This page has been archived and commenting is disabled.

"Shadow" Short Convexity: If You Short 'Fear', Be Prepared For 'Horror'

Tyler Durden's picture




 

Excerpted from Artemis Capital Management letter to investors,

Pre-emptive strikes on financial risk through unconventional monetary policy amplifies ‘shadow’ short convexity leading to tail risks that are near impossible to gauge. Shadow short convexity describes an immeasurable fragility to change introduced when participants are encouraged to behave in a way that contributes to feedback loops in a complex system.

Shadow convexity reinforces the dominant trend in a hidden non-linear way and effects all participants. The ultimate non-market example of shadow short convexity is the failure of communism and the fall of the Berlin Wall in 1989. Following decades of oppression, the wall literally and psychologically fell when crowds of East Germans gathered at checkpoints and border guards refused to use mass violence to suppress them. The wall collapsed organically and without violence after the suppressed desire for freedom became a self-reinforcing force of change that could no longer be denied.

The ultimate market example of shadow convexity is the role of portfolio insurance in the 1987 Black Monday crash. The portfolio insurance strategy relied upon selling increasing amounts of financial futures to protect against drawdowns in equity markets. The greater the decline in the market the more financial futures were sold to offset the loss contributing to a non-linear feedback loop and causing a -20% single day decline in the S&P 500 index. 

Modern markets contain many new sources of shadow short convexity stimulated by extraordinary global monetary policy.

Examples include risk parity, volatility targeting, machine learning, and exchange traded products. All of these structural devices contain a “shadow gamma” or “shadow liquidity” by reacting to market conditions that they themselves influence resulting in self-reflexivity. Volatility targeting and risk parity strategies create feedback loops by increasing and decreasing risk exposure based on volatility observed in the recent past.

As these strategies dominate markets they can begin to influence the same realized volatility used to make their initial risk decision. Risk parity is an example of a strategy that adds shadow short convexity to the system by leveraging short correlations between stocks and bonds.

Machine learning technology is a tool utilized by many high frequency and quantitative trading firms, including Artemis, and relies on advanced statistical methods to recognize non-linear patterns in historical price data. There are many advanced algorithms with fancy names like “neural networks” and “random forests” but they all rely on the same limited history of financial data to make decisions.

Quality data is always more important than the algorithm used. As machine learning gains widespread adoption the models may begin to recognize patterns in data that they themselves influence resulting in feedback loops.

When a self-driving car uses visual pattern recognition algorithms to react to the road it does not adversely change the fundamental reality it was designed to respond to. Now imagine a fleet of self-driving cars that, upon first sign of any risk, avoid accidents by encouraging other drivers to collide with one another. Now you see the problem.

Exchange traded products (“ETPs”) introduce self-reflexivity by creating a highly liquid security (listed stock) that tracks a potentially illiquid underlying instrument (e.g. high yield bonds, commodity futures). Exchange traded products with illiquid underlying assets remind me of a classic song from the Eagles because  “you can check out anytime, but you can never leave”. Leveraged ETPs also add to shadow short convexity by requiring non-linear exposure adjustments to linear moves in asset prices.

When combined with a liquidity mismatch any period of sustained buying and selling becomes self-reinforcing. All of the above structures and systems introduce shadow convexity to markets that reinforce the dominant price direction in a non-linear way. This works very well when central banks are providing ample liquidity and reinforcing the status quo but it can and will cut in the other direction. Lower volatility drives lower volatility… and higher volatility drives higher volatility. Minsky once wrote that stability is the greatest source of instability. Shadow convexity is the reason.

The concept of a ‘Black Swan’, defined as an extreme or rare event, has never been more relevant to markets, but the idea is so frequently abused in financial commentary that it risks becoming a cliché. The absurd meme that central banks have eliminated extreme tail risks through accommodative monetary policy, recently repeated by the head of research at a major bank, is part of the institutionalized narrative of moral hazard. By Taleb’s definition, Black Swan events are unpredictable, so how can a central bank prevent something they can’t even identify in the first place? More to this point the investment community has no consistent definition of what tail risk or high volatility even means. 

Volatility is about fear... but extreme tail risk is about horror.  The Black Swan, as a negative philosophical construct, is when fear ends and horror begins.

Fear is something that comes from within our scope of thought. True horror is not human fear in a definable world, but fear that comes from outside what is definable. Horror is about the limitations of our thinking.

In the novella, “The Call of Cthulhu”, the horror author H.P. Lovecraft describes an ancient and malevolent entity hibernating deep within the earth the sight of which can drive a man to madness. The imprisoned Cthulhu will destroy the world upon its awakening and this is a source of subconscious anxiety for all humankind even if we are individually unaware of its existence.

Cthulhu is a black swan. I’m sorry but the 2007-2008 financial crash was not a black swan. That is a collective lie propagated by policy makers so they don’t cry themselves to sleep at night. Many different people predicted and profited from the 2008 crisis including this author.

A black swan is when things go from bad to uncontrollably bad, when a linear decline becomes an exponential decline. The black swan resembles what amateur screenwriters call the “all is lost moment”. It is not the first act of the horror movie when people start turning into zombies... it is the end of the second act when the hero realizes he is the only person left who is not a zombie.

2008 was about the fear of failing banks and crashing markets... but the true horror was the impending collapse of the entire fiat money system that never came to be. That was the true black swan.

The unpredictable horror of a black swan often occurs following a predictable period of fear. For example, the Black Monday 1987 crash was an unpredictable event that occurred within a predictable crash. In the late summer of 1987 the market was trending lower and financial stress conditions were rising rapidly. Volatility rose even before that fateful Monday increasing from 21.83 at the start of October to 36.37 the day prior to the big crash. By this point, the S&P 500 had already experienced a -14% peak-to-trough drawdown. Many investors ranging from global macro traders to systematic trend followers correctly predicted a crash. Nobody predicted the market would fall -20% in one day or that volatility would peak at 150. 

Ironically, if the same price movement occurred today most people would short volatility and buy equities the day prior to Black Monday in anticipation of policy support.

Most crises occur slowly and then suddenly. A devastating earthquake is a tremor that just didn’t stop… and Black Monday 1987 was a crash that just didn’t stop. To this extent sizing long volatility positions into a crisis can yield life changing returns at the right point. Today, due to the actions of central banks, everyone is doing the exact opposite...

If you short fear you must be prepared for horror... in the Prisoner’s dilemma we are one step closer to HORROR
 

 

- advertisements -

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Fri, 10/16/2015 - 19:04 | 6677322 Peak Finance
Peak Finance's picture

Article was ok, gave 5 stars for working Lovecraft into a financial piece...

Fri, 10/16/2015 - 19:11 | 6677338 knukles
knukles's picture

He still forgot that Moses got the 3 Tablets of Duration, Convexity and Prepayments from 200 Water Street but when he came back to The Camp after 40 days and nights of binge drugging, he was astounded that all his followers had bought gold and long bonds.  So much for Bloomberg telly today having a special session on "Dispelling the Myths of Despondency and Despair".

Fri, 10/16/2015 - 19:16 | 6677354 GrowerJohn
GrowerJohn's picture

Bitcoin could work wonders in helping to mitigate these financial crises.

Learn how to use the digital currency here:

http://www.bitcointeaching.com

Fri, 10/16/2015 - 21:09 | 6677676 algol_dog
algol_dog's picture

Couldn't we equate technical analysis with what's being intimated in this presentation?

"the models may begin to recognize patterns in data that they themselves influence resulting in feedback loops"

 


Fri, 10/16/2015 - 19:11 | 6677334 buzzsaw99
buzzsaw99's picture

...and Black Monday 1987 was a crash that just didn’t stop.

please. 1987 gave birth to the ppt. it was the most lucrative time the maggots ever had.  the fed and fed gub will always make sure stocks go up or at least don't go below whatever number they choose even if said stocks are worthless.

Fri, 10/16/2015 - 19:56 | 6677457 tc06rtw
tc06rtw's picture

   
 …  keeping this  God-Damned farce afloat for 28 years,  a financial reactor-gone-critical  they’re trying to keep Scotch-taped together at the cost of their lives  (and everyone else’s).

Fri, 10/16/2015 - 20:11 | 6677506 TheRideNeverEnds
TheRideNeverEnds's picture

You can bet your sweet ass TPTB have already gotten their shit in order and they have contingency plans for their contingency plans. If SHTF we are fucked, they will be minorly inconvenienced.

Thinking the people responsible for this mess will ever be held to account in any way, shape, or form is pure fantasy.

Fri, 10/16/2015 - 19:09 | 6677336 Normalcy Bias
Normalcy Bias's picture
"Hello Almighty, Almighty, this is PBR Street Gang -
radio check, over."
Fri, 10/16/2015 - 23:45 | 6678164 shantyman
shantyman's picture

I am going to make a nice mango cream pudding

Fri, 10/16/2015 - 19:10 | 6677337 grunk
grunk's picture

Welcome to Earth, third rock from the Sun.

 

https://www.youtube.com/watch?v=vlAa0IGCXCw

Fri, 10/16/2015 - 19:35 | 6677405 El Vaquero
El Vaquero's picture

Or Third Stone From The Sun:

 

https://youtu.be/GsPHmfB50Wk?t=2m34s

Fri, 10/16/2015 - 19:26 | 6677377 Peter Pan
Peter Pan's picture

Preparing for the inevitable when the timing is unknown requires a lot of guts because there will be many around you who will continue to trade and to speculate and profit while you choose to throw your gold overboard at some lake.

Stay the course if not for yourself then for your children.

Fri, 10/16/2015 - 19:33 | 6677392 Tao Macro
Tao Macro's picture

This is excellent analysis. The risk of a non-linear shock is not priced in.  A 1929 or 1987 type hit could happen soon. 

http://taomacro.com/crash-comparisons-with-1929-1987-and-2015.html

Fri, 10/16/2015 - 21:54 | 6677839 jcdenton
jcdenton's picture

According to Sinclair, there is no precedent for what is coming ..

https://youtu.be/u7tTdO6oxUA

Sinclair keeps saying, back in the early 80s. "I was told." Guess who was telling him ..

https://app.box.com/s/hfgvcqg7gqh7i27at6sv53ywu87lwarp

Pay very good attention to WANTA-Book ..

Notice the Title:

Black Swan! White Hate

Fri, 10/16/2015 - 22:03 | 6677855 Urban Redneck
Urban Redneck's picture

"1929 or 1987 type hit" is the sticking point... same same, but different.  In 1987, the market structure, mechanisms, and strategies were different and more organic, and the datasets that drove trading were much less granular.  Back when the mortgage industry was automating, there wasn't historical transaction level data relating to impairment under (expected) adverse relative interest rate movements.  So the industry models for automated decisioning and pricing at the retail level became FICO & FuckIt, while on the institutional level Black(rock)-Scholes Shitty Deal model spread like a raging case of the clap in whore house, and the fundamentals of the '07 crisis wasn't any Black Swan unless you got your news from FNN reincarnated (CNBS).    In 1929, someone had to read actual ticker tapes if they weren't in the pit, by 1987 the Quotron umbilical cords were replaced the original QuoTek handheld "TVs" - now someone can log into Nanex while naked on the couch in their parent's basement while simultaneously VPNing into their co-located server in the whorehouse...

Fri, 10/16/2015 - 19:52 | 6677440 Turin Turambar
Turin Turambar's picture

Blah, blah, blah.

Fri, 10/16/2015 - 19:57 | 6677464 PoasterToaster
PoasterToaster's picture

The Berlin Wall collapsed because sooner or later common culture will overcome oppression by outsiders.  That's why America's special, unique culture in the progression of history will be its saving grace.

Fri, 10/16/2015 - 20:51 | 6677621 Peter Pan
Peter Pan's picture

That was true but the problem these days is that American culture has gone off the rails and if you don't believe just ask yourself how much of Miley or Kim you can watch before throwing up.

The greatest nation on earth is now scraping the bottom of the barrel with much of the so-called culture it feeds its masses.

Sat, 10/17/2015 - 11:27 | 6679205 Skiprrrdog
Skiprrrdog's picture

I have never watched a second of either one...but I could possibly do up to three minutes if they were rug munching each other...

Fri, 10/16/2015 - 21:11 | 6677670 stant
stant's picture

I was circling the wagons in late 99 .2 yrs after my father left me our co . I felt it coming then. We got 911 to cover that one. Again in 2006 . So. 2008! was no black swan , to many saw it coming. We are in the biggest of all now, global hell

Fri, 10/16/2015 - 21:22 | 6677725 MASTER OF UNIVERSE
MASTER OF UNIVERSE's picture

As the Social Engineer of March 10th 2008, I can assert with confidence that this article is inaccurate, but interesting.

Sat, 10/17/2015 - 08:06 | 6678733 Being Free
Being Free's picture

Not sure which points in the article you find inaccurate but this one has been setting up in reality for ~6 years now.

Ironically, if the same price movement occurred today most people would short volatility and buy equities the day prior to Black Monday in anticipation of policy support.

Just BTFD, right?  Black Monday will never come.

Perhaps Plosser was right to be concerned.  His comments from the March 10th 2008 conf. call are haunting ...

"... I am a bit nervous about the slippery slope here. Once we start taking assets of a particular class that is in distress, are we setting ourselves up for potential risks down the road, when all of a sudden some other asset class that is commonly used in both trading and securities, whether by mutual funds or banks, comes under greater duress and for which spreads widen significantly? Are we going down a path here in which we are going to implicitly provide support for a whole range of potential asset classes? I worry a bit about where this might lead us over a longer period of time. "

http://www.federalreserve.gov/monetarypolicy/files/FOMC20080310confcall.pdf

 

 

 

"And you tell me over and over and over again my friend
You don't believe were on the eve of destruction"



 

 

 

 

Fri, 10/16/2015 - 22:58 | 6677852 Aquarius
Aquarius's picture

The "Drone" papers, which have become viral - that have been leaked and published by the Intercept are really telling in the organization of the US Military operations and by extrapolation, US Government operations:

SNAFU nails it perfectly.

In the ME nobody knows who their allies are, nor who to arm; so they are all allies and all get armed except the civilians who get killed. It is policy to KILL first so that this situation does not become Public Domain. Cannot have the competencies of the US War Machine being questioned.

But the competence of the US WAR Machine now has no clothes.

 

https://theintercept.com/drone-papers/the-assassination-complex/

 

 

So, why would the "markets" cum "Casinos" be any different"

Does anybody really believe that the markets are today about "Investment"?

Does anybody really believe that these so called "Economists" with their Economic Theory have anything to do with reality? If you believe then you are in full Uncertainty mode and nothing can save you. (Risk being computable Uncertainty)

"Fear"? Volativity indicate fear and desperation, indeed, just look at thermodynamics; water-pipe shudder. The markets are being destroyed now by their own "turbulence" aka "water-pipe shudder". And soon this turbulence will be fully developed.

As Minsky said, and I paraphrase: 'Stability leads to instability'. But we are Human Beings and can transcend these physical limitations; but we don't, so are we just mere proto-humans, under-developed, cognitively lazy, dishonest and prefer to wallow in an ignorance of self agenda, rather than to evolve? Answer: Yes.

Nonsense:

This Global "leadership" Collapse has been brought about by the elite Global Economists that direct and influence Monetary and Fiscal Policy (and "Economic Theory: -sic). Bankers are morally and ethically out-of-control due to the actions of these same "Economists", their Corporate Mercenaries, and the looming collapse accelerated by the FedRes's premeditated and intentional  cutting of the unwashed masses from access to the networks and sources of wealth generated as fiat currency: IOW, irresponsible ignorance led and fortified by unadulterated ego and arrogance and bias in favour of their own social class. These so-called
Economists" know nothing of any importance to Society nor Humanity but have created the climate /environment / milieu (again) for vast class criminality against Humanity itself, by their ken. Yes, it is the Economists and their blind stupidity that have led the World to the edge.

Anybody that listens to any of these Economists and or the FedRes and or any Central Banker deserves what they get, that is, Death by 1,000 cuts, and, while their is total certainty of this outcome, mileage will vary.

 

Economics and Economic Theory(s) are crass nonsense; rubbish; garbage and witch-doctory; barbaric relics left over from the Paleolithic Age and its knuckle-dragger fundamentalist and irrational faith based Cultist which divine false dogma in order to rule the masses and profit-therefrom .

 

The Global Banking System is an un-natural and captured Parasitical drip feed that is targeted not to fully benefit Humanity as the innate Rights of free-born, nor civilization as an objective undertaking, but, merely to the enriched fulfillment of a few Banker families and their vassal servants. But, its global network is now broken; shattered in fact, their own hand; by courtesy of the FedRes itself and its owner TBTF Bankers,by the valued assets of Humanity and its wealth productivity being manipulated directly into the coffers of this elite select few. And, no wealth per se is now being created; the FedRes's actions have closed employment, entrepreneurial creation, Capitalism itself.The system of Western Civilization is now defunct; you can now hear the screams.

Get over it, because it is over.

 

If you want to blame some group, place it where it belongs: on Economic Theory(s) as it is pure and utter Bullshit and can and has been proven so. Who supports this crap but Economists (sic) and who do these Economists (sic) owe their loyalty and servitude? Answer: To the Banking system; in turn, the Bankers control the Banking system and the political structures and organization of all nations.

 

If an analogy were to be drawn here imagine the grape vine (the motif of Sir Francis Bacon aka William Shakespeare). See all the bunches of grapes as nations and all the grapes as states and all within those grapes, that is, the structure and organizations, as humanity. From where does the vines get its vitality? Answer: from its roots deep within the fertile soils.

 

Where do the grapes get their nourishment? From the vine (read: circulation network / infrastructures) which funnel / channel/ feed /'deliver the necessary nutrients from the roots; and the environment (milieu). It is the same in the human body and all life systems -excepting the Banking System of the proto-human.

 

Where is the vine's Banking system as we have today, so miserable and arrogant - as well as so ignorant? It is attached to the vine itself; a parasite called 'die-back' that kills its host. And this parasite has its agents called Economists, as well as servants, called Politicians.

 

As to the emerging nations (EM), the enemy is within and rules ------>> You. It is called rot and begins at the head.


 

Expect a complete collapse of the West led by the USA.

 


http://verbewarp.blogspot.com.au/2005/12/economic-heresy.html

 

http://verbewarp.blogspot.com.au/2006/03/warning-to-east.html

 

http://verbewarp.blogspot.com.au/2011/08/delusional-economics.html

 

No, the world is not ending; just the dominance of the decadent West and the United States of America.

 

The vine serves the grapes; the fruits of its creation.

The Banks serve themselves.

If you receive a shekel from the Establishment, it is for you to shut down your Humanity and human potential so as to benefit: 'they that would be king'. You can be free or enslaved; the choice is entirely yours.

 

Enjoy.

 

Ho hum

Sat, 10/17/2015 - 07:30 | 6678693 ZippyDooDah
ZippyDooDah's picture

Re. The Drone Papers and the military side of your post, the whole idea that assassinating individuals can or will stop a political/social/military/terrorist movement is just farcical to begin with. Not only a waste of hugely expensive complex technology, not only a lynch mob without the mob, not only creating more martyrs, but just completely ineffective. As in, it won't work. It's only effective to create more enemies. When one "key leader" is killed, another individual will step up and become the new "key leader." So, the cycle continues with no net effect.

Sat, 10/17/2015 - 21:52 | 6680466 Aquarius
Aquarius's picture

September 28, 2015

 

The Day that changed History.

The day that marks the end of the Old Epoch and the Beginning of the New Epoch.

Global Consciousness has already begun to change.

The Old will be put out as the garbage.

 

Remember this moment for the rest of your lives.

 

http://www.paulcraigroberts.org/2015/10/17/the-fall-of-the-unipower/

 

Warning: Epect the next ~8 years to be unpredictable and chaotic. Mileage will vary.

 

Good luck to all of Humanity. Go Well.

This is an Universal Event.

 

Fri, 10/16/2015 - 23:12 | 6678082 xrxs
xrxs's picture

Can't wait.  Have ringside seats to this one.

Sat, 10/17/2015 - 03:59 | 6678476 hibou-Owl
hibou-Owl's picture

I remember the media headlines in 1987 blaming automated trading systems for the extent of the sell off.

I was hand charting getting numbers from daily newspaper and running 65 charts, and using a broker by telephone. Look at what has developed, you can run an automated trading system from your mobile and get instant fills.

My agrument is the much higher percentage of personal traders today (compared to 1987) will disregard any money management principles in a sell off and dump the lot in panic. The gaps will be enormous and the market halted in nano seconds. Stops won't mean a thing.

In 1987 the market was down nine days in a row before it gapped, and you could get fills on the nasty days.

The dynamics of the market have changed, and the lights will go out just a matter of time.

Sat, 10/17/2015 - 09:36 | 6678884 FedFunnyMoney
FedFunnyMoney's picture

Inflate or die.

Do NOT follow this link or you will be banned from the site!