Derivatives Trading Legend: "As Little As A 4% Decline In One Day Could Start A Critical Crash"

Tyler Durden's picture

After building out Merrill's mortgage trading floor basically from scratch, then moving to the buyside at Pimco, several weeks ago Harley Bassman, more familiar to many traders as the "Convexity Maven" - a legend in the realm of derivatives (he helped design the MOVE Index, better known as the VIX for government bonds) - decided to retire (roughly one year after his shocking suggestion that the Fed should devalue the dollar by buying gold).

But that did not mean he would stop writing, and just a few days after exiting the front door at 650 Newport Center Drive in Newport Beach for the last time, Bassman wrote his first full article as a "free man", in which the topic was, not surprisingly, derivatives and specifically the recent collapse in vol - and convexity - what prompted it, but most importantly and what everyone wants to know: what threshold would be sufficient to finally launch the next "critical mass" market move (i.e. crash) and, just as importantly, what could catalyze it.

He answer all of the above in his latest fascinating note.

Bassman's full thoughts below:

“Rambling near the Edge”

Last month I attended the EQD (Equity Derivatives) Conference in Las Vegas. Diverse speakers opined upon a variety of topics, but a common theme was noting the near record low of both Implied and Realized Volatility in the financial markets. But despite the VIX kissing its nadir, realized volatility has plumbed even lower depths, and thus it was reported that strategies that engaged in selling Equity Volatility had both superior returns as well as the loftiest Information (Sharpe) Ratios among the dozens of strategies offered.

What was of special interest to me was that while many strategies involved the direct selling of Volatility via listed or OTC options, there were many other investment themes that had at their core a “sell Volatility (Convexity)” profile; thus, their recent success may not be due to the cleverness of the strategy, but rather is just fully coincident to the success of any short volatility investment.

There are many vanilla investment constructions that decline to use derivatives, yet are actually negatively convex portfolios in sheep’s clothing. These include:

  • Low Volatility – An equity portfolio devised by purchasing the least volatile stocks. Over the past few years these portfolios have generally out-performed the generic Index;
  • Equity Volatility Targeting – Embedded in many equity-linked insurance products, these risk targeted (often called “Managed Risk”) portfolios increase/decrease investment leverage on a formula based upon realized volatility;
  • Risk Parity – Similar to Equity Volatility targeting, but here the investment universe is widened to include fixed-income, currencies and commodities.

What all of these investment themes have in common is that not only do they profit when realized Volatility is low, but also that their implementation tends to make disadvantageous transactions (selling low and buying high) when Volatility increases; in other words, these strategies are implicitly short Convexity.

Every generation of investor builds a framework to support their portfolio construction, and I would propose that our current proclivity for “quant supported” notions has led to an over reliance upon Information Ratios (IR) in portfolio construction. So, while I do believe IR is a useful investment tool, I also believe it has quirks that can be underappreciated. Thus, my main complaint is that IR managed portfolios tend to increase leverage; and usually at the wrong times.

In simple terms, would you prefer to buy an asset (strategy) with a 15% return and a 30% Vol (IR = 0.5), or a 5.1% return asset with a 3.4% Vol (IR = 1.5)? Seemingly the latter is better, especially if we lever it 3x to a 15.3% return (with a lower volatility). But this is somewhat similar to selling a deep OTM put; usually a winner, until it isn’t.

What is most problematic about using IR for portfolio construction is that it focuses more on the destination than that path. A quoted volatility can be constructed by either a constant (10% annualized) or a variable (5% annualized usually with an occasional rogue wave of 30%) risk path. But while a lightly leveraged portfolio may survive a rough patch, a highly leveraged one may breach established portfolio strictures and force a quick risk reduction via asset sales during a short jolt of volatility.

Despite option theory being just the Physics of Money, I will not delve into Entropy and Enthalpy to prove my point. Instead I will skip to the conclusion that volatility stays low until it isn’t. A low volatility environment encourages more option selling (and more leverage) in a self-reinforcing feedback loop; a pattern that should presently seem familiar. However, once a destabilizing event occurs (adding heat to the system for you propeller heads), risk and leverage must be reduced in a similar, though opposite, feedback loop where asset selling begets more selling. This was how Portfolio Insurance exacerbated (but did not start) the 1987 crash. It is also how Index Amortizing Structured Notes (IANS) exacerbated (but did not start) the 1994 rate jump, and how Capital Structure Arbitrage exacerbated (but did not start) the sub-prime mortgage bond collapse a decade ago.

* * *

So, the ultimate, and frankly the only, question one cares about is identifying the tripwire that would tip our system into disequilibrium and force a self-sustaining reduction in risk (leverage/convexity).

And this is where the conference paid for itself. While most speakers declined to answer, one panel proposed that many of these passive portfolios can be synthetically constructed as long an Index plus short a +/- 4% out-of-the-money strangle. Thus, it seems possible that as little as a 4% decline in a single day could be enough to create critical mass; and this does not seem terribly inconsistent with many current risk parameters.

A decade ago institutional investors supported only 20% of Hedge Fund assets; presently, these investors (with a concomitant demand of narrower risk limits) make up 80% of the asset class. Since it is common for as little as a 6% drawdown to ignite a “stop out” procedure at many Liquid Alternative portfolios, it does not seem unfounded to think that risk reduction measures may preemptively commence near this 4% inflection (strike) point.

This commentary is not a call from Cassandra, but I will note that while every low point in Volatility does not lead to a calamity, extremely low Implied Volatility precedes every financial market dislocation. The purple line below is a variant of the MOVE Index that is once again kissing its thirty-year nadir.

The FED has actively encouraged and supported our current low volatility environment, and certainly this made sense in 2009-2011; but current policy seems to indicate they would like to wean the patient off the opiate of ZIRP. The slight complication is that instead of Portfolio Insurance in 1987, or AAA-Sub-Prime bonds in 2007, financial engineers have found a new way to indirectly market short optionality strategies to investors who may not fully appreciate the risk of a negatively convex profile.

* * *

So, the follow up question on your tongues might necessarily be: “What could be the catalyst to trigger such a significant pull back?

For the record, in a rare burst of modesty, I will say I do not know; that said, I think that Inspector Clouseau will find higher interest rates lurking near the scene of the crime. Moreover, I expect two sets of fingerprints will be found: 1) The FED, and 2) OMB/Treasury. As offered by many analysts, corporate stock buy backs have been an overwhelming support for equity prices. And as shown below, one wonders if the nearly 20% pull-back in 2011 was staunched only by the relentless - blue line - bid from Corporations.

In fact, away from Corporations purchasing equities (buy-backs or mergers), it is unclear who else is supporting the stock market against the relentless demographic tide of Baby Boomers rebalancing their portfolios away from equities and into –blue line- bonds. [You think ObamaCare is divisive, just wait until they “means test” Social Security.]

I can offer no proof, but common sense seems to support the notion that the cost of money (interest rates) should have some bearing on how much money one cares to buy (borrow). So clearly higher rates driven by the FED could reduce buybacks funded by debt. But an additional twist is that the real cost of debt must include tax benefits, and consequently, if tax reform were to include a provision to reduce the tax advantage of corporate borrowing, that would raise the effective cost of debt, and may be the catalyst for reducing share buy-backs.

While President Trump, with some support from Congress, has promised significant policy alternatives with respect to Healthcare, Immigration, Budgeting, and Trade, if asked to point to THE EVENT that will precede a significant bout of noxious volatility, I propose that it will be an unintended consequence of Tax Policy; and specifically, as noted above, related to the effective cost of debt.

In support of this notion, one might recall that Smoot Hawley was a well-intentioned preview of our current “Make America Great Again”; only after its passage did we fully recognize it as an accelerant to the collapse in global trade.

One cannot swing a cat without bumping into some pundit thinking they have revealed a great truth by penning a missive about “the calm before the storm”; but that is not what is noteworthy. Indeed, while it is also concerning that investors in search of yield have (once again) increased their use of leverage, the real flashing yellow light is the negatively convexity profile frequently embedded in portfolio construction.

[Note: Leverage is NOT the same as Convexity; leverage is the ratio of assets to equity while convexity measures the change in risk exposure as various inputs adjust. Buying $100 of stock supported by $50 in cash has a fixed 2:1 leverage while $100 invested in an option will have undulating exposure (relative to its gamma) as prices vibrate.]

To be clear, the focus of this commentary is to highlight that a negatively convex profile governed by a rules-based (quantitative) risk management process can be quite unstable in a volatile environment. So, if there is an investment implication to be derived from these observations, it would be that sizing is more important than entry level to enable one to ride out (unexpected) bouts of extreme volatility.

Chairwoman Yellen’s protestations to the contrary, forget the data, it will take care of itself; watch the major policy debates in D.C. The urgency Republicans feel to fulfill Trump’s campaign promises will likely lead to parliamentary maneuvers to quickly garner 51 votes. This rush may blind them to possible second order effects: A short-term win, but a Pyrrhic Victory.

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Bill of Rights's picture

So many doom calls for a crash.... taking a long SPY....

jcaz's picture

He's been the real brain behind Bill Gross for a long time.....

WTFRLY's picture

I will get beers and fire up the barbeque for that fine day

Antifaschistische's picture

STOP LOSS IN @ -3.99%   PROBLEM SOLVED!!   :)

evoila's picture

The central banks can read just as good as they can print. I wouldn't worry about this too much. The bigger concern is what happens when $1 in debt doesn't produce as much productivity as the cost of said debt. At that point, it's inflection time, but the executives who received their comp based on their stock price will be long gone.

PlayMoney's picture

Fed doesn't allow 4% drops anymore so no worries.

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mike_king's picture

Smoot Hawley passed long after the Depression started. This suthor is wrong except that a crash is coming. Due to debt.

rejected's picture

Martians landing on the moon could do the same thing.

Rainman's picture

4% is optimism maximo .... this sucker will crack at 1%. Fractional reserve banking was a real hoot while it lasted.

Peacefulwarrior's picture

Every Time the Word LEGEND or EXPERT or GURU has been used in association with someone I listened to (which is my own fault for not learning more and not verifying enough before trusting) I lost $$ EVERY TIME. 

ZH Rules have a good Night!

GUS100CORRINA's picture

Derivatives Trading Legend: "As Little As A 4% Decline In One Day Could Start A Critical Crash"

My response: I AGREE COMPLETELY. Just look at the MARGIN DEBT and do the MATH. We are seeing leverage using DEBT as never before. In some cases as much ss 50:1 or more. 

I am sorry, but math says in this environment it won't take very much of a push to get a SNOWBALL of selling started. I now believe that the Central Bankers are terrified which is why we never see corrections any more. With leveraged ETFs, all of the pieces are in place. The XIV etf (VelocityShares Daily Inverse VIX ST ETN) is another example. All the VIX has to do is double and this thing (that trades at $80 per share) can go to 0!!!! OUCH!!!

 

Peacefulwarrior's picture

+1 never underestimate the power FEAR

Chupacabra-322's picture

The vast majority of ZH's especially the veterans here understand fully that there are no more "Bear or Bullish" markets. There's only Fascism & Ponzi.

"If central banks purchase stocks in order to support equity prices, what is the point of having a stock market? The central bank’s ability to create money to support stock prices negates the price discovery function of the stock market."?-Dr. Paul Criag Roberts

"These questions came to mind when we learned that the central bank of Switzerland, the Swiss National Bank, purchased 3,300,000 shares of Apple stock in the first quarter of this year, adding 500,000 shares in the second quarter. Smart money would have been selling, not buying.

It turns out that the Swiss central bank, in addition to its Apple stock, holds very large equity positions, ranging from $250,000,000 to $637,000,000, in numerous US corporations — Exxon Mobil, Microsoft, Google, Johnson & Johnson, General Electric, Procter & Gamble, Verizon, AT&T, Pfizer, Chevron, Merck, Facebook, Pepsico, Coca Cola, Disney, Valeant, IBM, Gilead, Amazon."
-Dr. Paul Craig Roberts

http://www.zerohedge.com/news/2015-08-28/dollar-spikes-risk-slides-after...

mummster's picture

I've wondered about this fact as well. In the short term, they have been "good Central Bankers" and have supported the Ponzi scheme along with their brethern. In the longer term, if we go into hyperinflation, they will own a massive portfolio in the "cream of the crop" American business.

Scuba Steve's picture

let me guess, Red Shield owns Swiss Cent\Nat Bank ...

peopledontwanttruth's picture

When EVERYTHING from bonds to stocks on borrowed money to derivatives and fractional reserve banking and they're all debt instruments, it's all violatile. It's only a matter of time.

There's no sound money anywhere. Welcome to the grand illusion

Spinkbottle's picture

Implying there'll ever be a 4% decline. Be it over a day, a month, or 6 million years.

shoWTHyme's picture

Yeah, that dip after Brexit only hit 5.3% (from closing June 23 to closing June 27, https://www.google.com/finance/historical?cid=626307&startdate=Jun+20%2C...) and I'm headed for the soup kitchen now.

 

But they'd never allow that, so it must have been fake news.

BurningBetty's picture

No one seem to point out that the market has been cornered by the CBs? As the amount of participants decreases and the  market ownership by CBs increases, the volatility is dropping untill it's game over; 100% CB ownership.

HalinCA's picture

A+ professor! 

 

CBs can create infinite amounts of money to buy whatever needs buying ...

Scuba Steve's picture

unless of course, Russia n China are viable competitors.

I'm thinking some state constitutions are going to be re-written and the colonies are going to finally break up.

Finish what the south wanted to do 150 years ago.

In.Sip.ient's picture

So the DOW takes a dump to 20,500 tomorrow

( currently at the 21,430 level ) and shows over???

 

Well... let's see...

 

armageddon addahere's picture

In other words when the shit hits the fan, even a 4% drop will send the big boys screaming for the exits and when that happens goodbye market.

Add to that, the fact that the market has been artificially supported since 2009, and the institutions doing the supporting would love for Donald Trump to take the blame when they pull the rug out, and it looks like you should be ready to bail any time if you are smart. If you have money invested with a big hedge fund  or otherwise are too big to get out of the market in a day, it might be a good time to lighten up.

Chupacabra-322's picture

Wells Fargo has a derivative exposure of $3.332 Trillion dollars.
Its a too big to fail (TBTF) bank. WF has been charged for its role in allegedly pursuing illegal foreclosures and deceptive loan servicing. Wells Fargo was just slapped with a $85 million fine by Federal Reserve for putting good credit borrowers into bad-credit rating (high rate) loans.

In March 2010, Wachovia (owned by Wells Fargo) paid $110 million fine for allowing transactions connected to drug smuggling and a $50 million fine for failing to monitor cash used to ship 22 tons of cocaine. It also failed to monitor $378.4 billion (that's $378400 millions dollars) worth of transactions to Mexican "casas de cambio" (think WesternUnion, anonymous cash transfer) usually linked to drug cartels. Beyond that, WF lets its' VIP employees live in foreclosed mansions. WF knows how to cash your legit check, then claim "fraud" and close your account. WF also re-orders your transactions to create more overdraft fees. Wells Fargo's Wachovia also got a SECRET $159 billion bailout from the Federal Reserve.

Wells Fargo paid NO taxes in 2008-2010 and had a tax rate of NEGATIVE 1.4% while making $49 billion in profit during the same time.

buzzsaw99's picture

when there are no dips to buy selling deep otm puts doesn't seem very risky at all to me.  worst case buy the stock at an amount already agreed upon which is much lower than the current price.  I guess if the price totally cratered and one couldn't cover that would suck.  too bad, so sad.

Snaffew's picture

i can't remember when all indices have been down together for 3 trading days in a row...countless days up in conjunction...i remember an 11 day up run for all 3 post trump...11 fucking trading days in a row(sorry...1 day was down 1.2 points)...there was a run of 12 ups out of 14 w/ the 2 down days being a couple points---all based on hope?  When hope doesn't pan out...then the markets go up on...a prayer?  when the prayer isn't answered the markets will go up on what?

Chupacabra-322's picture

Derivatives: The Unregulated Global Casino for Banks

SHORT STORY: Pick something of value, make bets on the future value of "something", add contract & you have a derivative.
Banks make massive profits on derivatives, and when the bubble bursts chances are the tax payer will end up with the bill.
This visualizes the total coverage for derivatives (notional). Similar to insurance company's total coverage for all cars.

LONG STORY: A derivative is a legal bet (contract) that derives its value from another asset, such as the future or current value of oil, government bonds or anything else. Ex- A derivative buys you the option (but not obligation) to buy oil in 6 months for today's price/any agreed price, hoping that oil will cost more in future. (I'll bet you it'll cost more in 6 months). Derivative can also be used as insurance, betting that a loan will or won't default before a given date. So its a big betting system, like a Casino, but instead of betting on cards and roulette, you bet on future values and performance of practically anything that holds value. The system is not regulated what-so-ever, and you can buy a derivative on an existing derivative.

Most large banks try to prevent smaller investors from gaining access to the derivative market on the basis of there being too much risk. Deriv. market has blown a galactic bubble, just like the real estate bubble or stock market bubble (that's going on right now). Since there is literally no economist in the world that knows exactly how the derivative money flows or how the system works, while derivatives are traded in microseconds by computers, we really don't know what will trigger the crash, or when it will happen, but considering the global financial crisis this system is in for tough times, that will be catastrophic for the world financial system since the 9 largest banks shown below hold a total of $228.72 trillion in Derivatives - Approximately 3 times the entire world economy. No government in world has money for this bailout. Lets take a look at what banks have the biggest Derivative Exposures and what scandals they've been lately involved in. Derivative Data Source: ZeroHedge.

http://demonocracy.info/infographics/usa/derivatives/bank_exposure.html

http://www.zerohedge.com/sites/default/files/images/user5/imageroot/2012...

HalinCA's picture

Derivatives need to be made illegal and all existing ones wound down before they implode.

HalinCA's picture

Nah .... as long as the most trading is done by brainless algorithms, what can go wrong?

They don't 'see' the future ... they don't 'worry' ... they don't care if 30 millions Koreans get vaporized overnight ...

They are what have held the markets together for a couple of years now, at least.

They don't have 'common sense' and they don't care about their children.

And if some movement looks like its headed toward that magical 4% number, the circuit breakers will pop and the CBs of the world will intervene massively.

CBs can almost instantly create mony to buy whatever needs to be bought ...

So why worry?

The only way things could go wacky is if a virus or a backhoe hits a CB link to the trading floor ...

 

Sonny Brakes's picture

Get on with it already.

hola dos cola's picture

Study algo f-ups to develop bait.

Condition algos through baiting.

From behaviour distil a tag/tags; superbait

At the opportune moment stick* the tag on the dominant algo.

#TIDT

 

*fake news

hola dos cola's picture

Question: Is it possible to single out an algo through (outside; codeless) observation?

Fartboxbuffet's picture

Well fuk it nothing gonna change weve been had im gonna have a few beer turn up master of puppets and try to beat my meat to the beat and see if i can hit light switch with my load

OCnStiggs's picture

"To be clear, the focus of this commentary is to highlight that a negatively convex profile governed by a rules-based (quantitative) risk management process can be quite unstable in a volatile environment."

Anyone who can understand comments like the above need medical attention. If this kind of financial brain-vomit passes for common sense, no wonder we are in the derivatives pickle we are in. Its this kind of lunacy that created and sold them in the first place.

Stupid is as stupid does...

syzygysus's picture

<– grab a pussy
<– swing a cat

zrussell's picture

read financial gobbledygook info overload article for the day... check.

 

this guy needs to unwind from the previous career by sitting in the middle of death valley for a month, and contemplating the universe!

Anon2017's picture

"You think ObamaCare is divisive, just wait until they “means test” Social Security."

Means testing of Social Security began on a small scale via the backdoor about a decade ago with the introduction of Medicare premium surcharges. The base at which the surcharges kick in has not been adjusted for inflation in several years and is not scheduled to be increased until 2019, by which time some seniors will be impacted with a new surcharge that takes effect in 2018. An increase in Medicare premiums means a net reduction in your monthly Social Security check. For more details, read here: http://www.kff.org/medicare/issue-brief/medicares-income-related-premium...  

Econogeek's picture

So from here, he's saying 800+ down on the Dow and 100 on the S&P in one day should trigger panic selling.  He says one day, not a few consecutive days.

Hard to imagine the Fed wouldn't buy buy buy for a few hours until one of the circuit breaker thresholds could be changed retroactively to maybe 3 percent down in a half-day, or something transparent like that.

Skew Views's picture

What seems to be missing from all 'crash' theories, is the undedrestimated role of technology.
Analytical 'algos' have increased liquidity and removed the fear factor possessed by humans.
When we click of a 1 to 4% downtick, smart algos will battle it out and quickly establish support levels.
Panic may ensue for individual investors. But the robots will take advantage and buy it up.

skewviews@gmail.com