Election 2024: Follow the Flows ft. Cem Karsan

26:28So we start there, and then you have all this positioning in the options market, which I've talked so much about, which is, again, that skew, massive amount of open interest tied to structured products, et cetera, that's hedged by dealers. The whole market is warehousing this wall of worry or these short deltas against this skew in the marketplace. And that amount also needs to be bought back. On top of that, it's a very slow period in general because of the holidays, Christmas and Thanksgiving, the time, what we call time-weighted volume decreases. So there's just much less volume because of the types of holidays they are.

27:05There's much more time off and that accelerates charm, the time passing and that delta decay. So you have a period where there's a significant amount of positive flow, not only coming at the end of the year that people are watching, but flow coming as time passes every day. And at some point that turns into a chase, right? Everybody understands the chase. People are underperforming, so they have to buy. But why? How can they know what's going up? Well, there's these positive edges and positive reasons why not to wait. And that just begins to cascade and push things higher. So it's really a reflexive loop.

27:38Now, to be clear, there's no guarantees, right? We've seen periods where the market can go down during these periods. But the higher that skew, the bigger that positioning, the bigger those flows, and the lower the probability, the bigger the move needs to be to the downside in order, you know, that hurdle goes up in order for us to go into more of a gamma effect where we're pushing into the short interest and that downside tail can become a big problem. So there's no guarantees that tail is fatter further away, essentially. And as long as we don't get near that tail and activate all the open interest that's out there, the flows will be significantly positive.

28:20Yeah, and I know that this starts to melt people's brains when they look at the underlying calculus, the math that describes it. But this is D delta charm that you're talking about is D delta D time. the change in delta relative to the change in time relative to the decay on those contracts third order derivative for time itself i know it gets confusing yeah i mean again we we don't have to talk about the math terms right i think the general idea is um you know think of it as insurance products the world is uh that the street in the world is warehousing tail risk at all time because there's significant edge to do it just like an insurance company makes a ton of money for doing.

28:58They manage the risk in doing that. But in managing that risk, there are certain things that that whole world of warehousing has to do. And that is as time passes and as those insurance contracts roll off, they have to buy back stock. And these structural effects are real. They're massive. Anywhere from 25 % to 50 % of all flows on a given day now, depending on the environment we're in. And then add on these other reinvestment flows, et cetera. And it's a pretty high bar to bet against. And I think that's the important takeaway. So when we talk about the timing, what is the timing that you see in terms of the potential impact to the underlying?

29:41People who are obviously watching the S &P much more closely, retail investors I'm talking about here, than they are the underlying second and third order Greeks. What does it imply for the skew, the potential change of the S &P 500 as you see it over time during this period? Yeah, look, the skew is normally, call it 25 % higher than the at the money to the downside. And as much as, you know, and on average, probably about 35, 40 % higher downside, one standard deviation versus, let's say, upside. Right now, we're seeing something closer to 50 % higher, right? Significantly higher than we normally see.

30:26And that means the deltas are that much bigger as well. And then add to that the size, the positioning being bigger. And so it's hard to measure the exact percentage that will lead to. Part of the reason that's hard is because people are front running these things, right? People realize that this exists. So there's already some buying pressure, as we've seen, leading into this. That means there's more supply on the other side of this once we do start pushing up. Now, the markets aren't because of the risk of the event and not as many people understand these effects or I reckon it's a scale. These things are still there.

31:01They haven't been completely front-run. They can't be, honestly, fully front-run. But that does affect and dampen the effect. I would say if there was no knowledge about this, we're just sitting in a market with the national$100 billion daily flow, and we're going into the end of the year, this skew alone is probably worth about 5 % to 7 % in positive flows alone, without that rebalancing effect I talked about at the end of the year. That rebalancing effect, again, we said, let's say it's$4 trillion and the daily flows are 100 billion, right? I mean, you're talking about something that has 40 days worth of positive incremental flows, that alone could be worth another five.

31:46So 10 to 12.5 % in an average market. Now, we've already seen a big up push, right? And part of that is because people and big players and smart entities are playing the probabilities and understand that that's higher. So what does that mean to the end of the year? maybe another 5%. I think that's probably a good bet, right? But would it shock me if we got 10? Not at all. These are very positive flows and the risk is to the upside. I will add to that, outside of just up, down, how far can we go, upside implied volatility. So the price of these calls, it's not just that the puts are expensive, the calls are really cheap right now.

32:29So you can bet on these things without going all in on stock. The beauty of options, and I think the one thing that people don't appreciate enough is they are a much superior way to bet on parts of the distribution, to bet on certain outcomes with much less risk. It's a much better risk-adjusted way to bet on outcomes. You have every percent in moneyness in the market at any point in time in the market, you can much more precisely bet on the part of the distribution that you think is inexpensive and have a much better risk-adjusted outcome. Right now, calls two, three, four months out are actually very cheap.

33:14Yeah, people are looking at the market and saying, well, vol's hanging in there broadly. But a lot of that is because SKU is high. The VIX is pricing in a much higher price in general. And because of the event fall in November and December, is priced quite high. But if you go out to January or February or March and you go buy a call, you're able to buy these calls with some long-term upside for way lower than historical, in some cases, 11%, 12 % when the average is 17%, 18%. And we're talking about an election that has significant importance, significant potential for different outcomes. I would argue that this election here is holding actual realized vol at bay because people are waiting to see what happens before they make big moves, whether it's geopolitical or whether it's corporate action.

34:05People want to see where things are before they make a move. So I think an election unlocks some of that realized vol, unlocks some of that movement and actions on a realized level. And then these calls again are so cheap given these flows. I think you'd be silly at this point to be just long stock and trying to bet on the upside as opposed to some of these longer-dated calls. I guess some of the flip side to that argument is that they are not necessarily easy products for people to use. You've got to open a margin account. It is not simple. And I would point out you're also trading against Jem Carson, which for a lot of retail investors probably does not make sense.

34:45I want to push back on that a little bit, Ash. I think the reality is people think it's more complicated than it is. I think we get into the Greeks and people get confused or scared. I think the reality is if you do a little bit of education, a really little bit, you're still way better off betting directionally with some of these contracts, particularly in the liquid markets. I hear you if you're talking about some of the liquid stock with a very poor option chain that doesn't have enough liquidity. But people are taking way more risks than they realize betting on stocks and beta. The street has largely taught people that if you go buy stocks, close your eyes, and you'll be better off in the long run, the sharp ratio of the S &P 500 is 0.3 over the last hundred years of not a particularly good long-term investment on a risk-adjusted basis.

35:45We've been relatively lucky in the sense the last 20 years have been very, very positive for stocks because of very accommodative Federal Reserve policy. But I think the reality is in a market where we're likely to have more inflation, higher interest rates, given all the populism and effects we talked about, people need to learn to manage risk in this market. We can't just blindly say, hey, let's be long assets. And I think options are really, really great, a great way to do that more precisely. And it's not nearly as complicated as people think. So I think there's a lot of scare tactics around options and derivatives or some weapon of mass destruction, et cetera.

36:22I think they're actually superior products, superior ways to position much more precisely than just in two dimensions, long or short. Well, there are really two main points there, Jim. It's the idea that understanding these is not as hard as it seems at first blush, but also, and perhaps the more important point, is that there's risk in beta as well. We talked about this as S &P 500 creeps near this 40 % return on a trailing 12-month basis. I want to talk about the deleveraging risk. We talk about the releveraging that happens as stocks continue to drift higher. This is a classic sort of feedback loop type of scenario here, where the reason that prices rise is because prices are rising and it feeds back into the system.

37:04What is the risk and how do you assess it? How do you assess the risk skew and positioning for that event to have one of these Minsky moments where you have a flip over and things trade down very, very quickly? So this is one of my favorite kind of metaphors. I would think of stock market valuations as like altitude on a plane, right? I think where the market goes is the plane itself, right? And what drives an airplane, whether it goes up or down, is fuel. It's not the altitude, right? You can be way off the ground, right? And still go higher. Valuations don't actually matter historically in any period.

37:52There's a lot of research that goes over this in any period, less than 10 years. They're not correlated to outcomes over any short period. Over 10 years, they matter again, right? That's that weighing machine versus that voting machine. Now, let me explain what we're talking about here for people who may be a little lost here. So you're talking about essentially the price to earnings ratio, the price that you're paying for a stock, the net present value of the future cash flows. In essence, what you're saying is the data doesn't show any evidence that if you have a very high P.E. ratio in the short term, that it means it's going to come down.

38:26Why? Because of exactly the effects that we've been talking about here, the momentum effects of pushing higher. Yeah, absolutely. So the reality is what pushes things higher are flows, is that jet fuel in that jet. Now, if we have liquidity, if money is pushing in to stocks, the market will go higher, regardless of how things are valued. And a lot of the things that are pushing, a lot of jet fuel has nothing to do with valuation. As we highlighted here, it has very little to do with it. It's just the mechanical structure of markets and it's the Federal Reserve and it's the creation of money. It's things that have very, very little to do with earnings of a company.

39:05Now, to be clear, the way things, the weighing machine, things come back into line and they eventually do. it's almost always during some liquidity shock, right? Things get repriced when the jet fuel stops. When those engines start sputtering, the only thing that matters is how far off the ground, right? And so that revaluation happens when those flows are poor. And this is, to answer your question, the important point about how the reflex effects work the other way, So when we get a situation where all of a sudden those flows are not present, and then we get some type of shock, and this is path.

39:49The path can be seemingly quite random, but probabilities change based on these flows. And this is what we're looking at. When we say, okay, this is a seasonal period, the liquidity is very strong, the Chinese central bank is printing money, the Federal Reserve is cutting, we have a releveraging effect at the end of the year. We have these Vana and charm effects. As I said, a positive flow is coming. Yet all the way, I don't care what the valuation is. But at the end of the day, we're getting further off the ground, right? We're getting that altitude is rising. That valuation is becoming more and more irrational, right?

40:22And particularly in certain areas of the market. And as you begin to see that, you can, you know, I don't suggest that you try and short it at that moment, right? But you start looking and you start thinking about hedges and you wait to that moment where those flows maybe are, maybe those seasonal effects are gone. Maybe that re-leveraging effect has passed. Maybe the Federal Reserve is now saying, okay, inflation's a little hotter. We can't cut. Maybe China has to step back. When those flows, the perfect trade on the short side is when those flows start to turn, right, and the valuations have now gotten to a very, very high level, that's when all of a sudden the opposite can start to happen.

41:02Now you can start to get significant moves. You can activate some of this downside risk in the market and short skew, and that can lead to gamma effects that can accelerate. Not a surprise. I've highlighted this. Very few people talk about this, but that the COVID crash happened the day I started the day after FedOpex and ended the day after March Opex. Most people think that's some weird coincidence. We knew about COVID. I want to be very clear. At the end of December, there was a lot of conversation. I was talking to my clients in McKinsey and other places about COVID and how big a potential risk it was at the end of December of 2019.

41:41Yet January passed, the market rallied, and we went all the way to mid-February, the market kept rallying. Well, that's because there were a lot of positive flows into that early part of the year, right? A lot of ball compression. A lot of people were trying to short it with all those flows that only pushed things higher. But once we got to a point when the flow dynamics turned and then the risks were there and the valuations were such, we got a dramatic effect. And then it was not only just a down move, then we activated a lot of that short gamma in the market in that March quarterly OPEX, and that created a massive 30 % decline in a month.

42:15This is how these things work. It's not that the weighing machine doesn't matter. It only matters once the flows are in a position to allow the readjustment to happen. The reality is the world matter. But sometimes, to be clear, it can take years. I started in the business in 1998. Trust me, in 1998, the world knew that the tech bubble was a bubble. There wasn't any question as to when there was a bubble. But then the NASDAQ doubled into 99, 2000, returned 100 % in a year and change. we crashed 92 % and 95 % of all tech companies went bankrupt. But the reality is you had to hold on if that was the case.

43:00And instead of trying to hold on, it's pretty important to watch those flows and be prepared for when those flows turn, given the context of the weighing machine. Yeah, I mean, just a couple of points. And despite those massive 90 plus percent bankruptcies, 95 % decline, peak to trough, you still saw the technology that was being used during those periods and the startups became massive adoption. I mean, it was just a huge, huge success. And we can talk about it. You can talk about Amazon. There was never a question, right? There was never a question that the internet was going to change the world.

43:31There's no question that AI will change the world, but good luck trying to make sure you got here in the right names that make the money on it and make sure, you know, you had to wait a decade before you made any of your money back, right. From the tech bubble before you started making money again, price does matter. Also, you don't know how the profits from these technologies are going to play into any company. It could be that AI is not profitable at all for the AI companies. All the profits may accrue to nuclear or energy. We still don't know that. And the path that this takes can be incredibly bumpy and incredibly strange.

44:06So the idea of irrational exuberance has the word exuberant. You can't be exuberant unless something is really the case for it is it's so strong. there was never a doubt that the internet was going to change the world. There's no doubt that AI will change the world or blockchain for that. The question is, what are you paying for it? And who will be the winners and make money off it? And those questions are much more uncertain. Yeah, this is such a fascinating point. It's such a fascinating hypothetical that perhaps the AI tech itself gets arbitraged to zero and the wins are somewhere else in the system.

44:40Unknown, obviously, hypothetical, but it's such an interesting point. And to get back to your metaphor of the airplane where you're talking about these irrational pricing relative to the underlying risk or the value or the pricing valuation. It's just pushing more fuel into the plane, burning the fuel faster and maintaining that altitude until the moment that the fuel is no longer sufficient to keep it aloft. Yeah. And this is why blow off tops happen, by the way. It's the actual market structure of how these things tend to move at the end is an acceleration into a rational, massive boom with massive speed before a massive decline.

45:19And again, the reasons for that are not only lifting the altitude, so there's just more potential energy for a decline, but you create more short interest because people are worried, because people are concerned, they're under position, and that short interest can get squeezed. You create more put positioning and hedging, as we're seeing, and higher skew, which leads to more positive pressure. All of these things culminate in a push into the rally that is almost so fast and so big that people can't stay in the shorts. It's incredibly hard at the end. And the last element I'll add that people aren't aware of but actually is very important to the last dynamics is vol compression itself continues to compress.

46:00And as you get a big enough rally, you actually will pull out the vol compression. If you slide to a low enough ball on the call side, which you eventually will if you're sliding fast enough, then the ball just gets too cheap. And people start saying, well, I can own calls. I can own out the money. I can own a ball. And that makes dealers shortfall. So you can really create this dynamic into a rally where the ball starts going up at the end. This market up, vol up dynamic that happens to blow off tops. And that dynamic can really unpin the insurance market. It can really make it so markets become more volatile and more risky.

46:35And again, that's a bit of a counterintuitive thing, but I think it's important to note that it's not only potential energy, it's not only the short interest and the squeeze and the speed of the move that can lead to a decline. It's actually the unpitting of volatility markets. It's the short gamma that gets entered into the market from that type of up move that eventually can lead to a big move. So this is usually how these big structural moves end. And that's what I'd be looking for, honestly, in the next three, six, nine months. three, six, nine months. And again, you're right, so counterintuitive.

47:08The idea that artificially suppressed volatility leads to almost this tectonic pressure building up, building up with no outlet. And by the way, talking about this, just to put it maybe a slightly simpler way, there's no way to hedge against these risks because you bleed so much cash trying to do so. And that's the challenge with attempting to not just short tops, but also trying to hedge against potential downsides when you see this euphoria to the upside. Yeah, it's counterintuitive, but the way to bet on a decline coming early is actually to buy long dated upside calls. And again, I know that's very, very counterintuitive, but you're essentially buying implied volatility, which tends to go up well before the decline actually comes on, on a fixed strike basis.

48:00So these calls are very cheap. You may, right now, that may seem, oh, I would have been on the downside. Why would I go buy these calls? Well, if you buy those calls, you don't lose much if the market goes down because the vol is so low, the implied volatility will go up if a market declines. And more likely is that you get some type of blow off top beforehand. And when you do, not only will you benefit from the delta, the directional bet on that call, but you'll bet on the implied volatility coming up. So you get a massive amount of convexity. And then you can sell stock against those calls as you rally.

48:34And that essentially creates something that looks more like a straddle or a downside trade, a long volatility trade. So volatility, implied volatility tends to perform very well, well before a market tops. And so playing implied volatility with the cheapest kind, which is outside of the money, out of the money calls. And again, if you really want to be less bullish, you can even hedge those calls now. You could take a 10 delta call out four to six months, and then you could go hedge five to seven of those deltas, right? So you still have a little bit of upside given the probabilities. And worst case, the market goes down, that short stock takes over and your long implied volatility.

49:14So these out-of-the-money calls are too cheap given what's going on. And the highest probability is actually a rally first and then a decline. So definitely the best way to start looking at a long-term positive left-tail convexity for when the time comes. Very interesting and exactly, as you say, extremely counterintuitive. Jim, I want to just cover one more point, something you touched on earlier in the show. Having just returned from the RMC, the Risk Management Conference, talk a little bit about what you see in terms of the trends for all of these products, all of these solutions that we've been talking about here today.

49:54Yeah, I appreciate you bringing that up. I think there's a couple of really interesting things I took away. I actually, like I said, did a few interviews at the end of RMC of some of the speakers. We recorded them. We're actually going to release that for public the first time that anybody's got a behind the scenes look at what's happening at RMC. We'll be releasing that in the next week or so. But some of the big takeaways I think that are really important are the massive growth in ETFs and structured products. We've talked about that a bit, but to put some numbers on it, in the last two years, we've had$175 billion of new ETF AUM that are tied to options yield.

50:35So essentially options selling that's happening under the hood of an ETF, that's a 700 % increase in two years. So these are just getting started. They're essentially democratizing structured products in the form of ETFs. This allows for all kinds of different positioning other than beta, right? So people are increasingly saying, okay, listen, I don't like the prospects of the market going up or down. I don't know where it's going, but what I do feel good about is that there's a risk premia. And if I sell some of these things, I can make 10%, 15 % a year as long as these scenarios broadly hang out.

51:14and these things play out. And these probabilities are relatively low probabilities. So that seems like a much better risk reward. The Sharpe ratio on a lot of these strategies is close to one, whereas the S &P is 0.3, right? So they're painted as scary or people are confused by them. But a lot of these ETFs are providing positioning in the options market in a very low leverage way that allow for outsized returns. That growth is likely to continue. Now, the important part about that is it actually has reflexive effects on the market. We've seen structured product issuance increase by$500 billion in the last three years.

51:56So it's gone from a$500 billion per year issuance to about a trillion dollars a year now. Now, that along with this ETF yield offerings are compressing implied volatility because they tend to be vol selling. That vol compression on the index level is leading to dispersion, single list versus at the money. We've talked about that. To some extent, it's also leading to very low volatility in the short term, but kind of an illusion of volatility, right? Because those structured products are selling it, they're compressing the vol. But then, again, as I mentioned, at some point, these things, if they become unpinned, can really accelerate the other way.

52:43So I think that's an important, interesting thing going on, the amount of structured product issuance, the accessibility of it in the form of ETFs, other mutual funds, other types of products, and that's only accelerating and increasing. So these effects that I talk about so much are actually becoming more and more pertinent and relevant. It's not just the options trading going on. It's a lot of this issuance on that end as well. So I think that's a really big thing that came up. The other big thing, other than the election, we talked quite a bit about the election, is zero DTEs and how the trading in them is affecting market structure.

53:19Almost 50 % of all options trading is now happening on zero days to expiration. That means these are just realized positioning. Why is that happening? A couple of reasons. One, first and foremost, people want to position along the distribution, but it's too complicated for some people right now to think about implied volatility. Is this implied volatility high or is it not? They just want to bet on realized outcomes. They want to say, what are my break-evens? What can I make today if I'm right? And so a lot of funds are being issued and a lot of individuals are out there trading, essentially betting on different outcomes in each day.

53:55And it's a very clean one-day kind of bet. And that makes it easier for people to say, okay, I want to make this break-even bet for this day and not worry too much about the long-term implied volatility involved. That trading is is having a massive reflexive effect on markets as well. It is on some days where there's a lot of vol selling, compressing vol, but it's also on some days when all of a sudden there's a big order that's buying vol, changing things very quickly to a big move. And so that quick change, which is more like the vol of vol, right? The vol can be very, very compressed and then change very quickly.

54:33That vol of vol is increasing. And I think that's a big takeaway. the more and more we see zero DTE trading, the vol of vol, and the kind of disjointedness of markets can increase. And that's something that people are thinking a lot about. The implied volatility premium per day is actually the highest on those zero DTEs. I think that's another important takeaway. And so there's also some increasing selling of those. And I think that that pressure some days is more powerful than anything. So something to be aware of. We also talked about when there's an extra premium, when there's not, dove into a lot of interesting trading strategies and opportunities there.

55:12So tune into that if you're interested. Jim, I always wish I could borrow about 20 IQ points before we do these conversations, but I get less dumb in the course of our talks. Always enjoy them. Final thoughts, key takeaways that you'd like to leave our viewers and our listeners within about 60 seconds. I think the biggest point here is that the election has a very positive, supportive flow and that the likely winners, the people who are going to make the most money on this is not betting up or down. You're more likely to just bias up regardless of the outcome, but they're going to be on betting on whether if Trump wins, getting convexity for that potential outcome.

55:53It's an asymmetric trade, whether he wins or not. And some of those trades can be tied to labor costs. Inflation in particular, I think is a very big trade. Things tied to that, like a yield curve steepener. We're seeing it in banks as well. Those are trades that could really pay off with a lot of convexity if Trump wins. Jim Carson, thanks for joining us. Always a pleasure. Always a pleasure, Ash. Thanks for having me, buddy. Thanks for watching, everybody. picture yourself on a beach retired early and enjoying financial freedom if this is your dream then now's the time to level up your investing game and real vision can help you we arm you with the knowledge the tools and the network to succeed on your financial journey on your own terms take control of your future and visit realvision.com forward slash free that's real vision.com forward slash free.

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