Why the Short Volatility Trade Is Back and Bigger Than Ever

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1:27Hello, and welcome to another episode of the odd lots podcast i'm tracy alloway and i'm joe weisenthal joe do you know what's coming up the odd lots pub quiz that's true also valentine's day oh yeah that's a little bit later on what else what else do you have in mind do you do you celebrate the anniversary of volmageddon do i celebrate it yeah 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 day 2018 so it's the six year anniversary that was one of like our first like really good episodes where we sort of had a good we talked about what blew up the short vol etf xiv i feel like if we like go back through our history that was like an important episode wait don't say that was one of the first good ones because we were doing this for years before 2018 you're right we've had many good i think that was like a That was a good one.

2:23It was a highlight. It was a highlight. Okay. Yes, okay. 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 access on my chart and lo and behold about a week later, XIV not only blew up, but it was dead within a couple of days and actually roiled the market as well.

3:26I remember it was very popular, XIV, this vehicle. And there was a sound intuition about it, I think, which is that, you know, is this 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 sort of like a good way to a way that people supercharge their returns. And look, like a core thing is that when we talk about vol, I think like we are mostly in life short vol.

4:06Anyone who owns stocks for a long period or any period is short vol or 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. 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.

4:47So 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.

5:29You know, the Fed is hiking rates. We have geopolitical risk, as we always talk about and joke about on this 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? Let's do it. I am very happy to say that we do, in fact, have the perfect guest.

6:08We're going to be speaking to Chris Sidule. We've had him on the podcast before. He is the co-CIO of Ambrose 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. And you took a Zin this morning. I did not, although you tried to get me one. Can you imagine if I had a donut and a Zin at the same time? That would be bad. Okay. Chris, thank you so much for coming back on Odd Lots. Thank you so much for having me. 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?

6:50Yeah, 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. So, I mean, I said it in the beginning, but I sort of think that most life in investing is implicitly short vol. If you have SPY in your retirement account, then you think it's just generally going to go up very 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 your question is, why do people make that bet in the options market rather than just going the implicit route of being long risk assets?

7:41Yeah, 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 variant 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.

8:31When 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. Yeah. The journalistic euphemism that was usually deployed is picking up pennies in front of a steamroller, right? 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?

9:12Yeah. 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.

9:48But 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.

10:40This is when we're going to have to define vega. Vega notional. Tell us what you said. We should just do all the Greek letters just cut them out of the way right now, but Vega. Yeah. So in vol terms, right? Think one point of a vol move and how much you'll make or lose. Okay. 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. Okay. Vice versa. Right. 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 Baum again. 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, right?

11:39That's another sort of fact that's pretty insane to think about. What's the definition of a derivative income fund? Yeah, 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 traits.

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13:53It's intuitive to me why there was so much interest in these income generating derivative strategies during the ZERP 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 to the exotic route for income generation when there are very plain vanilla things that actually pay yield these days? 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.

14:37You 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 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. So you started having seven days till expiration options, five days till expiration, zero days till 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, right?

15:33Today, we could sell a zero DT 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, right? 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 seven days till expiration option and the one month till expiration option are both going to be negatively impacted.

16:20Maybe 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. Why not just pick up a little extra yield for not that much money? 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 does put out, it's not really entirely correct because a lot of these desks like to take a certain narrative.

17:16But 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 more cascading effect. In cheapness and richness and 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.

18:03And 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. Sorry, just to be clear, there is not currently a lot of people buying de facto tail insurance right now. Correct. Not at all. It's weird. I mean, I guess on some level, I'm surprised because, right, like 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.

18:46On one level, it feels like it'd 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. 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 u.s 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, like 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.

20:00Could 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? 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.

20:50It's still there. So people that are saying, well, nobody's going to hedge with 30-day options anymore because they're hedging with zero DTEs 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 zero DTE options? There's no way. Any sophisticated fund is going to realize, well, I probably need to extend my duration on that hedge.

21:27So that reach for one to, let's call it three month fall, 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. Just real quickly going back. So a short straddle trade, which are very popular, or it has 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, it's just like, you're just betting that things basically stay in a narrow range. Correct. You're selling, yeah.

22:01How did short vol make money in 2022 when the stock market was going down? 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 shortfall funds did in 2022. Really because there was not a pickup in equity fall. And a lot of people misunderstand this because rates fall moved, FX fall moved. It was almost like every fall in every aspect move, except for US equity fall. So when you look at, and you can look at just the VIX to begin with, VIX is a great representation of something like that because it's variance, right? So it's really vol squared.

22:43S &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. Let's go back to the sort of worst case scenario that you were touching on earlier. But just before Christmas, I think it was like a Wednesday or a Tuesday, there was a sharp drop in the S &P 500.

23:29And 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? Yeah. So we wrote a paper earlier on in 2023 that got a lot of attention.

24:13Surprisingly, 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 zero DT, 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. Black Shoals kind of stuff. Right. This is a black swan event. And I don't think either or are true.

24:59This 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 some 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%.

25:43It'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 trading 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. What's EMS stand for? 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.

26:27The 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. Yeah, that's the second problem there. 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 zero TTE, there's an implication that it's all these stupid retail traders who are using these things. And, you know, people talk a lot about Wall Street bets. And it is true that you can find some out there stories about people on Wall Street bets losing and also making money on shorter dated options.

27:08But a big portion of this is huge, institutional, ostensibly sophisticated investors. 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 that we can always talk about market environment and we are in a high vol environment or a high rates environment or a low rates environment. But if the allocation is going to change and new products exist. We see how that affects the market.

27:44What specifically were these decisions that were made where these big institutions felt that they had to like, tell us a little bit more about some of these decisions. 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?

28:26Because 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 is 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.

29:17Tracy now I am reminded it's so funny all these things I forgot from that time but there was like that big thing with like SoftBank because, you know, a massive buyer of just like 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 stuff. Gotta double down. No, I do find it remarkable that they're like everyone thinks Wall Street bets 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 on a sort of in a short an amount of time as possible.

29:57I 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, you know, getting a sort of Black Shoals-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?