so I don't think it's any different. It's just on a micro level.

Got it. And in theory, there can be no, but there isn't necessarily a loser on the other side, right? Like some retail guy could buy this option. The market maker makes a market, hedges it off, front runs it, for lack of a better word, they make money. The stock goes up, The option buyer makes money. And everybody's happy. Oh, correct. And to be clear, this is not a riskless trade. I mean, they've gotten very good at garnering the information and using the edge that they have to help ensure that they're the casino and make money over the long run.

But they lose money on trades all the time. And the bigger the trades, probably the more they lose, right? They get, cause they have to, if there's a block order coming in and they get run over, right. They have to take the first, second, third, fifth, 10th level. Right. And, you know, clearly they're trying to, you know, they're getting out of a lot of it along the way. And in the long run, they'll make money on it. And they'll move the curves aggressively to make sure that they have

enough edge to do well. But, you know, this kind of leads us into what's been happening kind of on the retail call buying side, right? Right. I was going to save that for later, but sure, let's hit that now because, right, is that as big of an issue as is being made out in the press that the robin hunters are buying all these call options and the dealers which is the same as market makers right uh it's kind of used uh in the same vein the dealers or market makers are covering their gamma exposure by buying more stock which drives it higher which leads to more call buying yeah yeah so i yeah i think so first I want to clarify when we say dealers, everybody, you know, that's a broad term. Yes.

Market makers are a subset of that, but market makers are also laying off their risk to other places that house this risk. Right. And a dealer is essentially somebody who is housing, you know, the risk. And a lot of times that banks banks, right? It's also prop firms, buy side firms that will take on these positions. But the important idea here with options is broadly, these people are hedging the trade. So when they warehouse this risk for edge, they're doing it, um, you know, hedged and, and try not to take the full exposure, right. They're trying to take the, the edge out of it. So, um, dealers are, yeah, dealers are, are taking, uh, the, the trades, they're getting

short calls. Uh, and there's a lot of them. Robinhood is just one of, to be clear, many platforms, uh, retail options trading has, uh, doubledail options trading has doubled in terms of as a percent share of volume in the last seven years. We're not talking decades. We're talking, you know, doubling very quickly. I think I saw one of your tweets. It's up to 38% are single name options now. What was that? Thirty thirty eight percent of of uh of total option volume currently yes

but in the last year it's been right around 20 25 so it's it's um you know it's not that's that's a bit that's a bit over over exaggerated there but but the reality is it's a you know we're talking about something that used to be five to ten 10%. And, you know, it was always the kind of the dumb money that would get faded, right? And get overtaken by the more intelligent, sophisticated players out there. I guess I shouldn't say intelligent, but more sophisticated players out there.

What's happened is now it's kind of the tail wagging the dog. It's such a big set of volume. And it's also very importantly, single directional, right? All of these retail trades tend to be call buying. It's what's kind of more easily understood. It's also kind of betting on these growth names and the convexity to the upside and kind of buying lottery tickets, right?

It's the same idea. So it's important that it's not just a large amount of the volume. It's all concentrated in a very specific group. So it's having significant effects in that group. The obvious effects are, as we saw in late August and throughout August, honestly, was because of the short dated call buying. They had the ability to kind of push the market. It was already kind of moving momentum-wise up, but they had the ability to kind of push those names specifically because of the pure scale and size higher because of the gamma involved on all these options. And there's so much notional leverage options, right? I mean, you buy a 10 delta call, and then it becomes 100 delta, all of a sudden, you know, you have 10x the leverage on the market than you than you originally did. And so it's a big, very concentrated buyer

with lots of leverage. And it has major effects. So the gamma push the market up. Now, importantly, dealers are taking this other side of this. The implied volatility is being forced higher because market makers and dealers are moving. They're losing money on this trade. So they're moving the... Right. They're making their spread that we talked about earlier. Like, this is getting more risky for me. I got to make the spread higher. I'm going to charge you more for that option. Absolutely. Not just the spread wire, but they're moving up the level implied volatility aggressively because they know these guys are buyers, right? So, you know, I've had a supply demand, they're buyers, I'm the seller, I'm going to try and sell it higher. Yeah, correct. Especially

there's embedded lots of buyers, right? You're going to go to infinity. Yeah. And, you know, the more buying there is, it doesn't go really linearly. It kind of increases exponentially, right? Because at some point, you know, you just, there's not enough liquidity or capacity to absorb it. And the only way you're going to sell it is if it's, you know, significantly higher or the risk return is worth your time. So anyway, this is what happened. And, you know, ultimately the streak got really, really short, implied volatility to the upside and growth names very specifically. It was widespread. And the only way to hedge that is to buy implied volatility elsewhere and to try and spread it off. So there was, you know, the natural place of supply is in the S&P 500 and in value.

Right. Where there's always call writing, you know, buy writes are a very common thing and they come around very regularly. There's natural call, you know, supply in these names. So, you know, ultimately the street ended up taking very, very cheap calls in the S&P and the mall complex, you know, index mall complex in general

versus these single name calls. And how did that end up, right? Eventually all of the deltas that locals or, you know, dealers were long and underlying, they had to sell out as the market declined, right? So they're short gamma, they're short these calls and the growth names are long the stock and they've gone from a 10 delta to 100 delta. They have all of this long delta and as it

declines, the gamma goes the other way and they have to sell it out. And that also importantly, didn't just help exacerbate the decline in the market, but it did two other things. And I kind of put this out there before it happened. You could see this in action about to happen, but because the way you hedge all of this ball is by buying extra ball to help protect yourself against yeah because you'll make a lot of money if that ball declines but you won't in theory lose too much if you have enough ball on the other side what this ultimately did is there was an oversupply of implied volatility once you moved away from the calls and the growth names there was all this ball in the smp complex complex, other places on that decline implied volatility got crushed. And it also led to a rotation. So you had all the selling of stock in the growth sector,

right? And all these names that were the calls were bought on the decline, whereas that pressure didn't really exist in a major way in the broad index, and the index was more broadly pinned because of low implied volatility. So you really got an interesting dynamic there where you got to kind of, you know, we called it in real time, you know, look, market's going to decline, you're going to get vol compression and there's a good chance you're going to get a rotation as well. And sure enough, they all happen. And to a sizable extent. Which is basically we're seeing market down, vol down, and then some scenarios market up, vol up. And so we're saying this was some of the mechanics going on behind the scenes. So we got way off script there, but it was good.

But I want to do two things. One, we'll get back to AGEA. But one, can you just run through quickly? Because we've already thrown some of these terms out there. Let's just do a little rapid fire definitions of some of these option terms, if you don't mind. So we'll start with the simple ones can go super short on these Delta. Yeah.

Delta is the change in price of options relative to the underlying market. And when you say 10 Delta would be 0.1 delta. So per one point move in the underlying, that would be a 10 cent move in the option. In the option price. Cool. Vega. Vega is the dollar change in options relative to a 1% move in the implied volatility. So if implied volatility goes up by 1% for an option and there's $1,000 of Vega, the option goes up in value by $1,000. Theta. Theta is the decay.

So the amount of money that comes out of the option value per day of time. They really wanted to make it complex. We're gonna give each Greek a different denominator and different unit, right? Right, right. Like some are percent, some are dollars, some are time. All right, somewhat more involved. You throw this out on your Twitter a lot, the fixed strike vols. Yeah, so a fixed strike vol, a lot of people ask me about this. And it's a much more, it sounds much more complicated than it is. But the reality is, when you look at the implied volatility of

an at-the-money option, in the underlying options for, let's say, the SPX, there is an underlying skew. So if we move down 1% in the market, you're going to actually naturally slide. The implied volatility of that option that is 1% out of the money is higher than it is here. So that straddle is naturally going to increase as you slide down. That doesn't mean that implied volatility has increased. If you see the VIX go up on a down move in the market, that does not mean implied volatility has actually increased. Most people don't understand that. People say, oh, the VIX is going up. The VIX naturally goes higher when the market goes down based on the skew in the underlying S&P 500 or these products.

I put my pencil up there, right? You're just going, but tie that back to fixed strike. So what's important to look at when market makers do and most sophisticated players do is they look at fixed strike fall. That gives you a real color of how volatility is performing relative to the underlying volatility assumptions that the world is pricing on. So if the market moves down 1% and that 1% down vol was a 50 vol, the question is not whether it's where are we relative to that 50 vol that we've moved to, not the fact that we were at a 45 vol to begin with, right? So when you look at fixed strike vols, you're looking at the strike by that strike that you're moving to.

How much has that volatility changed? And that's why I'm always talking in fixed strike ball. That is actually the correct way to objectively look at what's happening in the implied volatility space. I'm a sailor, so it's kind of like true win versus apparent win. Exactly. It's all relative to the embedded assumptions of the market. Exactly. Love it. Skew, which we mentioned already a little bit, but. Yeah. Skew is essentially the skewness of the distribution, the downside and equity products is always more highly skewed.

That means there's a higher implied volatility to the downside. Except for August that we just talked about? Even in August. Okay. I mean, there's relative steepness of skew and it changes all the time. That was definitely on the lower end of skew, but equity indexes always. I mean, always. I mean, we've never seen, I guess there are, I say always, not for a single idiosyncratic stock necessarily, but for indices, always skews higher.

Why is that? Two reasons. First reason, the market historically moves much quicker to the downside than it does to the upside. So there isn't actually a real reason that there should be skew in the market. On a realized basis, realized vol is higher than the downside. The elevator? Yeah, exactly. Elev yeah exactly elevator down stairs up that's exactly right but we're saying the skew is just saying hey a 10 away uh put is more expensive than 10 out of money call correct correct it's a yeah the same moneyness or you can look at it in terms of probabilistically delta sticky um people look at it in different ways. That relationship is always going to be a higher implied volatility per amount of moneyness or probability to the downside versus the upside.

The second reason, which I want to get to is not, is a supply and demand issue. And I think that's the more important issue. The world is long the market. It's long assets. It's long, you know, if you live, you have a job, you're long, right? Like that's just how it works. I call it the financial industrial complex, like the military industrial complex, right? Everyone's geared towards making you as long as possible. A hundred percent. And, you know, that's where the money is made in the long run, right?

Assets create a yield for the most part. So these are insurance products at the end of the day. And so if you want insurance, you don't want generally insurance for the upside in the market. You want insurance to protect your long position. So people buy puts and they sell calls. They write calls against their long positions and they buy insurance protection for downside convexity. This supply and demand has always been there and it always will be and it creates an overvaluation right relative to outcomes of downside relative to upside. So that increases the skew and particularly during times when the market's up on a big run and people are making lots of money, skew tends to be even more exaggerated.

Actually, an interesting point, in the S&P 500, you know, we tend to have the highest skew in the world. There are lots of other products where the skew is not as steep as here, but this is where broadly the world comes to hedge. That's an important point, right? Even if I'm long, any country, pick a country, if I'm going to put some hedging program into place, I'm probably using some S&P, if not all S&P. Correct. And that's because, you know, rule of law, this is a safe place to buy insurance. Liquid. You probably don't want to have puts in Venezuela, right? Like, you know, that's for one, two, it's very liquid, like you said, and there're dealers and you're able to get some significant size of these things done and get in and out of them. There's several other reasons, but, you know, I think those are the main ones. All right. Now some next level stuff. Vanna.

Yeah. So this is one that is not well known and well used. I want to be clear. Everybody's always asking me on Twitter, like, where can I read more about this? Is this, you know, how the effects of this, you know, there are very few number of people who use even in the market making space that use VANA regularly. It is a second order derivative. VANA is the change in delta per change in vol, per change in implied volatility. Yeah. So as implied volatility decreases by, or sorry, let's say increases by one, it's the amount of deltas that change of your options position. Another important one that kind of goes hand in hand with it, which I talk a lot about is charm. Charm is a bit more commonly looked at and used, but still, you know, second order derivative.

That is per change in time. So per amount of decay, call it, right? How much your delta changes as well. Both of these are, you'll notice, are delta focused derivatives, right? Right, which ties back to the market maker's desire to be delta hedge neutral, right? Right, which ties back to the market makers desire to be Delta hedge neutral, right? Right. So the reason I use them so much, I look at them so much as these really embody a lot of the Delta effects of the underlying assets. And the broad world looks primarily at the underlying assets. And most of the world is not very familiar with how these derivatives can have a substantial

effect, especially now that they're, you especially now that the leverage in these products has increased so much over the last 20 years. And so understanding these delta-based derivatives of the underlying options is very important to understanding those flows. Now, who came up with charm? They lost the Greek alphabet there? That's a great question i'm actually not not sure what if that doesn't i think that might be it's still a greek uh i don't know maybe that's the wrong guy i don't really know we'll look that up separately i'll have to get back to you yeah and then i was actually clerk in the bond pit staring at the bond options at the board of trade and right that was they all had their sheets right and the bond market's moving and they're looking down at their sheets i don't think they had vanna and charm

listed but they had the calculations of if it moves two points up i gotta hedge with this many futures and they'd arbit into me in the future space so that's the whole concept of delta hedging of based on these statistics based on these greeks I know exactly how many futures I need to buy or sell to maintain a zero directional risk. And I'm just then betting on picket volatility or time decay or whatever. Correct. Yeah. And I think I think, yeah, going back to my market making days, like we didn't have Vonna or charm on our sheets. We didn't even really look at it very closely, right? We did look at charm in a sense that we'd move our market, our model forward a day or in time, and we'd have a sense of, okay, I'm going to have a bunch of stock to buy back tomorrow or something, right? But it wasn't,

it definitely wasn't as discreet and definitely not looked at as, you know, as meticulously as I look at it now. Again, delta, gamma, those things were, you know, every second, every minute, kind of looking at this and understanding the risks associated with that. But yeah, Vaughn and Charm have been a much bigger part of what I look at and I think are increasingly important to understand. And Volga, last one.

Yeah, so Volga is change. It's like the gamma of vol. So per change in Vega, it's per change in vol, how much Vega you add or subtract. So how much vol increases in an increase in vol, yeah. Correct, so it's essentially the gamma of Vega. It's kind of like gamma is to Delta, Volga is to Vega. And people look at Volga a lot more actually on the market making side than they do some

of these other effects. I tend to look at it less because it doesn't have as much of an effect on underlying assets as much as it has an effect on the underlying volatility of the product. Because for a market maker, that's what could take them out in a body bag, right? If that just explodes. Their focus tends to be on managing implied volatility and the risks associated with implied volatility. They try and tend to be more market neutral. Again, every shop is different. Whereas my focus and a lot of people's focus is understanding how does this move the underlying product.

So with that background, it seems that, and you just mentioned looking at Vanna and Charm, it seems you like to play the players more than the game. Is that fair to say? And you can get get a little i think there's a song right there there is i'm not gonna go down we go there but yeah don't don't don't hate the player hit the game i think it's yeah don't hate the player but uh but you're kind of looking at how the vol service reacts to um all these different players and what they're showing in the market with these different readings and then kind of the feedback loop that that generates. So, yeah. So what I've discovered in the last, yeah, what I've discovered really in the last five to 10 years is there's a ton of

sophisticated players and some of the most sophisticated players out there looking at what's high, what's low, trying to put on relative value positions and implied volatility on a dispersion basis, on an underlying basis within each product, on a correlation basis, you know, that is so picked over, right? And the reality is what ends up happening is the edge in those types of positions are very transient. They don't really kind of stick really kind of stick at the end of the day. The way you end up capturing those, that, that edge that's there is essentially getting out ahead of how the underlying movements are going to affect the balls and skews themselves, right. Based on that position, as well as the underlying movement of the moving of the underlying

asset as well. And I'll give you a good example that may be a little bit confusing. But imagine, and this is kind of a common, this is a kind of a common one is, you know, at monthly or quarterly expirations, vol and skew tend to be elevated relative to the week or two weeks following it. Why is that? Because supply and demand, those are the most traded assets. There's a lot of structured product tied to these monthly and quarterly contracts. If that's where all the volume is and that's where all the buyers are, you're going to get a lot of buyers of puts in those products, sellers of calls, and you're

going to get higher skew and probably higher implied volatility. So if this is a regular occurrence, you know, you think, well, I'll just go sell those monthly and quarterly, and I'll go buy the puts or ball behind it, right? Great spread. Yeah, that is a good spread. But not surprisingly, it doesn't tend to realize into, you know, any meaningful profits. Why? Because the whole street has that position on it. If the whole street has that position on, it's a valuable, good relative value trade. But what ends up happening is it has effects on how the market moves,

both in terms of the underlying and volatility and skew as the market moves. So given that same position, let's imagine a downside put spread. The market goes down. You're right going into expiration, let's say a week before that. Let's talk about now what happened on Monday.

The October, you're short. You're long in the October 30th puts behind it. Market goes down into your shorts and they're high. What happens to the october 30th the october 30th skew and vol gets compressed and vega broadly gets compressed because you own really cheap skew and really cheap vega because of this relationship that exists yeah so the reality is you can't just put that spread on say i, I'm going to make money because everybody has it on. So the second that the October declines, the October 30th is going to decline and SKU is going to have to decline and implied volatility behind it's going to have to decline. And so understanding that, those are the effects that are internal to SKU and vol and

the effects of these positions will have on the SKU and vol. But also you'll is as that october decays away and you're just left with the october 30th which was really cheap you have to there's charm and there's um and there's vana to these products so the october is disappearing that was your long delta versus your short delta behind it um what happens as that disappears you have to be you have to be buying the underlying right Or selling some other ball somewhere in the put wing. And increasing rate. And increasing rate, exactly. And so what does that do? That affects, as the days pass and as the implied volatility drops into these down moves, it forces buying, forces buying of that underlying

asset and it supports the market. And these flows are big. These are big. I mean, the world has a skewed trade on everybody buys, puts, sells, calls. Dealers are short put, long call on the indexes. And it's a very profitable trade because you're selling a high ball, you're buying a lower ball and you're short stock. And there's some short convexity to it. There's some risk to it, right? But in total, this is a carry trade that's very profitable. But every day that goes by, right, you have to go buy that delta back. That's charm. And as that volatility gets compressed, you have to also buy that delta back. And so during periods of the calendar, it's very important.

It happens every month, every quarter, to the extent there's open interest that's sizable and that there's more, you know, you've moved into, you know, more, you know, long ball or short, sorry, short put in the front, long ball in the back. It's even more, it's even greater. So by using this framework and understanding the positioning that's actually out there, you can really get ahead of what's about to happen. You can see the supply and demand flows coming. Now, is that the only factor out there? Is that driving everything?

Like, no. And I think some people interpret like, that's all I look at. And that's the only, absolutely not. But if you're looking at a world that doesn't include that information, you are flying blind. It is such an important factor.

You're lost. And people don't understand why these things are happening. And, you know, people's eyes are coming out of their head when they see kind of the predictive power of these things. It's incredibly important. You know, these flows are increasingly, you know, driving markets in these windows, in these important periods where bond has increased, right, towards expiration cycles. So understanding this is very important to getting out ahead of the Delta and the market. Let me ask, so that was present in February of this year, right? So it's like there's a feedback loop, feedback loop until there's not, right?

Yeah, so that's exactly right. From everything you just said to when there's a crash. Yeah, that's a great question. So there's basically two counteracting factors, right? There's, there's gamma, right? And then there's Vana and charm. I kind of put Vana and charm together. They're two kinds of sides of the same coin. It's a function of time. It's a function of, of, of all, but you know, if I'm short out of the money put, and I'm a long and out of the money call, right. And I go to strike or towards strike and time passes and

that put expires, right? I have a lot of deltas to buy back, right? But if we go through it and the speed of the move is big enough, right? Then you don't have stock to buy back. Then you've actually, that's gamma, right? Then you've accelerated and that's convex, right? You can really lose a lot of money on that. And that effect itself is very important as well i mean so you can't just look at bonnet terms hey i'm going to go buy stock and that's why people don't just go go preemptively just go buy a bunch of stock going into periods like that's why they do it over time time passes they'll buy stock end of the day every day buy stock morning decay comes in buy stock that's why it comes at the beginning of the day and the end of the day, right? People are moving their curves, resetting their curves,

saying, okay, I've dealt with the buyer. And there are people out there with algos front running these as well. So it kind of comes in a little earlier. But the reality is there's embedded risk because that speed all of a sudden, you buy back all the stock. And let's say the last day or two days

before expiration, all of a sudden, you bought back all the stock and then it declines dramatically through your short, right? shirt and so what happened so what happened and then they're puking out yeah exactly and so what happened in march is not a coincidence i think that not enough ink has been spilled on this but i think the you know in march when we declined the bottom in the market happened right at march expiration literally Literally the bottom, the peak and ball, the bottom of the market happened the day of March expiration. March 23rd or something.

Yeah, not a coincidence. Why did that happen? Because everybody was short gamma. They were getting margin calls. Everybody was short March. They were long behind it, right? Because March is where all the demand is and people were short.

And the second March rolled off and expired, everybody was left long vol, long protection, no longer had margin calls, market stabilized, took off. And so, yeah, these factors are, and again- Then they could go back to just their normal buying pattern. Yeah, not just buying pattern, like then you're less long this vol, a really high vol. Everybody is all of a sudden went from,

I got to buy this back to, oh my God, I better get rid of this and sell this otherwise right this is on an 80 vol right but it's still elevated for quite a bit but yeah i mean 80 down to 30 yeah yeah yeah no 100 but there's but that's also we can get it go down a rabbit hole here but that's also why after big events tornado comes through town insurance is always the best sale at that moment right you're You're less likely, and it's actually, there's a reflexivity to it. I mean, you're less likely to get these declines in the market when everybody's prepared for them. Implied volatility is higher right now. People are less willing to sell things because the sellers have been pushed out of the market, A. People have a recent memory

of the risk involved. That seems like it's true only until it isn't true right so you can be like oh we just went down 30 now's the time to sell vol until the day when we go down 60 then you're right oh i'm not talking in absolute terms probabilities right yeah you have you have uh i mean i think a great example of that is 2017 the amount of risk at those low implied volatilities right in 2017 well no i beg to differ and that's the thing nobody nobody would uh want to sell because the risk on their sheets looks awful it was actually the most profitable year in history to sell implied volatility. It was the lowest realized volatility and risk adjusted as well. I say risk adjusted relative to the amount of money that was lost at any point, right?

Yeah, yeah, yeah. It was the most profitable. But that's the hindsight. In the moment, it was scary trade though, right? Because you're so low. Well, for some. But the reality is there's a reflexivity. And I think that's important that a lot of people miss here.

I'm kind of going off track, but when implied volatility is compressed, the market, everybody's longing. Again, supply and demand. The world is stuck long ball. Market's not going anywhere. Yeah. Actually, it's not just because,

oh, people are long ball and they'll make a lot of money. There are structural, like people will hedge that profit as the market moves. The market moves half a percent and you're long very cheap ball you're gonna you're gonna buy some stock the mark goes up half a percent you're gonna sell some stock and that's that's the power of gamma and ball and everybody was long ball in 2017 and it reflexively pinned the market created you know the lowest implied ball in history by 30 percent yeah greater than a three percent yeah right i can't remember what a 61 days or something without a one percent move yeah that was uh the biggest move was less than three percent

and you know from peak to trot so i want to talk for a second about, so you're using also some of this flow information and Vanna and Trump to inform trend following, right? Correct. So we should take a stop and go into what AGEA does so we can come back to that. Yeah. So AGEA has been around since late 2011. Our primary focus was originally, and still, you know,

a big part of it is relative value long vol. Our flagship products are still long vol products. We obviously started that in 2011 and riding it through 2017 was, you know, we created a ton of that alpha, but the market went straight up. And, you know, I think our average alpha for including these recent years is just over 11%. What are you basing?

It's a good chunk of alpha, but a negative beta. What's the beta you're basing? Just basing on underlying, right? I know that's not a perfect metric, but, you know, I'd actually say we have a lot more alpha than that because we're long vol and long vol itself intrinsically has negative alpha. So we've kicked off a negative positive, sorry, 11 percent to the market with a negative one beta.

You know, this is a product that, you know, has been has had a lot of edge in it. We've done a lot of great things with. But the tough the tough business side of being a long ball product is the markets tend to go up and implied volatility tends to be overvalued, you know, relative to realize. And so, you know, it's not a very profitable business in the long run, unless, unless you're just collecting a man, a really chunky management team. So we have a decent chunk of assets, you know, we've been doing it for a while. We have a couple of institutional clients,

but, you know, we decided as a business to really shift towards where we think there's more edge, a much more scalable product, you know, understanding we have this deep expertise and understanding how the markets move and how these products affect those moves. And, you know, part of me going out on Twitter, you know, yes, I like to educate and to do other stuff,

but it's really to get the word out about how this is an important product and how, you know, people should be understanding how this can add value to their investments. And I always wonder, like, sometimes you're like this, I'm getting out of my lungs here at 30, like, it seems like you've given away a lot of info there. Yeah, no, a hundred percent. Sometimes I, you know, wonder how much of this I should be, you know, communicating. But, but yeah, no, this is very inside baseball stuff.

This is, you know, forged by fire. Nobody taught me this. You know, this has been complete self education on how markets move. You do this for 22 years and then think of these markets, you learn a lot. So I think this is a valuable, important stuff to people. But I also think without being on the inside and really understanding these flows and having the approach

and expertise that we have, I think it's very hard to replicate. So I think- It used to be easier. Seems so hard now, right? Like you got to know all this stuff. It used to be like, I got to have a view

on where the market's going and I'm going to trade that. Making money on the implied volatility relative. It used to be like, okay, I got to have a view on where the market's going and I'm going to trade that. Making money on the implied volatility relative value stuff used to be easier. And that's part of why I think we're moving away from that as well. I think there's just much more edge. I think the edge from these relative value trades in the ball market really get, like I said, stripped out by the actual underlying move. And if you can get out in front of the underlying move in a very kind of risk-adjusted, positive way,

you can make a lot more money with a much more simplified position and do it in a much more scalable way. These vol trades are not that scalable and they're also not as liquid. And so just, I think it's a great business model. I'm excited that we've started kind of running this on the prop side and we're going to have,

you know, we have an amazing track record going on it already and they're excited to launch that probably in the next six months. Wait, so dive more into that. I lost myself there for a second. So, cause I asked about trend following, but we didn't talk about trend following. Yeah. Yeah. So let me go, let me go into the underlying. So obviously there's a lot of trend following means a lot to a lot of different people. And, you know, again, I'm,

I don't come from the trend following, you know, world. So some people might, some people might, you know, beat me up for the terms, the semantics I use, but, but yeah, I mean, I consider it trend following in the sense that we are, you know, we're using big data sets and we're looking at technical indicators as well as volume and flow indicators in the broad market and pairing that with the flow and indicators that we have on the vol side to come up with predictive analytics to help us get an edge. And I think everybody's kind of seen how good some of these things are. But I mean, to be clear, I'm not just looking at these Vana and charm flows on their own, you know, looking at it, you know, looking at basic mean reversion, looking at momentum, looking at, you know, sentiment and, you know, put call ratios, you know, I could go on and on, but there, you know, we have a 24 factor modelactor model, and we're really first starting with qualitative measures of understanding our framework and how we believe this world works and who the different participants are, not just in the ball space, but risk parity, ball control, all kinds of other products that are out there, the trend-following space, and trying front of when those flows kind of tend to tend to come into the market at what spots and get ahead of them. And but it's all still reflected in options. So it's all option trading or you'll do. No, no, the CTL is very much trend following underlying.

We are looking at where the underlying in the S&P and the Nasdaq, as well as we're primarily focused on equities now. That's just where our expertise is. But I'm really trying to understand and get out in front of how these things are going to move relative to one another and independently on the road. And then taking delta directions, as well as implied volatility directions based on that. So maybe all right short ball at times. Yeah, great. Absolutely. A great example. I did that the other, I think last week, I was like, look, implied volatility is oversupplied. We're up against, we're very overextended. We're like the two standard deviation up,

right? There's an underlying Vana flows that are supporting this market, right? You have all these different flows and factors. So this market's going to be pinned for a week. Go sell vol. Don't try and take a direction one way or the other. There's not much to do there. You should do sell vol. And so that's what we did. Hybrid between the model and the factors and discretionary?

The discretionary is more leverage-based. So we will leverage on, leverage off, risk on, risk off. Even that is fairly quantitative, but we do have the discretion there. The model itself is very kind of algorithmic, quantitative. It's not auto-execute. We are deciding exact moments. When you have a lot of experience, you want to use as much of that as possible without, without, you know, being, you know, messing with your kind of system too much.

Right. And without spending $12 million to code your brain, right. Correct. Correct. And there's just some things that, you know, it's almost impossible to code. so next we got some twitter people wanted some more color on this of you and uh mike green on twitter got into a little friendly debate i wouldn't call it a debate but a friendly hearing of info on momentum versus value. So give me your side of the equation. Yeah, I want to be clear about this before I get started. I don't want to speak for Mike.

He's not here to defend himself. Not that he needs to. I have the utmost respect for him. He's been on the right side of most trades for many decades. So I tread very lightly when I'm debating with that man. Yeah, to be clear, though, you know, my expertise is, I'm a practitioner in the ball space, I have a very kind of unique perspective on how these things work. This, this debate is not central to my, my background in the ball space. It's really, you know, I'm also kind of at the front of this,

you know, I studied public policy in college as well as math econ. So I have this great interest in, you know, economics, policy. And, you know, it's something that I do on the back end that informs some of my

kind of broader kind of trend ideas. But for the most part, I just want to say, like, you know, this is really kind of healthy debate on something that I'm interested in and not really central to fall. Which is what I'm interested in, too. to passive and the effects that that has on the momentum factor and particularly growth, large cap growth, which is tied to that momentum factor and has been in recent history.

He's been spot on and he continues to pound the table on this is just the beginning and that this will continue for an extended period of time. Again, it hasn't even been pushed back but my you know the reason we kind of got connected is you know i was really arguing at the top there in august that we're going to start to get a value to growth rotation and my argument was originally based on the ball arguments i made earlier but i also said i think this can continue for you know an extended period of time meaning uh this is a beginning of, and fits and spurts, a decade long. This trend could really be a broader trend. And my point to that was, with the upcoming election,

I have this mental model that monetary policy has been a major, the influence in terms of creating this growth momentum factor. I think it's as important, as probably more important than just the active to passive move. I think the active to passive move is important. It's critical. It is a driving force. But I do not think it's the force. I don't think it's the only force.

And I think essentially giving know, essentially giving- And we're basically talking about Fang outperforming everything else and Apple being the size of the whole Russell 2000 and all those sorts of stats of why is that happening? Besides those being great companies, is there some deeper thing? And Mike would say, well, part of it

is because everyone's moving to passive. You're saying, well, part of it is there's huge fiscal policy stimulus. I'm saying actually that up until now, there's been a huge monetary policy stimulus. A monetary policy at its core is lowering interest rates and providing money to companies. If you're a company like Amazon or like Amazon was, not now, but Amazon was when they were starting out. I actually stuck up for you on Twitter there and threw that Amazon thing. I appreciate it. Yeah, that's right. I need all the help I can get against them.

Uber is another great example. These are companies that would not have survived in any other market time. They're companies that have survived because they've been given basically limited limited liquidity and ability to invest and drive lost leaders for decades plus and to focus on a 20-year goal without profits. And if you do that, if you create a structure that allows companies to dream up mining meteors on asteroids or creating spaceships and going to Mars without a profit, eventually these things will win. It may be 40 years, but they will win if you allow them to do it without a profit.

You provide them unlimited liquidity, right? Especially if they're the first mover in that space. But who's allowing them to do it without a profit? The Federal Reserve. So the Federal Reserve is creating it. But they're not directly funding it. But you're saying because investors can access that cheap Federal Reserve money for basically nothing or at the banks, and the banks can in turn give it to investors for cheap, that it's flowing down into the system and creating this. There's no real risk if you can get 30-year money at 3%, 4%, right?

There's no real risk to a liquidity event for these names, right? Tesla could have easily have gone out of business, right? Yeah. Three, four years ago or two years ago, right? They don't have cash flows. The argument was solid that they don't have the lifeline. If there's a liquidity event during that time, they'd be out of business. But the market and broadly, you know, the Federal Reserve has allowed, you know,

infinite liquidity and protected the downside. And this is communicated through two main factors. You have scarcity or the Tina effect, right? People have to put their money somewhere because there's no other place to put their money. Tina equals there is no alternative. There is no alternative. There is no alternative. Exactly.

And secondarily, because you have a moral hazard, for lack of a better term, where the Federal Reserve will come in and support markets and provide even increasing liquidity with any risk of a liquidity crisis. So if you have this situation, you're naturally favoring these names and eventually they're going to win. Amazon is going to beat a Walmart unless Walmart is willing to do the same thing and compete on the same terms. And so growth names that are willing to not spend attention to cash flows and pay attention to future growth will ultimately see the benefits in the market. So that's a broad concept. And the passive active is a critical part of the communication mechanism of how that works. But my point to him was, because this is the case, as we move away from monetary to fiscal, we haven't done that for 40 years. And define that real quick. Monetary is Fed policy. Fiscal is sending people checks. Correct. It's sending, essentially lending money to companies.

And, you know, when you lend money, individuals for the most part don't borrow money. Wealthy individuals and companies borrow money for the most part. And so monetary policy is lending money. Fiscal policy is actually getting dollars into people's hands, whether it's by healthcare,

whether it's their infrastructure spending or just jumping money out of a helicopter. I mean, that's the kind of Bernanke example, right? And we're basically saying we've exhausted the monetary side. Yeah, we're at 0% interest rates. Yeah, you can go negative. Yeah, you can do more

qe but the the you're all you know everybody's heard the term pushing on a string like the feds the more the you know they're at the lower bound the more they do they get very little effect at this point and they've been very vocal how about how they want fiscal policy to take the handoff they want fiscal policy we're out of arrows over here. Can you guys? Correct. And because of the political environment here, we haven't been able to for many, many years. We haven't had to until really about 48 years ago.

It's been more pressing, but we're at a point now where it's necessary. The Fed is very aware of it. And importantly, I think this is the part that people are missing. The zeitgeist has changed. The way people realize the inequality that has been driven by monetary policy is unsustainable as well. And the masses for once are actually broadly clamoring for more fiscal policy,

more infrastructure spending, more direct spending and money to people as opposed to corporations. And I think that has become politically untenable, you know, for people who are not arguing for that. So I think that political push, in my opinion, is essentially an inevitability. Obviously, you'll have corporations and lobbying that will try and fight some of these trends. But I think the political movement is in such a place where, regardless of what party you're in, you're going to get some amount of increased fiscal spending. You think we'll get basic income? I think eventually you will. Yes.

I don't think that's going to happen right away. That's going to be a stair step, but I think that's the natural kind of ending place where we're going. Like, Hey, the country can't keep going unless you pay these people another check, give them another. I think the first, you know, like we'll see who gets elected right the election i mean this is why this has also come up i think i come up the election here is

is not just important you know for other reasons but i think the most important structural reason for marketing for markets is under a democratic or biden administration i think you'll get a very very quick move to aggressive fiscal policy and And I think they've been very vocal. Their first move is massive infrastructure spending, though. I think infrastructure spending has a massive multiplier on it. When I say that, per dollar you put in, you get $3 out. Why? Because you create a job and you pay those people money, but then you create something

that then also generates more profits for companies, for individuals. Especially in construction here in Chicago. For example, it depends what kind of infrastructure you're talking about. Right. But yes, absolutely. But you know, infrastructure is 5G networks. It's you know, you know, electric, electric gas stations, whatever, you know, you can do a million things to help a green new deal, whatever you want to call it.

All of these things are infrastructure spending. And that money flows directly to individuals and that creates price inflation. That when people have money, for the most part, lower middle-class people spend money. They don't go buy investments. They do to some extent, but lower to middle-class don't have enough money to save. They're to some extent, but lower to middle class don't have enough money to save. They're trying to get by and try to pay their rents. But doesn't Amazon

wins either way, right? Yeah, sure. But you have to realize it's all relative to valuation, right? Yeah. So yes, this should be brought, this is what the economy needs. The Fed says it as well. This is not my opinion. This is, you know, textbook, like this is what the economy needs. The Fed says it as well. This is not my opinion. This is, you know, textbook, like this is what the economy needs. The economy will do better under this environment, especially because we're the reserve currency, and we can afford to do this without a major, you know, problem on that end. Right, let's borrow at 0.1% for 100 years. Right. The problem with this for the markets is the economy could do very well. And ironically, that's not good for the market. That's not good for the market because if interest rates go higher, if inflation goes higher, which is a natural result of fiscal policy,

long-term rates unwind this whole mechanism we've been talking about, how the growth multiple game, right know the price you buy these things on almost doesn't matter right but if interest rates go higher there's an alternative there there's no longer the team effect disappears right you have higher you have three four five percent bonds you have i've always i've always contended like there's no way interest rates can ever go higher like everything is based so in trying to bring out on lower that's if you give the people money directly that's because we haven't done fiscal policy we've done supply side trickle it's not just monetary policy we've been doing supply side economics since reagan we've been giving companies money and expecting to trickle down

and guess what it hasn't trickled down yeah right but i'm saying even the mom and pops like need cheap mortgages and like card loans like everything's based on low credit right on low rate correct so at the end of the day look the the my theory here is like it's not going to happen overnight i'm not calling for you know you know fiscal policy will take a while to work through the system initially it'll be very positive for the economy and the market will probably see that as a broad positive. And you're saying value will outperform growth when and if that happens. Right, because cash flows to value will go to the roof.

Are you being paid off by Cliff Asness? Absolutely not. But this is bad for multiples. Higher interest rates is bad for multiples eventually. And things that are trading on ridiculous multiples will be affected. No, no, those aren't around right now, are they? I mean, look, when things get too extreme, people are always like, but what is the mechanism which is going to make this come back into life? I'm trying to give you a broad framework that will create this at some point.

This is how it will play out. Mike Green's argument is, you still have a secular active to passive trade and that's not going away. And my argument is, it doesn't have to go away. But he also feels that makes the system more fragile and it would be more apt to break with a little trigger.

So you could both be right. True. And that's exactly right. We're talking about orthogonal kind of arguments. They're not contrary. And I agree with his argument. My point is, I think this move from monetary to fiscal is how money flows through the entire system and is much bigger than the active to passive flow. And ultimately, if you get a revaluation of multiples and growth relative to value, I think this cycle could eventually untether growth, right, from momentum.

Value could become the new momentum name. Yeah. And you could eventually get an active to passive move that is a tailwind to value not growth now you can get a passive move in value yes and that's but again that would take a big kind of massive multi-year move right you'd have to have massive momentum move and and you know there's a lot of mechanics where he still is kind of uh you know he basically doesn't agree with certain of the mechanisms that I talk about. But that's the broad argument. We could go deeper.

But, you know, and I think he I think he agreed on some major parts of what I'm saying. And I think, you know, I definitely agree with his theories. I think we've agreed that the only way this is really going to happen is a broad revaluation of the market where growth massively underperforms value on the downside. And then, and he said, basically, how are you going to get people buying value to begin with before? How's it going to create that momentum on a flow level? And my argument is it'll come from corporations, you know, whether they increase dividends or whether, if you can no longer borrow money, you're dependent on your own cash flows. And if your cash flows are increasing and you're getting more earnings, you're going to borrow money, you're dependent on your own cash flows. And if your cash flows are increasing and you're getting more earnings, you're going to increase your dividends, you're going to increase your buybacks, and that will ultimately provide support for these names and

create relative momentum relative to growth and underpin those names. And that's kind of where I think the ultimate, whether it's through M&A, dividends, buybacks, LBOs, you'll have the ability to support names with real earnings and cash flows. We'll go back to a DCF model. I know it's unthinkable, but it hasn't happened in 40 years. So that's the thing. Whenever you're arguing for something that hasn't been in 40 years, you automatically get people looking at you like you're crazy. Right. But cycles happen and, you know, they happen fairly reliably on a lot larger scale. And sometimes it's easy to confuse macro cyclical for secular. And I think this is,

we're getting to the end of a macro cycle major macro cycle of capital versus labor. And people are lost thinking that there's a secular, you know, 200 year, you know, Yeah. So there you go i love it last bit you mentioned the election and you've been uh talking a lot about the different right at first it was just like oh october vix futures are high because of the election and

they look 30 days out and then it was like oh well novemberIX futures are high because of the election. And they look 30 days out. And then it was like, oh, well, November futures are now high. And now December is elevated. So go through a little bit of those. It's fascinating, right? We're kind of like how vol works. It looks out to these. And we've also introduced this new thing of like how the election actually works, right? That there's a vote, but then they get tallied and then there's the electoral college vote. So it's like vol surface on top of how our elections work, which is absolutely fascinating. So until I'll be candid, like until eight to 10 years ago, you know, when I first started the business, event vol wasn't even a thing. There wasn't even like a discreet event vol. People didn't even look at this.

They should have, right? And obviously they did it, you know, they did it in, I want to be clear, in the indexes on a macro level. This was done for earnings, right? This was done for- Yeah, merger, arbitrage or something, yeah. Correct. But, you know, people broadly kind of faded these events

and, you know, a lot of sophisticated, you know, just like any other thing, people started pricing in discrete event malls and doing it, you know, successfully for a profit. And, you know, then you started seeing a real move in the surface of equity indexes and other products based on these events. And, you know, if you know how to do it, and I'm not going to walk through the math, but a lot of guys on here, I'm sure we'll figure it out. You know, you can price the relative to the curve, right? The event, you know, move that's being priced in, that's extra. And you can do that with multiple events, depending on how you define a discrete event, that's very important, right? You know, what's an event, what's not is, you know, always a challenge. And so by doing this, you know, we're able to look and see in real time what the November, you know, fourth election is relative to the things around it. And it's been very cheap, like, relative to, in my opinion, right, we're running about $73, $74 in the S&P 500.

You know, you're talking about essentially a 2% move, you know, in the underlying, I think for something that's as big as it is, that seems incredibly inexpensive. And it's particularly cheap. And I think this is important. All the way up to November, November 27th. It's still very cheap relative to December and January implied ball. And actually, it's come in quite a bit and it's normalized. But for extended period there, it's still high. But relative to where it was, it's been a very profitable trade for us but but you know for the longest time people were not we're pricing in a massive secondary event which was uh this uh you know contested election world falls apart post-election like the election passes we don't have any new information really and then there's a contested election and people are being like we don't buy the streets who wins we just care that somebody wins. Then it's safe, right? That the world doesn't fall apart or that there's not, you know. And I think I got overblown.

Actually, I feel confident. And obviously, the price movement has borne that out. But essentially, the problem with that, you know, in terms of a mental model is, you know, you know an election is going to happen. You know there is 100% probability that there's going to be an election is going to happen. You know, there is a hundred percent, probably there's going to be an event election and, you know, put a number on it, but you know, 75 to 95, depending on how you look at it, uh, percent of the time you're going to get the majority of the information of who the winner was. Right. Even if it's contested for, you know, on that election day or within,

or the days following right within, you know? By the time the votes are counted. Now, granted, there's always risk, right? There's a 5.538.com, 5%. I think they're underestimating 20% chance that it's contested. And when I say contested, not just that Trump or Biden contested, but that there's a realistic kind of argument

that a Supreme Court or whatever would hear out to, you know, to change the results, right? And so that's a conditional probability. You have to get past that first election, right? And let's say there's a 20% chance of then there being a contested election, you know, then based on 20%, you know, what are the moves that are going to happen? You have to kind of dig through those probabilities. And once you're down to a 20% probability

from a 100% probability, regardless of how big that scale, I mean, not regardless, at some point it'll be worth it, but if you're talking about 5% move under 20% likelihood, right? That's, yeah, it's a big move and it's scary, but the odds of it happening are still one in five.

And so I think, yeah. And so the pricing just got like people were, it was, it was based on fear. People were pricing like, Oh, there's an 80 to a hundred percent probability that we're going to get a contested election and that it's going to be, you know, a three to 5% move when it happens. So so they just they've all got priced too high um relative with a uh a new greek for that like pala or something is the the amount of all increases every day the election doesn't get settled we'll call it the the jam the jam my son yeah uh. Well, so anyway, but so that's kind of what happened.

It has come back in the line in quite a bit. There's still an opportunity out there in this where you can, you know, get short kind of some Dees or Jan, you know, Vol, and I won't get too discreet about where I'm doing it or how, and you can be long some no, which is two and a half weeks after the election for relatively cheap. And you can do it in a way where you also get some convexity and VIX calls, right? And hedge and you have convexity and you're flat gamma and flat vega, and really kind of taking out a big, like extra little bit of edge with, you know, a good a really good risk reward position. And in the 80% plus chance

that it's resolved by November, you make a lot of money. And the chance the market goes down is stressful between now and then. You're fairly hedged and you can move things around as necessary. And there's a good chance implied volatility will decrease regardless during that time, in my opinion. I can get into why I think uh you know really set yourself for a really nice risk reward exactly among other things and then so you get yourself into a nice risk reward position and that's kind of what we set ourselves up to do yeah just to me it was i'd never considered right you know everyone knows about the electoral college but i never knew when they actually vote right summer 14th yeah right so now it became like an event an event risk yep that's exactly right but but again i think you have to realize that a lot of

information will you know come out between now and then and look i've been through enough of these events i've been through brexit i've been through you know you know y2k i've been i've been through the the trump election you know i can go on and on. But those, you know, the Trump. Y2K, that was a big nothing burger. Exactly. But they almost all are, right? Even the ones that are. So you have two kinds of that. You have the kind that where nothing really happens. Right. And it's a massive sale. That's the easy one, right? But then you also have the one where the most unexpected thing happens, like the Trump election, like Brexit, right? Those were incredibly unexpected events. And they've all resolved in a similar way. Now, there's no guarantee that this will happen. But again, back to flows and positioning, which is what really matters in terms of the probability of outcomes. If we get a contested election at this point,

is anybody really going to be surprised? Yeah, no, it's become the expected outcome. Yeah. Correct. I mean, it's not going to be a huge shock to the system. It's not like a black swan that comes out of nowhere, right? Two, people are hedged because they're scared. That implied ball is high because people are like, afraid. So what happens when the event happens? If people are along this hedge and then you go down. What do they have to do? They got to monetize that hedge.

They got to do it quick. Right. So what happens in these- The flip side of that is like, hey, we're calling in the tanks to suppress Illinois or something, right? Anything can happen. Nothing is risk-free. I'm not sitting here saying like, hey, just go sell ball at all events, always. Like, you'll be fine. Don't worry about it.

Don't worry about the tanks. Right. But my point is there are ways to put on good relative value trades right and generally the you know broadly those events tend to be overvalued and if you can do it in a way that you know you're relatively protected you're going to win eight nine out of ten of those and and uh you know those. And when these things come around, they're big opportunities for people who kind of get what's going on. But there's a feedback loop. And we talked about VANA and charm

when you have a really high implied volatility for an event and the event happens, regardless of the outcome, that vol has to decline. Like the information is out. The thing happened, vol declines. What happens when vol declines? People are short put. Dealers are short put, long call. Same thing, right?

Well, I think every first time option traders experience that, right? Of buying a call into earnings and it beats earnings and the call price comes down. You're like, what? Correct. The Trump election was a great example. Market went down 5% overnight, right? That's kind of the gamma effect, right? But then all these people who are long vol, right? Market opens, they got to monetize that vol and vol got compressed. And the second vol comes from like a really high level

to a low level all at once. The flood of stock buyback that has to happen in order to kind of monetize this is huge. And so there's a natural underpinning reflexivity that actually tends to make these events you know non-events if it's an expected event it tends not to be an event um and so again you never know i'm not saying like again full disclosure don't don't come sue me if you sell vol i'm not telling you to sell vol right like uh jim said there'd be no tanks so anyway but that's the that's the broad concept and you know so this is working this

works for you on lots of different levels it's a really uh kind of um you know cute little trade and opportunity and then they don't come around that often so when they know and i think it's a good insight into how your brain works and how you structure the trades as well let's finish up with uh some quick fire questions here um you ready yep favorite jam favorite jam strawberry strawberry all right uh mine as well my sister just got i had to email her the other day i'm like stop she did a homemade jelly of the month thing for last christmas so i've been getting them like every month i'm kind of low carb i'm like stop sending me sugar jellies please so we used to go to turkey every summer my grandmother used to make her own jam she'd sit out in the sun like on the windowsill, like five different containers.

So jam is very dear to my heart. All right. Favorite croissant? Croissant? I didn't know there were different kinds. Yeah, we can get the almond one, the chocolate. Oh, yeah. Almond cheese.

Yeah. Pond chocolat. I don't know if you can call that a croissant. All right. Done. Yeah, pond chocolat. Favorite city you've lived in been a while you guys oh yeah i mean istanbul istanbul the coolest coolest city on the planet if you haven't been you gotta go i haven't been just the history the the mix of people

uh it's it's a crossroads so you know of history and of culture. It's amazing. Yeah. All right. Put it on the list. Now you say you're a biking as a hobby. What, what kind of biking? Road cycle? I mean, I don't want to overstate it. Like, you know, it's not like I'm out mountain biking every weekend, but you know, I love biking with my kids. I bike to work every day. It's a good way to kind of get exercise.

Your own bike? No, my own bike. My own bike, yeah. And I like to kind of haul a little bit, you know, when I'm out there, just try and beat all the traffic on the way in. Are you a Tour de France watcher? Sure, yeah. I mean, it's not necessarily my first sport,

but I love biking in general, and definitely competitive biking is pretty cool. Favorite Tour de France rider? Got one? Le Mans. Greg Le Mans? All right. Greg Le Mans, baby.

I would go Julian Alaphilippe. You can't say Lance Armstrong anymore. I know. He was great. So, Constantinople, Istanbul, can I call it Constantinople? Sure. Favorite, if I go, favorite tourist thing to do there?

Favorite tourist thing to do, I mean, the Hagia Sophia, you can't overstate it. It was a temple, then a church, then a mosque, then a church, then a mosque again. And the layers of history, they just peel away. This was created in 400 BC. Yeah, I mean, we're talking 2,600 years of history.

And it's still standing it's an amazing structure that's just mind-bending to think of that they built it when they did and that it's still kind of um standing and just just seeing history kind of that whole area uh you know around the the golden horn which is kind of the original um you know, Constantinople is just, you know, it's an outdoor museum. It's amazing. Yeah. We, we put that song on the pod once for Jason Buck. I think he worked in a Istanbul rug market or something. And when he, there might be giants, right? Yeah. There might be giants. Maybe we'll throw it in here as well.

I love that song. And last one we ask all our guests favorite star wars character oh uh bubba fett bubba fett i love it uh not jango boba the original the original yeah he was the coolest at the time i used to have like the millennium falcon i probably had like 200 star wars i was a huge star wars kid oh yeah our uh our guy who does the audio on this pod has a his work from home when we're on the zoom he's got all his old star wars characters in a frame behind his zoom thing i just it's the best i went to uh prep school and i came home uh one one day like a year in and my mom had donated all my star wars stuff to a friend of a friend of the family but like i could never i it was a huge i still don't i still don't really

forgive her i had a similar thing happen it's the worst all right jim well thanks so much it's been fun um absolutely look forward to seeing you in person around chicago and we're back back in action would love to thanks for having me. Corona. All right. Take care. You've been listening to The Derivative. Links from this episode will be in the episode description of this channel. Follow us on Twitter at RCM Alts 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.

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