There are plenty of one-off risks at the moment, but it seems like betting on pretty much nothing happening is more popular than ever. Investors are increasingly reaching for a wide variety of derivatives to bet against volatility. Those derivatives include one- and zero-day options which expire in 24 hours or less, and have become a hot button topic on Wall Street. So what's the impact of this explosion in options trading? Why is it happening at a time when the possibility of major disruptions seems more likely than ever (even if realized volatility remains low)? And what impact could it have on the wider market? In this episode, we speak with Kris Sidial, Co-CIO of Ambrus Group, about the return of the short vol trade. This transcript has been lightly edited for clarity.
Key insights from the pod:
How to people express going short volatility? — 5:33
How big is the short vol trade right now? — 7:55
Why investors want to short vol — 11:18
The role of market makers — 14:00
Fewer investors are buying tail risk insurance — 16:06
How being short vol makes money when stocks go down — 19:08
The doom loop scenario in 0DTE and 1DTE — 21:09
The second order effects of options trading — 28:38
How do people manage vol exposure — 31:16
The winners from the explosion in options trading — 34:43
Measuring the impact on the market — 38:22
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Tracy Alloway (00:10):
Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe Weisenthal (00:14):
And I'm Joe Weisenthal.
Tracy (00:16):
Joe, do you know what's coming up?
Joe (00:20):
The Odd Lots pub quiz?
Tracy (00:21):
That's true. Also Valentine's Day.
Joe (00:25):
That's a little bit later on. What else? What else do you have in mind?
Tracy (00:28):
Do you celebrate the anniversary of Volmageddon?
Joe (00:32):
Do I celebrate it? I mean, gee, who doesn't? No, I don't celebrate it. But that was such a formative moment. So that was February, when was the date?
Tracy (00:41):
2018. So it's the six-year anniversary.
Joe (00:43):
That was one of like our first really good episodes, we talked about what blew up the short vol ETF, XIV. I feel like if we go back through our history, that was an important episode in our show.
Tracy (00:56):
Wait, don't say that was one of the first good ones because we were doing this for years before 2018.
Joe (01:01):
You're right. You’re right, we've had many good ones. I think that was a good one.
Tracy (01:05):
It was a highlight.
Joe (01:07):
It was a highlight, yes, okay.
Tracy (01:07):
Well, I do in fact celebrate the anniversary of Volmageddon because I always enjoy going back to tweets around that time. Because there are a lot of volatility traders on social media who have very strong and often erroneous opinions. And one of the opinions they were holding around January 2018 was that everything was fine, short vol was this perpetual moneymaker, no issues with the two volatility exchange traded notes that eventually ended up blowing up, one of which was XIV, as you pointed out.
And I remember tweeting things in January of 2018. Stuff like if the VIX curve inverts – which was about to happen – this would be an absolute disaster for XIV. And I had a bunch of people pushing back, complaining about the axis on my chart. And lo and behold, about a week later, XIV not only blew up but was dead within a couple days, and actually roiled the market as well.
Joe (02:09):
I remember, it was very popular, XIV, this vehicle, and there was a sound intuition about it, I think, which is that, you know, it was basically betting against the VIX. And you start with the assumption that, okay, people systematically and perpetually overpay for downside protection. Understandable. People pay for insurance. And so you can harvest that premium basically by taking the other side.
And that by and large, shorting vol is a way that people supercharge their returns. And look, a core thing is that when we talk about vol, I think like we are mostly in life short vol. Anyone who owns stocks for a long period or any period is short vol, where sort of like vol is bad for portfolios, etc. So like when we talk about specifically shorting vol though, then that's where it gets interesting.
Tracy (03:02):
Yeah. So this is one of the things that I find very remarkable about our current moment, which is that, you know, shorting vol post the 2008 financial crisis became a very popular strategy because you had low interest rates so people wanted to pick up yield wherever they could. You also had central banks out there in the market literally crushing volatility. So you knew that there was the put that sort of existed over the overall market, so why not try to monetize it?
There wasn't a lot going on up until 2018, so it made sense to bet on nothing basically — on things not happening. But what I find really fascinating about the current moment is we seem to be seeing a return of that short volatility trade. So you and I have discussed on this podcast, these shorter-dated options, one- or zero-dated options, becoming incredibly popular, absolutely exploding in terms of volume. There's other types of derivatives that are also becoming more popular.
And yet when I look around at the market, it seems like there is so much potential for one-off events. You know, the Fed is hiking rates, we have geopolitical risk — as we always talk about, joke about on the show – supply chain disruptions, the chance of one-off events actually happening seems greater than ever. And yet shorting vol is popular and measures of vol itself remain pretty low. The VIX is pretty low, the volatility of the VIX index, the VVIX, is really low. So I think we need to ask why is short vol back? And why is it particularly popular at this moment in time? And what does it mean for the wider market?
Joe (04:46):
Let's do it.
Tracy (04:47):
I am very happy to say that we do in fact have the perfect guest. We're going to be speaking to Kris Sidial, we've had him on the podcast before. He is the Co-CIO of Ambrus Group and he is now officially one of my favorite guests ever because he brought us donuts. And if I sound more energetic than normal it's because I'm currently on a sugar rush, and also I'm talking about volatility.
Joe (05:08):
And you took a ZYN this morning.
Tracy (05:09):
I did not. Although you tried to get me one. Can you imagine if I had a donut and a ZYN at the same time?
Joe (05:15):
That would be bad.
Tracy (05:16):
Okay. Chris, thank you so much for coming back on Odd Lots.
Kris Sidial (05:19):
Thank you so much for having me.
Tracy (05:21):
So when we talk about short volatility, Joe and I discussed it a little bit in the intro, but what is the expression of going short volatility?
Kris (05:33):
The expression of going short volatility is taking a bet that the normality will continue. So effectively if you are betting on long volatility, you are pretty much betting on the abnormality taking place.
Joe (05:51):
So I mean, I said it in the beginning, but I sort of think that most life and investing is implicitly short vol. If you have SPY in your retirement account, then you think it's just generally going to go up [over] time. That is normal. But per your definition that is an implicit short volatility. How does it get expressed in the options market? Or maybe a question is why do people make that bet in the options market rather than just going the implicit route of being long risk assets?
Kris (06:24):
Yeah, because I think it's something that generally pays off the majority of the time within the spread as to how you can trade it. There's this embedded risk premium that, I mean sure people could argue that there's an equity risk premium as well, but the expression towards how you apply this, whether it's short S&P puts, short VIX calls, short variance swaps, it has a tendency to win the majority of the time.
And this expression lulls market participants into very poor habits of expressing the trade. Imagine you have taken a trade and you're going to win 90% of the time and when the trade is working against you, you're adding more size and you're adding more conviction over the course of years.
When the trade is beginning to work against you, you have a tendency to believe that this is just another one of those cases, right? It's like being rewarded for buying the dip. If you do it over and over again, you're going to feel this conviction towards it. But in short volatility terms, eventually it catches up and it all goes wrong at once.
Tracy (07:36):
Yeah, the journalistic euphemism that was usually deployed is, ‘picking up pennies in front of a steamroller.’ So why don't you talk to us about the numbers that you're seeing in the market. We say short vol seems to be back and bigger than ever. What are the actual figures around that?
Kris (07:55):
So I think it's important for listeners to have a little bit of an understanding of my background and why it is we track these numbers. So I was a prop trader on two different desks, Chimera Securities and Xanthus Capital. And then I went to a large Canadian investment bank. I spent three and a half years there and most of my time was spent trading exotic derivatives.
Then myself and a couple of my partners who are ex-CTC, ex-Citadel guys, we got together and we said ‘Hey, we could run this carry neutral tail risk strategy,’ which effectively, when volatility is exploding, it's going to have this massive return. But when markets are dormant, we use a lot of short-term proprietary trading to be flat. So you'll have foundations, high net worth individuals, family offices, that will use something like this as a hedge in their portfolio, right?
Because of that we need to understand the derivative market microstructure, and also the ecosystem. Understanding how certain agents in that ecosystem are participating with one another. So over the last year what started to come up in the data was that the short volatility trade was coming back in huge size. So when you think about the S&P complex, and the VIX complex, the net short vega notional today is two times higher than when it was during January of 2018, which was the month right before Volmageddon.
Tracy (09:23):
This is when we're going to have to define vega.
Joe (09:26):
Vega notional, tell us what all it.
Tracy (09:27):
We should just do all the Greek letters and just get them out the way right now. But, vega.
Kris (09:31):
So in vol terms, right? Think one point of a vol move and how much you'll make or lose, right? So if you're net long a million bucks of vega, and volatility moves up one vol point, you'll make a million bucks. Vice versa. So what that’s saying, today that number, the netting short exposure, is two times higher than where it was during January of 2018, which is right before Volmageddon. Additionally, and I sent you guys this chart from Morningstar, which is such a crucial chart in my opinion, these derivative income-generating funds, the AUM in these have increased by over 10X since January 2018. That's another fact that's pretty insane to think about.
Tracy (10:27):
What's the definition of a derivative income fund?
Kris (10:29):
So it's the same thing as to what we were talking about at the beginning of the pod where we said different expressions towards harvesting these volatility risk premium trades.
Joe (10:56):
It’s intuitive to me why there was so much interest in these income-generating derivative strategies during the ZIRP years when you couldn't just generate income by going out and buying a government bond, but now you can get 5% or whatever. So why do people go the exotic route for income generation when there are very plain vanilla things that actually pay yield these days?
Kris (11:18):
I think 2021 is a year that will go down in the derivative history books. Because what happened during that year was you had a slew of new mandate additions between large foundations, pensions, RIAs, endowments, mainly because of what transpired in 2020. You had a really big vol move in 2020 and then also in Q1 of 2021, you had the whole meme stock sort of debacle.
So if you were a large institution that did not have exposure to derivatives and that type of mandate, you were almost looked at as archaic in a way, right? So at that time a lot of these institutions said ‘We want to start trading options.’ Simultaneously, what was going on was the exchanges started listing more and more tenors, right? So you started having seven days until expiration options, five days until expiration, zero days until expiration.
And a lot of the consultants at these larger institutions started realizing ‘Well, back in the day if we wanted to sell a 20% out the money S&P put, we have to wait one quarter to collect five bucks in premium terms. Today we could sell a 0DTE option for 50 cents and do that 20 times over and over and over.’
And what this does on paper is that it changes the path dependency. So you really won't get hurt for one little thing happening at the end of the month or the end of the quarter. The problem with that is that on paper it looks like that, but when you run certain correlations you realize that you're still taking the same exact trade. Because if you wake up tomorrow and you say ‘Vols are up five vol points across the vol surface and the term structure,’ you're going to realize that the seven days ‘till expiration option and the one month ‘till expiration option are both going to be negatively impacted.
Tracy (13:22):
Maybe this is a good chance to talk about the ecosystem of the options world. So setting aside the derivative funds which are buying these things, someone is also selling them the options. Usually the market makers or the dealers. So what is the role of market makers in this process? And then also I'm curious, how cheap it is to go short volatility in general now. Because this was also a hallmark of the 2010s, which was, it was pretty cheap to do these trades, right? And so that was also another part of the appeal, like why not just pick up a little extra yield for not that much money?
Kris (14:00):
Right. So in the ecosystem, the market makers play a very unique role because if you look at some of the data that some sell-side research desks put out, it's not really entirely correct, because a lot of these desks like to take a certain narrative. But that positioning changes day by day with these market makers. So it's not to say that every single day they're long gamma or short gamma. It's at certain moments where that positioning becomes unbalanced and can really create that cascading effect.
In cheapness and richness in volatility terms, we're seeing one of the lowest levels of tail exposure that we've ever seen. And this is something that is really surprising because everybody understands you shouldn't sell tails. That was something that people learned in 2008, 2018, 2020. Yet that exposure keeps making its way back into the market. And right now, forward skew — that like 30 days out skew — and I'm not trying to get super esoteric with the vol terminology, but just that type of ‘wingy’ exposure has been oversupplied over the last, let's call it six to nine months.
Joe (15:24):
So wait, sorry. Just to be clear, there are not currently a lot of people buying de facto tail insurance right now.
Kris (15:33):
Correct. Not at all.
Joe (15:34):
It's weird. I guess on some level I'm surprised because things seem crazy and there's wars going on and people are concerned about what the Fed is going to do and the economic environment is uncertain and the political environment is uncertain. On one level it feels like it would be an environment that would be ‘Oh, I want to grab tails, I want to buy insurance.’ On the other hand, the stock market is at all time highs, volatility is low. Clearly just looking at financial markets, this is not a market environment in which many people seem particularly concerned about very much.
Kris (16:06):
Well, why would you buy tails? Think about this. It's been four years since the last real vol move. So in the face of rising inflation, in the face of a declining S&P in 2022, in the face of a mini banking crisis, in the face of all those things you've been able to sell vol and make money. This is why.
So some of the data that we track is, like, US equity short vol hedge funds. That AUM has grown six times since 2018. Why would that AUM grow? Because those funds are doing insanely well. Because you've been able to sell volatility left and right and really just get away with it. A generic straddle selling program, without having any sort of true quantitative input, you just wake up every day and sell straddles, has made money hand over fist over the last four years.
Tracy (17:03):
Could it be the case, you mentioned the shorter tenors that are now available and this has been a much discussed point among market commentators, the impact of zero and one day options, ODTE and 1DTE. Could it be the case that people are buying less tail risk exposure or extreme downside protection, in favor of maybe hedging themselves on a day-to-day basis with the shorter-dated options?
Kris (17:31):
So what we're seeing is that during certain events, that's the case. However, that doesn't take away for the reach that you have in that 30-day exposure, because when you look at the volume across the VIX complex and you look at the volume traded in that 30-day exposure, it's still heavy. It's still there. So people that are saying ‘Well, nobody's going to hedge with 30-day options anymore because they're hedging with 0DTE, so the VIX won't go up,’ that's really a bad view.
And there's one real point that I'll bring up, that will push back on that in a pretty large way. If you are an institution, a multi-billion dollar institution, and tomorrow, god forbid, there's a geopolitical event, are you going to hedge a multi-billion dollar book with 0DTE options? There's no way. Any sophisticated fund is going to realize ‘Well, I probably need to extend my duration on that hedge.’ So that reach, for one to, let's call it three month vol, will always be there. It's just that in the recent environment, again over the last four years, that has not been the case because we really have not been met with a catalyst that has tested the broad market.
Joe (18:47):
Just quickly going back, so a short straddle trade, which are very popular, or have been a big moneymaker as you said, that's just betting that markets won't move much. Selling a call and selling a put at the same time, implicitly you're just betting that things basically stay in a narrow range.
Kris (19:01):
Correct.
Joe (19:03):
How did short vol make money in 2022 when the stock market was going down?
Kris (19:08):
That was the main point of 2022, if you were a vol trader. And you don't need to take my word for it. You could look at how well short vol funds did in 2022, really because there was not a pickup in equity vol. And a lot of people misunderstand this because rates vol moved, FX vol moved. It was almost like every vol in every aspect moved except for US equity vol.
So when you look at, and you could look at just the VIX to begin with, right? VIX is a great representation of something like that because it's variance, right? So it's really vol squared. S&P vol squared is going to give you VIX. So S&P 30-day implied vol always stayed in that range, from like 20 to I believe the high end was like 30 something. It's really difficult to get vol to move up when you have a lack of realized move and panic that's coming in. So a slow grind down, every day going down 1%, half a percent, 2%, that's not really going to get people panicking, to bid for that insurance protection.
Tracy (20:18):
Let's go back to the sort of worst case scenario that you were touching on earlier. Just before Christmas, I think it was a Wednesday or a Tuesday, there was a sharp drop in the S&P 500 and this kicked off a wave of speculation about the degree to which shorter dated options had exacerbated that fall into the close.
And the thinking here is that, well, when stocks start to move down like that, all the market makers have to go out and hedge their exposure. And so you can get this sort of doom feedback loop in the market, where stocks keep going down because dealers have to hedge the fact that stocks are going down. Walk us through that dynamic, and then how much are you actually seeing an impact in the wider market, from these shorter dated options on a day-to-day basis?
Kris (21:09):
So we wrote a paper earlier on in 2023 that got a lot of attention. Surprisingly it got attention from regulators and central banks. And I think when some of the regulators reached out to us, it was because they understood as well just how severe a certain situation can end up being. And they want to collect data on that as well. So when you talk about 0DTE, it usually falls into two camps. You have Camp A that says ‘Oh no, nothing's going to happen. The positioning offsets one another, this is not a risk.’ And then you have Camp B that says ‘This is going to create a massive catastrophe...’
Tracy (21:54):
Black-Scholes kind of stuff, right?
Kris (21:56):
Right – this is a Black Swan event. And I don't think either/or are true, right? This becomes a problem when dealers are hedging their exposure in a high vol environment. So what ends up happening is, during normal conditions, when you have most of the flow that's lean-to-sell these shorter dated options, that is stabilizing to the broad market.
However, when volatility is going up and these end users are not only closing their position, but opening new ones, that puts dealers under pressure where they now need to hedge their exposure, and reflexively that could drive the asset price lower or in certain cases higher as well. So in this situation, it's not really a case of the S&P going from 0% on the day, to down 5%. It's what does this look like if the S&P is down 5% and then could escalate to down 10%?
The second point to that, that I'll bring up, and this is a very valid point if you are a hedge fund or an asset manager, you understand that the larger primes are concerned with their clients trading this stuff because of the lack of visibility around certain intraday margin requirements. So if you're a hedge fund, you have a certain EMS that may be outsourced somewhere else….
Joe (23:19):
What's EMS stand for?
Kris (23:20):
It's just like an execution management system. So you might be trading somewhere else and those positions are settling at the end of the day – the PB is not really able to see that. So if those positions go against you, you may be on the hook for certain exposure that is not accurately assessed for. That's really the second problem there.
Tracy (23:45):
I have so many questions already, but I do think this is actually an important point, which is that in a lot of the commentary on shorter-dated options and 0DTE, there's an implication that it's all these stupid retail traders who are using these things. And people talk a lot about WallStreetBets and it is true that you can find some stories about people on WallStreetBets losing and also making money on shorter dated options. But a big portion of this is huge, institutional, ostensibly sophisticated investors.
Joe (24:17):
I'm glad you brought that up. Because actually this brought me back to something that I wanted to return to – the sophisticated investor. Talk more about what happened in 2021 with the introduction of these mandates. Because I do think that feels like a very important element.
We can always talk about the market environment, or a high vol environment, or a high rates environment or low rates environment, but if the allocation is going to change and new products exist, we see how that affects the market. What specifically were these decisions that were made where these big institutions felt that they had to – tell us a little bit more about some of these decisions?
Kris (24:55):
Yeah, so think of 2020. 2020 was a year that option trading did very well on both sides. Hedging programs did very well. And then also when the market rebounded, certain stock replacement programs did extremely well. When 2021 came, Q1, and the meme stock craze hit, that was almost like the nail in the coffin where you had certain investors and boards that started pounding on the door and saying ‘Why are we not exposed to options? Because look, everybody's making money,’ — not in the sense that they want exposure to meme stocks, but they're saying ‘Hey, we should have long call tech exposure, or we should have volatility risk premium harvesting programs.’
And ultimately that put a lot of pressure on certain consultants. It put a lot of pressure on certain teams. But as I said, simultaneously, when the exchanges began listing more and more tenors, people started realizing that ‘Well, ideally we probably want to engage in these volatility risk premium harvesting programs because look, if this is what the S&P's doing, look how much more we can make by selling vol.’ And now the path dependency has completely changed. So ideally this becomes an easier trade for everybody.
Joe (26:19):
Tracy, now I am reminded, it's so funny all these things I forgot from that time, but there was like that big thing with SoftBank, you know, being a massive buyer of long call options on tech. As if it weren't already exposed enough to tech beta, they also bought a bunch of call options on tech stocks.
Tracy (26:37):
Got to double down. No, I do find it remarkable, you know, everyone thinks WallStreetBets and that retail craziness was sort of people trying to imitate Wall Street. But now we basically have Wall Street trying to imitate the retail crowd and the sort of YOLO mindset of ‘let's just try to make as much money as possible, in as short an amount of time as possible.’
I want to go back to the impact on markets and I take the point about the doom loop scenario, although as you say, you don't think it's as bad as getting a sort of Black-Scholes-esque kind of crash. But one thing I guess I don't quite understand in this argument is people are not going to keep doing the same stuff if the market is falling significantly. So if someone has a put that went up 500%, they're probably going to sell some of it, right? So if you have people selling puts, then wouldn't that bring in buying from the market makers, which could actually stabilize the market in that scenario?
Kris (27:43):
No, no. So when an end user is short the put, the market maker is effectively long the put, right? So at that time, if they're long the put, they're going to be long the underlying on the other side. So long stock. It changes when the end user is now long the put, that puts the dealer short the put, if they're short the put, that's bullish, which means that they now need to sell the underlying on the other side.
And this is where this comes into like a second order effect. Naturally, if the end user is selling this, the market maker is stabilizing this. When that position starts to move against them, what is the end user going to do? They're either going to close off that position, right? Or they're going to close it off and then take more of the other side. So they're going to say ‘Okay, we're closing this off and maybe we're going to bet on long volatility.’
Tracy (28:38):
I see. Okay.
Kris (28:38):
That is when the market maker begins to get put under pressure. And just to be clear, this has existed since derivatives started trading. I think people think that gamma hedging is something that came about six years ago. That's not the case. If you were a market maker in the early 2000s and the 90s, you realize that ‘Hey, this is how we hedge a derivatives book.’
So that second order effect only becomes more relevant because the sheer size of what you're trading is so much larger. So now you have, if back in the day you had 20 market makers, today you have four, right? Four main market makers, or let's call it five, that really control the flow in the US equity market.
Joe (29:23):
These are really big bank trading desks?
Tracy (29:26):
Not just banks.
Kris (29:27):
Not just banks. I'm not going to name them, but...
Joe (29:31):
Well, just like what are the nature of these, the four or five...
Tracy (29:34):
I'll whisper them to you after the show. Wait, we could… I mean we have no limitations on saying who the big marketmakers are.
Kris (29:40):
You guys could.
Joe (29:41):
Tracy, who are we talking about?
Tracy (21:42):
Okay, so people like JP Morgan, Citadel, that kind of thing.
Joe (29:47):
So just big trading shops. So some banks but not necessarily banks.
Kris (29:53):
Yep. So going back to the numbers, right? Index option trading has grown two times since 2018. And equity option trading has grown almost two and a half times in totality. So when you think about the concentration risk here, you have less market makers, and more options being traded. So of course it's natural to think that those market makers will get caught offside on positioning, especially when the end user is so dogmatic in their application of this short vol trade.
Tracy (30:43):
You mentioned EMS earlier. What is the underlying risk management architecture for managing these positions? Because there must be so many numbers involved with this and, like, the values are constantly changing. So things like gamma and delta are changing along with the market. And if you are one of the market makers, I can only imagine all the different exposures you have at any one point in time that you're trying to calculate in real time as well. How do people actually do it?
Kris (31:16):
So if you are a sophisticated vol arbitrageur, you will have certain in-house systems that monitor certain second order Greek exposure, like vol of vol, spot moves and gamma exposure, vanna exposure. [There are] very few people in the world need to care about that. For the most part, if you are an RIA or even like a macro hedge fund that's trading options, you're probably going to be on a certain bank platform and that's going to be okay, right? Because you really don't need to care about second order Greek exposure.
But if you are more of a dynamic vol shop, those things become more important. I think when you're thinking about the problems of an EMS and how that translates to something like this, and then also the applications of short vol, really you have to understand that the majority of the world and how they trade is not like a sophisticated vol shop. It's like an RIA that's going to wake up and say ‘Hey, we need to make 50 basis points every month. So sell these options.’ And if the position begins to move against them, they're going to say ‘Oh, well, great, sell some more.’ And then it moves against them, ‘Sell some more.’ And then it moves against them, and then maybe they'll capitulate the position.
So the bulk of the world is not really dynamically trading these things. They're more so dogmatically taking a one-sided view on this and that's why you get those vol blowups.
Joe (32:51):
Yeah. Who is long vol these days? Because, again, in my mind I just think, my very rudimentary–
Tracy (33:00):
Theoretically they should net, right? The amount of people shorting vol should be offset by the amount of people going long vol?
Joe (33:05):
Yeah, and also I just think like if I had a lot of money, I would want to take out some insurance against some sort of blow. But if the people with the money, even they are sort of changing their strategies, is there anyone who's structurally long vol in parts of their portfolio for the hedging aspect?
Kris (33:25):
Yeah. So for what we do, it's called carry neutral tail risk hedging. And this is more so a tactical approach. However, the majority of what you call strategic, or solutions based long vol, or tail risk hedging, has done insanely poor over the last three to four years. It's been obliteration.
And, you know, we're pretty outspoken that those type of applications don't work because what you'll see at an asset management firm, they'll say, ‘Okay, great, if you're a family office, you have $500 million in equities, let's take 1% a year and allocate it to some long vol.’ And then over the course of years you realize that, well, that's really destroying my portfolio. I can't just lose a percent a year. That's why you're seeing more sophisticated institutions lean towards tactical defensive hedging as opposed to the solutions-based defensive hedging. Because those just really do not work over the long run. So you just can't wake up and say ‘Yeah, I'm going to buy a put and just keep rolling it and rolling it.’
Joe (34:33):
That eventually costs a lot of money.
Tracy (34:36):
Who are the big winners from the explosion in short vol and derivatives in general? I have to imagine the CBOE would be in there given that they're the ones selling the shorter dated options. Maybe some of the market makers. Who's making tons of money from this?
Kris (34:53):
Definitely the exchanges are doing quite well. Market makers generally do quite well when you have big vol environments, for the most part. It's important to note, and I think that this goes over a lot of people's heads when they're going through the research – CBOE is incentivized to make sure that the data that they're showing you is pretty. So CBOE’s never really going to come out and say ‘Hey, all these options traded are a hazard.’ Because it just goes against what they're trying to do as a business.
And for what it's worth, I like the guys at CBOE, respect them, clearly doing extremely well from a business standpoint. But the exchanges are doing quite well. Market makers are doing quite well. But whenever you're reading research or data about these options or 0DTE, it's important to take it with a grain of salt when you're getting the research from people who have been doing well.
Joe (35:51):
I just have one more question and it kind of goes back to what I was saying, like how I understood the value of income generating strategies through derivatives, particularly in the Zirp era when there were not many sources of just sort of income. The market complexion has obviously changed quite a bit because now there's yield, but also traditional like natural hedges in the market, don't work anymore. So if you had the old 60/40 portfolio, at least for a while, it was terrible. And so this idea of ‘Hedge by having a little bit of long here and long here and they do differently,’ like that doesn't work. How has that changed the vol trading business, these sort of reversals of some long-standing just sort of correlations of bread and butter assets?
Kris (36:38):
I think it's for the good of the ecosystem. Because I think it has cycled out the bad managers. Managers who have not been able to navigate this environment have been really taken to the woodshed. And I think that's important. You need a healthy cycle out of those bad products and those bad managers, because look, everybody's a hedge fund these days. Everybody manages some sort of assets these days. And the reality is that that alpha doesn't exist everywhere.
So when you have poor products, after a while people start realizing just how poor they are, and then those participants get cycled out. So I think it's healthy that this sort of stuff has come to light because you shouldn't just be able to put somebody in some generic put buying program and charge 25 basis points and a 5% incentive fee on that. That doesn't just jive well.
Tracy (37:38):
I have one more question, which is how do you prove that the explosion in options is having an impact in the market? Because so far the observable pattern that I have seen is that something like a December 21st happens, where the market falls, JPMorgan publishes a note saying part of this was because of short dated options. And then the CBOE comes out and says ‘ No, no, no, we didn't see any evidence of that.’ And you have all this polarized commentary, it feels like in something as mathematical as options trading and finance, we should be able to point to concrete evidence. But we are still having this debate about the overall impact. So what do you look at to prove that this is happening?
Kris (38:22):
So the way we trade is literally by a second-by-second basis. And I think unless you're trading like that, you won't be able to have a good picture as to what's going on. So we have certain agency desks and market makers that cover our flow, and you talk to these guys, you go out to eat with them, you build relationships with them. And there's an ongoing joke that we have with one of them and they say ‘Listen, every time volatility spikes, we have five clients that will come in and fight with each other to sell it. They are jumping over one another to sell volatility.’
Now, it's hard when you don't have that color or you're only seeing the price on screens, but when you understand the ecosystem and what's transpiring under the hood, it paints a cleaner mosaic to understand that we've only seen one side of the equation, which is volatility being stabilizing and just not really performing in dormant markets. But there will come a day when there's a catalyst that pushes this thing through.
And it's very similar to Volmageddon, where everybody who was trading vol during that time understood the exposures were baked into the ETPs. And then after it occurs they'll say ‘Oh yeah, it was so obvious, didn't you know that everybody was short volatility in the ETPs?’
Tracy (39:55):
I swear to God, it was not obvious to everyone. Kris Sidial, thank you so much again for coming back on Odd Lots. That was a fantastic explanation of a pretty technical change in the markets. But an important one. So thank you.
Kris (40:07):
Thank you guys for having me.
Joe (40:08):
That was great. Thank you so much.
Tracy (40:22):
Joe, that was so good. That was really interesting. I have a joke.
Joe (40:26):
Uh-oh.
Tracy (40:27):
It's not as good as Kris’s joke though. Maybe I shouldn't tell it.
Joe (40:31):
Tell it, tell it. Tell it.
Tracy (40:33):
What does a risk manager with a science degree at a large market maker say when he wants a salary increase?
Joe (40:45):
Tell me.
Tracy (40:46):
He asks for a gamma raise. Haha.
Joe (40:48):
Oh, that's good.
Tracy (40:52):
Gamma raise! He asks for a gamma raise. I'll work on it. I'll workshop. No, I thought that was really interesting. He sort of, Kris crystallized — Oh, Kris crystallized something in my head, which was about the exact mechanism of the feedback loop. Because I had assumed that as the market moves around, people are lessening their exposure, but as he put it, the thing they're doing to lessen the exposure can also lead to market maker behavior that is not ideal in a stocks going down, and everyone's scrambling altogether scenario.
Joe (41:26):
Yeah, I thought that was really interesting. I also just thought, this sort of big picture, if you have a lot of money, you just cannot buy insurance trivially. It's not like oh, I'm just going to, as he pointed out, take 1% of your assets a year and roll it into some fund that supposedly is going to deliver major returns every time there's a pandemic or some major thing. Like, you're just going to lose too much money that way. And so then the idea of, okay, well, these institutions take the other side and see opportunities in shorting vol. And so you sort of see how this trade can just get so large on one side.
Tracy (42:04):
I also like the point that, okay, this is not nothing, it's not a trivial evolution of the market, but at the same time it's not a Black Monday, Black-Scholes redux, where this is going to lead to a massive crash. Because at the end of the day, one day options expire. At the end of the day, the options are ended. The end-day options end. Okay. I need to workshop that one.
Joe (42:27):
Keep workshopping. Yeah, but there’s something there.
Tracy (42:29):
But no, I like that point. I thought it was a very clear description of the ecosystem. And it is amazing to me, given everything that's sort of gone on, how much the vol trading environment has changed. Because you would've thought after 2018, after the wildness of the post-pandemic period, that things would've gone in the other direction? But nope.
Joe (42:51):
No. And also we knew, in 2021, we talked a lot about retail obviously, and then that fell off and then you could see CBOE as a stock kind of peaked at the end of 2021 for a while, and then fell and everything. But obviously there's just so much more than retail. And so when we're talking, I think if people hear zero day options or any of these options, they just sort of think about people like on their apps gambling. But the idea that it's not necessarily gambling, but this sort of like very dynamic, intentional hedging participation in these markets from big money, is pretty astounding.
Tracy (43:30):
Sometimes it is gambling though.
Joe (43:31):
And there's gambling.
Tracy (43:32):
All right. Well at the end of the day, one-day options expire. That's what it is. But the conversation and the controversy over them certainly does not. It goes on> Forever.
Joe (43:43):
Sounds good.
Tracy (43:44):
Shall we leave it there?
Joe (43:44):
Let's leave it there.
You can follow Kris Sidial at
@Ksidiii
.