Podcast Summary
Combining local insights and global expertise to identify investing opportunities: Investors can consider shorting volatility as an attractive option for yield in the current market environment, but it comes with risks and requires careful consideration.
Principal Asset Management, as a real estate manager, leverages a 360-degree perspective, combining local insights and global expertise across various asset classes to identify compelling investing opportunities. During the Odd Lots podcast discussion, the hosts reflected on the anniversary of the "Vomageddon" event in 2018 when the short volatility trade suffered significant losses. The hosts emphasized that shorting volatility became popular due to low interest rates and central banks suppressing volatility. However, the current market environment shows a potential return of this strategy with the increasing popularity of shorter-dated options. Despite the potential risks, shorting volatility can be an attractive option for yield-seeking investors. It's essential to remember that investing involves risks, including possible loss of principal.
Shorting volatility remains popular despite risks: Historically profitable strategy, but false sense of security can lead to significant losses, especially as short volatility trade resurges
Despite the heightened geopolitical risks and potential for supply chain disruptions, shorting volatility, or betting that normal market conditions will continue, remains a popular strategy among investors. Chris Sidule, co-CIO of Ambrose Group, explains that this strategy, often expressed through short options positions, has historically paid off more often than not. However, this can lull investors into a false sense of security, leading them to add more size to their positions when the trade starts to turn against them. Sidule warns that eventually, this can result in significant losses. He also shares that data shows the short volatility trade is making a comeback in a big way. Sidule and his team monitor this trend due to their background in trading exotic derivatives and managing tail risk strategies for clients. They emphasize the importance of understanding the market microstructure and the roles different participants play in the ecosystem.
Increased interest in income generating derivative strategies due to low-interest-rates and market volatility: Institutions are increasingly investing in income generating derivative strategies due to low-interest-rates and market volatility, with net short vega notional and AUM in these funds seeing significant growth.
The interest in income generating derivative strategies has significantly increased due to the historical low-interest-rate environment and the increased volatility in the markets in recent years. The net short vega notional, a measure of volatility risk, is currently trading at twice the level it was during the January 2018, just before a major market volatility event. Additionally, the assets under management (AUM) in the derivative income generating funds have grown over 10x since then. This trend was driven by large institutions seeking to gain exposure to derivatives after missing out during the volatile markets of 2020 and the meme stock debacle in Q1 2021. The exchanges also started listing more short-term options, allowing for more frequent premium collection and reducing the impact of end-of-month or end-of-quarter events. However, it's important to note that the market makers and dealers play a crucial role in the options world by providing liquidity and facilitating the trading of these complex financial instruments.
Unusually low volatility and tail risk exposure despite uncertain conditions: Market makers' lack of demand for tail insurance drives low volatility, but large institutions still seek longer-term protection, which could lead to a sudden increase in volatility
The current market environment is experiencing unusually low volatility and tail risk exposure, which is surprising given the uncertain economic, political, and geopolitical conditions. Market makers play a crucial role in this ecosystem by adjusting their positioning, and right now, there's a lack of demand for tail insurance or extreme downside protection. This trend is driven in part by the availability of shorter-term options and the success of selling volatility over the past few years. However, despite the popularity of shorter tenors, the demand for longer-term hedging, especially among large institutions, remains. The reach for longer-term protection will always be there, and a catalyst that tests the broad market could lead to a significant increase in volatility and tail risk exposure.
Profitable Short-Term Options Strategies in Low Volatility Markets: Short volatility strategies, like selling both calls and puts, can generate profits in low volatility markets. However, they can lead to significant losses when market volatility increases, creating a 'doom feedback loop' and potential unexpected exposure for larger institutions.
The use of short-term options strategies, such as selling both calls and puts at the same time (known as a short volatility strategy), can be profitable in a market with low volatility and minimal price movements. This was the case in 2022 despite the overall stock market decline. However, when market volatility increases, dealers who hedge their exposure to these options can create a feedback loop that drives asset prices down even further. This is known as the "doom feedback loop." Additionally, there is a lack of visibility for larger institutions regarding their clients' intraday margin requirements, which can lead to unexpected exposure if these positions go against them. It's essential to understand that these strategies can have risks, particularly in high volatility environments, and it's not just retail traders using them.
Institutional investors' shift to options trading pressures market makers: Institutional investors' response to retail investors' success in meme stocks led to a surge in options trading, putting pressure on market makers and potentially causing market instability
The behavior of institutional investors in the options market shifted significantly in 2021 due to the success of retail investors in the meme stock craze. These institutions felt pressure to adapt and began implementing volatility risk premium harvesting programs, leading to an increase in options trading. This change in market dynamics put pressure on market makers, who found themselves in a precarious position when end users' positions moved against them. This second-order effect, where market makers are forced to sell underlying stocks when end users close their put options, can have a destabilizing effect on the market. This dynamic, where end users and market makers have opposing positions, is not new but gained renewed attention during the meme stock frenzy. It's important to note that while the potential for a doom loop scenario exists, it may not result in a Black-Scholes esque crash, as some market participants may choose to close their positions or even bet on increased volatility when market conditions turn against them.
Market makers and options trading: A complex relationship: Market makers, as the most active participants in the options market, need to manage complex Greek exposures to effectively manage risk. Fewer market makers and more options trading increase potential for market disruptions or blow-ups.
The concentration of market makers in the US equity market, combined with the significant growth in options trading, increases the risk of market makers being caught off-guard by positioning, particularly when end users are aggressively pursuing a specific trade. With fewer market makers and more options being traded, the potential for market disruptions or blow-ups becomes greater. Additionally, the complexity of managing options positions requires sophisticated risk management systems and a deep understanding of Greek exposures. Most market participants, such as RIAs and macro hedge funds, do not require this level of sophistication and are more likely to take a static, one-sided view on options trades. This dynamic can lead to market volatility and potential blow-ups. It's important to note that the risk management architecture for managing these positions is intricate, with various exposures constantly changing in real-time. Market makers, as the most active participants in the options market, need to be aware of these second-order Greek exposures to effectively manage their risk. Despite the potential risks, options trading continues to grow, and understanding the underlying dynamics and risks is crucial for investors and market participants. The market is not static, and a dynamic approach to options trading is becoming increasingly important to navigate the complexities of the market.
Explosion in short-term options trading leads to debate on market impact: Institutions shift towards tactical defensive hedging as carry neutral strategies fail in low interest rate environment. Market makers and exchanges benefit, but unbiased research is needed on overall impact.
The use of carry neutral tail risk hedging and other traditional income generating strategies through derivatives, particularly in the low interest rate environment, has not been effective due to the changing market complexion. Instead, sophisticated institutions are moving towards tactical defensive hedging. The exchanges and market makers have been major beneficiaries of the explosion in short-term options trading. However, it's important to note that research on these options should be taken with a grain of salt, as those doing well in the business may not provide unbiased data. The recent market environment has led to the cycling out of poor performing products and managers, making the ecosystem healthier. Despite the mathematical nature of options trading, there is ongoing debate about the overall impact of the explosion in options on the market, with conflicting reports from different sources.
Insights from market experts: Understanding market trends and behaviors requires building relationships with key players and going beyond screen data. Market conditions can change unexpectedly, and having a deep understanding of the financial ecosystem is crucial.
Understanding the intricacies of the financial markets and building relationships with key players can provide valuable insights into market trends and behaviors. For instance, the speaker shared an example of how market makers and institutional investors behave during volatile markets, which is often not apparent to those who only rely on screen data. He also mentioned the evolution of the volatility trading environment, which went against the general assumption that it would stabilize after the pandemic and the retail trading boom of 2021. The speaker emphasized that this change is not trivial, but it's not a cause for concern as options eventually expire. Overall, the discussion highlighted the importance of having a deep understanding of the financial ecosystem and the interplay between different market participants.
The Complex and Controversial Nature of Options Trading: Options trading involves both intentional hedging and gambling, leading to ongoing controversy and debate in the financial world
Learning from this episode of the All Thoughts podcast is the complex and often controversial nature of options trading. While some participants engage in intentional hedging, there are instances where gambling is involved. Regardless, the conversation and controversy surrounding options do not seem to expire, as one day they do. The hosts, Tracy Alloway and Jill Weisenthal, discussed this topic with their guest, Chris Sidio. They also mentioned their own social media handles and those of their producers. The episode ended with a promotion for another Bloomberg podcast, Money Stuff, featuring Matt Levine and Katie Greifelt. Overall, the episode highlighted the dynamic and ongoing nature of options trading and the various perspectives surrounding it.
