Podcast Summary
Unexpected impact of ETNs on the market during Volmageddon: Derivatives like ETNs can have unexpected impacts on the market and raise concerns about potential cascading effects on the S&P 500
The financial markets can be influenced by unexpected events and seemingly insignificant instruments. The case of Volmageddon in 2018 serves as a reminder of this, where two volatility exchange-traded notes (ETNs) had a significant impact on the market and ultimately collapsed. The post-2010 environment saw a profitable trend in keeping a short volatility trade, but this changed in an instant when these ETNs imploded. Now, in the current market, there is a growing trend of retail traders engaging more directly with derivatives, particularly one-day or zero-day options. These options have seen a surge in volumes and have raised concerns about potential cascading effects on the market and the S&P 500. History shows that derivatives can have feedback loops and lead to significant market movements, as seen in the 1987 stock market crash. As always, it's essential to be aware of the potential risks and monitor the markets closely.
Institutional investors drive demand for zero data expiry options: Institutional investors, not just retail or degenerate gamblers, are seeking zero data expiry options for risk management and high convexity payouts in the current market environment.
The surge in zero data expiry option trading in 2021 cannot be attributed solely to retail or degenerate gamblers on platforms like Robinhood. While the retail investor presence is significant, the demand for these options is also driven by institutional investors seeking to manage risk and exploit high convexity payouts in the current market environment. The explosive growth of options usage can be traced back to the larger speculative excess boom of the past few years, which includes the Wall Street bets phenomenon, stimulus checks, SPACs, and cryptocurrencies. The Cboe, which serves as a proxy for the growth and usage of options, has seen significant demand for daily expiration options and 0 DTE products. However, it's crucial to understand that the usage of these instruments is not solely for hedging purposes, but also for speculative betting. Analyzing open interest and volumes alone does not provide a clear picture of how the instrument is being used. It's essential to consider the macro and volatility regimes to understand the true drivers behind the surge in option trading.
Profiting from downside demand for protection: In high downside demand periods, selling options or hedges can be profitable. However, in the current QT era, the Fed's actions reduce the need for protection, leading to lower volatility and less profitable opportunities.
During periods of high downside demand for protection, such as when financial conditions are easy and assets are highly leveraged, selling options or hedges can be profitable due to the large number of buyers seeking protection. However, in the current Quantitative Tightening (QT) era, where the Fed is shrinking its balance sheet and jacking up rates to tighten financial conditions and address inflation, the situation becomes perverse as the Fed effectively tells investors to hold more cash and be short assets, reducing the need for hedge protection and resulting in lower volatility, as seen in the low VIX levels. As a leading real estate manager, Principal Asset Management delivers local insights and global expertise across various investment strategies, including public and private equity and debt, with the understanding that investing involves risk, including possible loss of principal.
Understanding the complexities of retail vs institutional usage of electronic options in the American Express Business Gold Card context: Recent trends indicate that institutions are the primary users of electronic options in the American Express Business Gold Card program, despite the difficulty in distinguishing between retail and institutional flows due to sophisticated market making and advanced algorithms.
The American Express Business Gold Card offers numerous benefits for businesses looking to maximize value from their purchases. However, when it comes to understanding the retail versus institutional usage of electronic options in this context, the situation is not as clear-cut as it seems. The traditional methods of distinguishing between retail and institutional based on options contract sizes can be misleading. Electronic options trading involves sophisticated market makers using advanced algorithms and risk tools, making it difficult to identify retail versus institutional flows. While it's true that large orders may not be easily identifiable, recent trends suggest that this product is predominantly used by institutions. Institutional investors have been observed spending significant upfront money on put buying, which is unusual for shorter-dated options. This is because of the inherent mean reversion flow in these products, meaning that positions need to be unwound and monetized if they move in the desired direction. The Cboe assigns end-user tags to options flows, distinguishing between broker-dealer and institutional investors. In summary, while the retail versus institutional usage of electronic options in the American Express Business Gold Card context may not be easily discernible, recent trends suggest that institutions are the primary users.
Market makers and customers in the options market: Market makers provide liquidity to the options market and set bid-ask spreads, while customers buy and sell options based on individual market outlook. Market volatility can cause concerns about potential cascading effects from market maker short volatility positions.
Market makers act as net sellers of options, while customers are net buyers. Market makers, who are tech-savvy entities, provide liquidity to the options market and are responsible for setting the bid-ask spread. Customers, on the other hand, buy and sell options based on their individual market outlook. During market volatility, the dynamics of these flows can lead to concerns about potential cascading effects, as was the case during the "Volmageddon" event in 2018. In this scenario, a large buildup of short volatility positions among institutional investors led to a rapid increase in volatility when market conditions shifted. The concern was that the resulting mark-to-market losses on these positions could lead to forced selling, exacerbating the market downturn. However, it's important to note that not all market participants agree with this extreme interpretation of the potential impact of short volatility positions on market volatility. Regardless, understanding the dynamics of market maker and customer flows is crucial for gaining insight into the options market and its potential risks and opportunities.
Unexpected Macro Catalyst and Market Volatility: Institutional investors seek short-term protection due to market uncertainty and potential volatility caused by macro catalysts and changing market conditions. Principal Asset Management provides local insights and global expertise to help clients capitalize on opportunities.
During the December January period in a certain market, an unexpected macro catalyst occurred in the form of the Trump tax plan being approved. This led to a fiscal boom and an unstable market with spot up equities and volatility. The market was caught off guard by this inflation scare, leading to a significant sell-off. Institutional investors, specifically those managing large-scale portfolios, have been seeking short-term protection due to the changing volatility regime brought about by Quantitative Tightening (QT) and the low volatility environment. The demand for short-term options is a response to the increased uncertainty and potential for market volatility. This shift in market conditions underscores the importance of adaptability and the need for a nuanced understanding of the market environment. Principal Asset Management, as a leading real estate manager, leverages a 360-degree perspective to deliver local insights and global expertise, enabling clients to capitalize on market opportunities. Investing involves risk, including possible loss of principal. Principal Asset Management SM is a trade name of Principal Global Investors LLC. American Express Business Gold Card offers benefits to help businesses unlock more value from their purchases.
Increased usage of short-term options due to daily event risks: The market's favor towards short-term options led to heightened intraday volatility, but did not result in a market-wide 'portfolio insurance doom loop' scenario.
The market environment last year favored short-term options due to the lack of major market crashes and the prevalence of daily event risks. Hedgers and market makers alike sought to hedge these risks with short-dated options, leading to a significant increase in their usage. This symbiotic relationship between demand and market makers resulted in heightened intraday volatility, with multiple 1% moves in a short period. However, this did not lead to a market-wide "portfolio insurance doom loop" scenario, where the market is heavily short gamma, but rather, an environment of enhanced intraday volatility.
Wall Street Bets and the rise of high-risk option trading: The democratization of financial info and trading led to a surge in risky option trading strategies, with market makers profiting from daily price swings and customers trying to create gamma squeezes.
The Wall Street Bets phenomenon, fueled by the democratization of financial information and trading, led to a surge in option-centric, high-risk trading behavior. This "YOLO gamma squeeze" strategy became particularly popular during uncertain macroeconomic conditions when market movements were heavily influenced by individual data points or central bank decisions. Market makers and dealers, who profit from these intraday price swings, have seen a tailwind for option products due to the regulatory advantages they offer and the ability to keep positions open until the market closes. Market makers are effectively short both puts and calls on a daily basis, with customers buying calls in the up 1-3% range and puts in the 97.99-down 1-3% range, trying to create gamma squeezes. Despite some market volatility and potential losses, this cultural trend of short-term, binary outcome-focused trading remains influential in early 2023.
Exploiting Intraday Volatility Expansion in Options Markets: Sophisticated traders are profiting from intraday volatility in options markets, causing price swings through mean reversion property, while market makers bet on limited moves.
Sophisticated market participants are actively exploiting the intraday volatility expansion in options markets, specifically same-day call options. This is due to the mean reversion property of these products, which requires traders to monetize them by the close of the trading day. This intraday gaming is contributing to the acceleration of volatility flows. For instance, an upside call buyer may lift a large position, causing the market to rally. As the market rises, the buyer must buy more to maintain their hedge, amplifying the move. Conversely, downside moves can also trigger similar reactions. This behavior is considered within the bounds of fair play, similar to buying or selling large quantities of futures contracts. To better understand this concept, consider a theoretical trade where an entity consistently makes a 5% profit by buying and closing same-day call options, while maintaining a positive sharp ratio. This strategy is not common in the current volatility regime, where volatility is barely ticking higher. Market makers, who are short puts and calls, are making bets on limited moves. However, in a regime shift scenario where significant market moves occur, market makers could potentially face large losses.
Market Stability vs. Speculative Macro Regimes: In a stable market, professionals manage short volatility and short gamma with oversight. However, in a speculative macroeconomic regime, there's less cash yield and pressure on pros to take on risk, potentially leading to market instability.
The current market setup, where professionals manage short volatility and short gamma with regulatory oversight, is considered a stable environment. However, a potential risk for market makers with short straddles could arise in a highly speculative macroeconomic regime, such as a resumption of quantitative easing, where there would be less cash yield and more pressure on professionals to take on risk. The opposition to the "Volmageddon" scenario is that if a put went up significantly, market makers would sell it, bringing in buyers and supporting the market. The current environment, where market makers hedge their risks and close trades when they're going their way, is different from the past when large volumes of short volatility had to rebalance, leading to an "extinction event." The low daily volatility in the S&P 500, despite intraday volatility expansion, is due to the compressive effect of mean reversion flows on daily volatility measures. Despite the low volatility, the CBOE and market makers are not necessarily minting money, and equities traders still need to be present for the full day, not just the open and close.
Intraday options trading creates a volatile environment: Intraday options trading allows for opportunities to profit from short-term market movements, but requires careful monitoring and a solid understanding of underlying risks.
The recent proliferation of intraday options trading has led to a mean reversal dynamic in the market, where buyers and sellers constantly buy and sell options throughout the day. This can create a volatile environment, but it also allows for opportunities to profit from short-term market movements. However, it's important to note that dealers and market makers are responsible for managing the underlying risks associated with these options, and their ability to do so can impact market stability. Additionally, these options have a short shelf life and are highly sensitive to changes in the underlying asset, making them attractive but also risky. Overall, while intraday options trading can provide opportunities for significant returns, it requires careful monitoring and a solid understanding of the underlying risks.
Managing Market Risk with Short-Term Options: Institutional investors turn to short-term options to manage daily market risks, driven by market volatility and cultural shifts towards speculation.
Every day brings new market dynamics, and while the macro environment may present less risk due to lower leverage and higher interest rates, there is still the risk of one-day market moves. Institutional portfolios are increasingly turning to short-term options as a way to manage this risk, rather than relying solely on long-term structural protection. This trend is driven not only by institutional rationality but also by the cultural shift towards gambling and speculation in markets, fueled by the rise of crypto and retail trading. Despite the potential for increased intraday volatility, short-term options may actually help dampen large market moves due to the natural mean reversion of market participants. Overall, the conversation highlighted the importance of being adaptive to changing market conditions and the evolving role of options in managing risk.
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