Episode #252: Cem Karsan, Aegea Capital, “30 Day Vol Tends To Be Overbid And You Have Extended Supply In The Back Of The Curve Historically”
Guest: Cem Karsan is Founder and Senior Managing Partner of Aegea Capital Management, LLC, as well as its Head of Research and Risk Management.
Date Recorded: 9/23/2020 | Run-Time: 56:03
Sponsor: Ikon Pass
Summary: In today’s episode, we’re getting deep into the weeds of market volatility. We hear from Cem about cutting his teeth in market making and S&P 500 equity options and eventually launching a strategy focused on long-volatility.
We get into structural inefficiencies around market vol that tend to increase during times of market stress. We talk about what the year has looked like so far from his perspective, and the feedback loop and risks associated with liquidity, compressed risk premia, and a low-yield environment. We chat about what he sees markets pricing in and risk perceptions around the election, and some trade ideas to potentially take advantage of what he believes is mispriced volatility in the December to January period.
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Links from the Episode:
- 0:40 – Sponsor: Ikon Pass
- 1:21 – Intro
- 2:17 – Welcome to our guest, Cem Karsan
- 5:09 – Trading philosophy for Aegea Capital
- 6:43 – An example of what the strategy looks like
- 11:00 – Implementing a long vol strategy
- 13:34 – Structural inefficiencies
- 16:42 – How the changing markets has impacted the strategy
- 22:18 – Adapting the strategy
- 25:59 – What 2020 has meant for Aegea
- 29:04 – Chance of bonds going negative in the US
- 30:40 – Cem’s view on the markets today and near-term outlook
- 33:17 – How the markets are pricing the election
- 37:28 – Election odds
- 40:46 – Diversifying
- 43:59 – Robinhood, Portnoy, etc.
- 47:52 – The outlook over the next 10 years
- 49:34 – Capacity for vol arb
- 50:41 – Most memorable investment/trade of his career
- 52:35 – Vol expectations
- 54:55 – Connect with Cem: twitter @jam_croissant, aegeacapital.com
Transcript of Episode 252:
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Meb: What’s up, friends? Super interesting show for you today. Our guest is founder and senior managing partner of Aegea Capital Management. In today’s chat, we’re getting deep into the weeds of market volatility. We hear from our guest about cutting his teeth in market making, and S&P 500 equity options and eventually launching a long vol strategy. We get into structural inefficiencies around market vol that tend to increase during times of market stress. We talk about what the year has looked like so far, from his perspective, and the feedback loop, and risks associated with liquidity, compressed risk premia, and a low yield environment. We chat about what he sees markets are pricing in and risk perceptions around the election and some trade ideas to potentially take advantage of what he believes is mispriced volatility in the December to January period. Please enjoy this episode with Aegea Capital’s, Cem Karsan. Cem, welcome to the show.
Cem: Thanks for having me. It’s nice to be here.
Meb: I am as ecstatic. As most of our listeners know, I love having newbies on. We got a podcast version today, folks, introduced by a common friend. Cem, give us a quick background. I know you’re in Chicago, give us a quick one to two-minute overview of your origin story and then we’re gonna get super weird and deep, all things vol.
Cem: Sounds good. Yeah, born in London, I lived in Turkey as a child, moved to Texas after that, and kind of grew up in that stateside educated here. Parents lived Norway, went to prep school on the East Coast. kind of got a real interesting look at the world early on, and I got to travel a lot, always interested in math, econ, public policy, and that kind of took me down a derivatives trail. I went to Rice University for college, did math, econ, policy there. And then natural landing place after college was Chicago, knowing I was interested in derivatives. Started in market making land in the S&P 500 equity options in 1998. Trial by fire during the tech bubble, moved up the chain pretty quickly given my background. And was fortunate enough in 2003, to leave and start a big market-making operation for a prior specialist firm, Bear Wagner Specialists out of New York. They were looking to diversify into the market-making world, and we built a 25-person operation for them. And eventually, in 2006, I left and started my own market-making operation. Good timing. Right during the beginning of the financial crisis in 2007, we became about 13% of SPX volume during that time. We played across equity indexes, as well as ETFs, but really equity vol. And really cut my teeth during that time and really built out some new trend following stuff and some structured trades. Eventually sold my stake in that business in 2010 when I had like 95% of my net worth in it and started Aegea Capital after a year-and-a-half, kind of enjoying the fruits of my labour at late 2011. So, Aegea Capital has been around like I said, eight-and-a-half years. We trade volatility products, mostly algorithmic and quantitative approach. Our flagship product is long vol and has been which has been a slog, as you’d imagine starting in late 2011 until recently, but we have kicked off north of 10% Alpha a year with positive returns long vol throughout that whole period. It’s gone over two minutes, but that’s kind of the origin story and kind of brings us to today.
Meb: You and I would have overlapped at one point at Rice. I was only there for about a week. I was a super nerd and I went to a tissue engineering conference once there as an undergrad. You guys were known for a big biotech program there, but I decided it’s too damn hot. I couldn’t take it. I had to spend all the time indoors. It was too hot. I think it was in the summertime. All right, so interesting because you cut your teeth in a few different market environments. You mentioned starting your firm about the same time we started ours prior firm in ’06 right before the financial crisis. And then you’ve had this pretty mellow period since. Talk to me a little bit about Aegea, though. That’s what we’ll kind of focus on, some of the ideas. When you say long vol, that means a lot of different things to a lot of different people. So give us sort of an overview of the strategy, the process, what that means to you guys.
Cem: Yeah, absolutely. So, we really take focus on long vol in both the VIX and equity index land. We do look at a couple of other products, but we’re focused on equity vol. We really believe based on extensive research that the peak has for 40 years been in 30-day vol. Even though long term vol is theoretically higher and skew extended is theoretically higher, the actual structural demand kinks the 30 days. So we actually try and focus on capitalizing on the inefficiency and relative peaks in the 30-day vol and look at hedging that with tail products up in the VIX calling, as well as some other dispersion trades depending on the vol environment. We really have a machine learning quantitative background. So we’re kind of out there really studying different environments, What’s happened long term? What’s happening now? But where it’s informed by 20 plus years of experience in these products and how things have moved. I think we’ll get into that a little bit later.
Meb: Yeah. So maybe tell me a little bit about, you don’t have to give away the secret sauce, but maybe any just general examples of what a trade may look like or what a strategy may look like, just so people can have a broad understanding of what you guys might be doing when you’re talking about some of these ideas?
Cem: Yeah, so without going too deep, we’re essentially looking at the peak of skew and domestic indexes is generally, in the monthly, it’s about 30 days out, we’re looking to monetize that skew based on… We basically take a distribution of a market events based on different market environments. We look at the potential moves underlying in that vol environment, scale to strategy, and then look at the volatility surface across both ETFs, that single list names as well as the VIX and find not just what’s high and low on the curve, but what relative to potential outcomes sticks out. We then structure a trade based on our tools and proprietary technology that allows us to put a position on that is long tails, long Vega, within a band has a very structured position and shape and has a positive expectancy over that period relative to risk-return. The idea being that there’s always opportunities on the curve based on supply and demand dynamics, but intrinsically structuring it with tail and convexity.
Meb: And so, what’s the actual products you guys are trading? Is it options on ETFs, options on indexes? Are you mixing in futures, ETNs? What’s the toolkit?
Cem: All the above. The flagship is obviously the SPX options over the CBOE, as well as the e-mini options over at the Merck. But we also trade the VIX futures, VIX calls, and puts the options on the VIX as well as all the ETFs and larger equity options as well. We’ve traded some structured products over the counter, but we keep that to a minimum, and we really think liquidity is key when you’re being long volatility and you want to make sure that you have the ability to monetize appropriately and don’t want things marked against us.
Meb: And you’re not trading any other markets. I assume you’re not trading international equities or fixed income or commodities or anything else? Is it mainly focused on U.S. sort of concepts?
Cem: We’re focused domestically. We do obviously watch and look at Euro stocks as well as NIKKEI and KOSPI, and those factors feed into our models. One thing I didn’t mention is we also run a CTA trend-following strategy proprietarily. This is not for public consumption currently. But that trend following strategy is it produces feed into our vol strategies as well. So it’s not just Volare [SP]. It’s also looking at reactional components. And what makes that one unique is really its vol indicators. We’re looking at vol indicators across the board, where supply-demand dynamics are imbalanced at what points, and how that helps indicate price direction, generally, on a daily, weekly and monthly level. We’re not very high frequency. But those vol indicators have always been great, really had a nice edge to CTA trend following and what we’ve discovered is over really the last eight years their efficacy has exponentially grown as well. So…
Meb: And so on the vol ARB side, like, how active is this? Is this something that, like, you’re updating on a minute by minute, hour by hour? Are you doing daily? How long did the trades last? Is this something in the short-term, long term, how’s it kind of the position sizing, risk management, all work into the book?
Cem: Our distributions that we look at are five days or weekly, so we are forced to rebalance at a minimum weekly. But for the most part, our average hold time is a day-and-a-half. So, the trades rebalance quite quickly based on market environments. Obviously, in a low vol environment, they’re gonna rebalance more slowly, in a higher vol environment more quickly. Our rebalances are driven by moves in implied volatility, as well as market underlying movements. They’re really focused on kind of delta skew points and making sure that trades are balanced on a risk to profitability kind of metric. So, making sure that everything is constantly optimal, routed to slippage, and making sure that we’re in the best part of the curve at all times.
Meb: So, before we get into some of the regimes over the past number of years and decades, perhaps, any other ideas like when it comes to actual portfolio strategy that I’m glossing over that when you’re talking to institutions or investors, one maybe, like where does this fit in? How should people think about a strategy like this? But also, any other mechanics or things that I missed out on before we sort of skip over to some other ideas?
Cem: Look, this is meant to be a 5% to 10% of portfolio. It’s non-correlated to pretty much every single other product out there. It is by definition, a tail and convexity hedge that you can put in your portfolio for structured alpha. If you look at a long put, you know, out there that generally historically has yielded south of expected value of that over a long period is 10% to 20% negative per year of scale to capital. We’re kicking off at about 10% alpha on average over what has been a very low vol period. So, being able to add that into your portfolio is not only important on a kind of beta adjusted basis, but more importantly, having that tail exposure that allows you to buy in times of stress, not liquidate parts of your portfolio at the most opportune times. And I think that’s really the big argument here that people miss a lot of the time, is, why have that tail hedge in the portfolio, especially if you can sit on poor performance for relatively long periods of time? And the answer is to obviously be in a position of strength when things are at their most desirable to buy.
Meb: When does this sort of strategy work best? When does it face headwinds?
Cem: The best performance for the strategy in the last eight years has been August 2015, Yuan’s evaluation, we obviously made about 30%, February 2018, similar number, and obviously, March of this year, at a peak of about 50%, up 50% for the month. It does well not only in big kind of moves, but if and when you get to…which we haven’t really get a secular move, like in 2008 to the downside, it has actually its best performance. So, it does have a tail component, but it also does quite well. This month and last month would be a good example, in a trending market as well, trending down market. So, it was informed by a lot of my greatest successes, which were in 2008, 2009, as well as kind of .com bubble. So it will do very well month after month by taking advantage of a structural inefficiency that increases during those times of stress and ultimately will pay dividends month after month.
Meb: Tell me a little bit more about that comment. Structural inefficiencies in markets often don’t exist, they’re hard to find or you’re taking advantage of something, whether it’s behavioural, macro, technical, tax-related, people being idiots, whatever the category is. Why does this sort of approach continue to exist? What is the structural inefficiency? Anything more you can say on that point?
Cem: There is a heuristic in vol markets, I would say. Money managers don’t want to buy a long-dated vol, for the most part. They see it as a drain on month after month of cost. They also see theoretically as long dated vol as being for lack of a better term, kind of the highest implied volatilities, the highest skew. There’s a natural inclination to not buy longer-dated vol and to buy a one-month vol. That allows them to hedge dynamically when they see fit. They also don’t want to manage a big structure position with longer vol versus shorter vol and rebalance it on a constant basis. So, money managers will jump in and buy puts when they feel it is best. They’re also… Because of this tendency which has been there for, like I said, 40 years, products have developed around these tendencies like the VIX to help support buying of that kind of dynamic 30-day vol. And so all of these factors force demand, which ultimately if you’re ever looking for a structural inefficiency, it’s gonna be a supply and demand imbalance. And there’s a massive supply and demand imbalance in 30-day vol, 30-day vol tends to be overbid. And you have extended supply in the back of the curve historically, not just because of a lack of demand, but you have sellers on a Delta adjusted basis. Delta sticky skew in vol are longer dated, whether it’s an institutional manager like Warren Buffett or Carl Icahn, but you have sellers out there or CTAs, that just like to sell that stuff. So, you get this kind of kink in the curve, I guess, I would say, and it’s not just a visual kink, but relative to expected outcomes. I think an important part here, I’ll go down a little bit of a rabbit hole too, is people like to look at this stuff, theoretically. And you may get some arguments back on this, that, “Oh, longer stuff is still theoretically more expensive.”
I think the important takeaway here is, the longer out you get, there’s a liquidity premium that should exist, like you saw during long-term capital management, other crises, the longer-dated you go, and it’s not just a matter of realized versus implied vol that matters, it’s really a function of supply and demand. And a longer dated vol ultimately has a tail on it. The long end, especially during a secular down move, like we saw in ’08. And owning that stuff can be… You have a limited downside with big structural upside on the tail and how that can perform. Whereas one-month vol is ultimately going to decline into expiration, expiration that is immutable. And you’re able to hedge the gamma effects of that 30-day vol into that decline with shorter-dated options the next n vol. And there’s a way to structure these trades, where you can get long Vega, long skew, collect kind of decay, have convexity, and do it in a way where you’re taking advantage of the kind of some of the structural mispricing that exists. It’s something like I said, that’s worked for a period of time. And the inefficiency if anything has increased with the increase in demand for vol products and the introduction of products like the VIX.
Meb: So, you’ve existed and survived, which is a compliment, we often tell people in our world, through long vol, but also through a few different totally different types of crisis. I was smiling as you were talking about secular bear markets and trends. And I was gonna say, what’s that? We haven’t seen one of those in a while. But talk to me a little bit about, have there been any different…? I mean, obviously, there’s different environments. I mean, 2017, the market went up every single month. And then you have things like this year, which is totally different. And then the financial crisis and you highlighted a few different months. What is sort of like vol and liquidity over the last 10? And for you feel free to extend to 20 years because you’ve been doing this sort of for a while. What’s changed? What’s been the same? How do you survive certain periods of fallow and famine and everything else in between? Any general thoughts?
Cem: Yeah, it’s changed a lot. I think anybody who’s been in this market for 20 years has seen a dramatic change in the way these markets work. There’s structural dramatic changes, primarily driven by the Federal Reserve and increased liquidity. Vol compression, really starting after the tech bubble with lower interest rates in response to that liquidity crisis have crushed risk premia, risk premia in all terms, not just volatility products, but credit spreads. I mean, I don’t have to tell most of your people listening to this podcast, but you have the massive increase in carry trades, lack of liquidity premium and products. And that crushing or I guess, the production compression of risk premia has led to a very different market. There is a move, I would say… There’s a feedback loop into kind of markets. With that risk premium, compressed, you essentially create markets like in 2017, which I think is really kind of the best example on where implied volatilities are historically lower. And realized volatilities as a result are lower than they’ve ever been in history. And that’s not a coincidence. The feedback loop of low risk premia leads to everybody being a long gamma and hedging much shorter periods. We didn’t move greater than I believe 3% in 2017 to the downside. And as kind of proof positive that there is a feedback loop, I think 2017 is a great example. 2017, we saw also, historically, the lowest correlation in equities by 20%. And again, not a coincidence. So why is that? Implied volatility is compressed. And the index isn’t particular, which is where all the compression happens from volatility selling. There’s still idiosyncratic risk. At the end of the day, markets, single stocks will move based on coming up with cure or better earnings or some idiosyncratic issue. And when one stock goes up, another stock has to go down, it’s the implied volatility as the risk premia is compressed.
And so, a lot of people think it’s the other way around, that correlations were the lowest they’ve ever been, so implied volatility was compressed. We have a strong belief based on history that the opposite is true. That risk premia being compressed has really led to structural changes in the way these things move. And so you have a much lower realized volatility locally than you’ve ever had, relative to history, but bigger, faster, more painful moves that happened on the tail. So essentially all liquidity has been moved to local and, you know, the moral hazard and the Fed being in the game has essentially led to bigger and more painful tails. So, that’s the biggest change in the markets. I think that is probably the biggest change that have been big changes based on that and how the implied volatility surfaces of equity options have moved. They don’t move the way they did 20 years ago, particularly skew in these products. You have longer-dated skew, really getting compressed into down moves and really going to higher highs than it’s ever been. The range has dramatically increased relative to history. The idea, again, being that secular moves are not in the data set for the last 20 years. And what works based on automated models and past investing is to sell the longer-dated vol and skew into a drop in the market and buy gamma protection that allows you to lever into vol selling and essentially leverage buying of the dip. These trades work and have very high Sharpe ratios. And as long as you’re creating a strategy that cuts that tail when it needs to, and that’s based on a lot of assumptions that you can do that, selling that vol and skew into a dip and buying it back when the markets rallying is the way to keep short vol and to keep collecting that premium.
That has completely changed the structure of how these volatility services work and move and changed a lot of strategies that used to work. And so at the end of the day, and this is a big kind of issue that we can talk about as well, is if that liquidity were to ever change, if interest rates were to no longer be pinned near zero, or were to actually come off that level, the implications for this market and the way it moves, and the ability for a secular decline to happen, I think dramatically increase. I think the Federal Reserve knows that. But there are very few points in these data sets that people are running and trading these products that points to that. So, I think if anything, that makes it even more dangerous and more likely to have a change in monetary or fiscal policy, which we may be facing here, going forward, can change kind of the movement and the way that vol and risk premia products are trading, and can have a dramatic effect on what happens in the next 4 to 8 years.
Meb: All right, I got a lot to add. How much input…? And the struggle I always have with markets, of course, is this time different, being able to try to figure out how much is a structural change and how much is just business as usual? You referenced long-term capital, it’s such a great example on a lot of levels, of this. How do you sort of manage that process over the years? I mean, because there’s so many different levers. You mentioned some of the put selling and just vol selling strategies and how much impact that may have, how much of its fiscal, how much monetary, how much for something just getting pushed one way. I guess part of my question is also just how much of what you’re doing is just purely algorithmic and how much have you had to change and adapt over the years?
Cem: We’ve had to adapt a lot. Obviously, the first 10 years I traded are very different than this world. I think it’s important, though, to have that experience. I think a lot of people managing money now don’t know what it was like 20, 30 years ago, and what another market looks like. I think the increased financialization, automation of a lot of these passive ETFs, ultimately, most of that based on data for the last 20 years, which is a very in my mind, historically unique environment. You have to respect the reality of the last 20 years and position yourself accordingly. But also be prepared that, especially given where we are, both in terms of policy and politics, I think it is important as well, that interest rates could very well move higher and go back to what would be a completely different regime that had very little to do with the last 20 years. And again, I think the leverage in the system, not just leverage in traditional senses, but leverage in all of these risk premia products, which really increase into extended moves, like we saw in March, really create a dynamic, especially if it were to ever be a secular move because again, if something like March happens, and it’s quick, and you’re able to save in that mark to market certain products and have losses come back, things are okay. But if you have a system where people in longer-dated volatility… I think a great example is ’08, you know, we saw 10-year vol, which makes no sense on a rational sense go to north of 60. That doesn’t make sense. Nobody thought that 10-year vol would be 60. But a leverage in the system created a situation where people had to buy it back at those levels.
And just like in 2006, prior to the financial crisis, 10-year vol was I believe running at around 13. Again, ridiculous, it doesn’t make any sense but the feedback loop in these markets can do crazy things. And so, add to that the amount of leverage that’s in the system, and no matter how big these positions are now, across the money management space embedded into structured products, you can really get a situation where the effects are almost untenable for an entire economy, not to be Dr. Doom, or… I think there are real aspects of this market that are built on a lot of assumptions. And the recent assumptions, they’re based on, again, data sets that are not particularly relevant for longer-term timeframes and different regimes. And I think we’re entering a time now, in particular, where at least the perception of the very minimum of a potential change, given potential fiscal policy and potential inflation could really change kind of the liquidity dynamic that has really supported a lot of the trading and performance of certain strategies.
Meb: I was gonna use the more technical phrase, “Shit’s gonna get weird,” but I figured we’ll keep it just pretty basic vernacular. Cem, talk to me about 2020. You mentioned 10-year vol blew out. Was this year too quick? Did it happen in March? Maybe walk us through just kind of what this year has looked like so far.
Cem: Yeah. So this year, again, and very little has been talked about how March happened and how it ended so quickly. I mean, the bottom really happened right at March expiration. The quarterly exploration derivatives played a significant role, and the liquidation that happened at the bottom. It has really since 2015, at least every major downturn, all of them have been resolved, though, with Federal Reserve liquidity, and greater and greater amounts that have been necessary obviously. You know, there’s a lot of talk about how the Fed’s pushing on a string and it needs greater and greater medication to solve the metaphorical illness. And the idea there is by increasing liquidities to allow these risk premia trades really. And that’s what nobody talks about, that much to not get out of hand, to not allow the market to market losses, and these credit spread losses, and these vol product losses, structured products on and on, to snowball to a point of a lack of confidence in the system. The problem is, again, great, you can continue to support this market and not allow it to decline but at some point, which has happened over the last 20 years, it’s a long time, creates a moral hazard, A, so people are…systems and programs are set up to take advantage of this and assume that tail, have the lower probability than it actually has. And they’re also forced because of the compression of the yields in these risk premia to really because of a scarcity of potential yield. Obviously, there’s that Tina effect, where it leads to even more selling and more compression. So you have a leveraged system, with more selling because of a fear of missing out, a lack of potential other options, scarcity, paired with a moral hazard. Creates a massive system that’s self-reinforcing.
And if you ever have a system where liquidity disappears, the effects are exponentially worse than they ever were. The Federal Reserve knows this. But there’s very few ways out. And I think the reality is, if they really want inflation, that’s what they’re talking about now, I think not enough ink has been spilled on the effects of inflation and how it can unpin the risk premia trades that have been supporting all of this leverage in the system. I think that’s an unintended consequence that’s not being explored and thought about by the Federal Reserve and by many market participants at this point. Again, higher interest rates, a de-levering of the system is ultimately at these, given the way the system works, given the positions that are out there, is incredibly bearish long-term. And again, would mean a complete regime change, it would lead to a growth value, rerotation out of growth and into value, it would lead to a reduction of vol selling and unpin the markets in a lot of ways. And I could go on and on. But I think there’s so many assumptions built into current models and understanding that the tails are now, with the potential risks of a move towards a more inflationary environment, really opens the door for a completely different regime with completely different strategies.
Meb: 2020 has been weird already. We’ve had negative-yielding sovereigns around the world. Oil futures traded negative at one point, all the other crazy things going on, the whole Broncos line-up is hurt. So, we’re recording this just time dating, September 23rd. What do you think the chances as far as regimes, and this is more of a happy hour, coffee gossip question? Do you think there’s a very real possibility, no possibility, something in between for sovereign bonds in the U.S. to go negative? Do you discount that as something that’s no chance, like on the tenure or probable? What’s your thoughts?
Cem: I think it’s highly likely. And the reason I say that is, I think the Federal Reserve is going to be forced in the next downturn, to do exponentially greater things. I think they’re going to have to control. They’re going to have to… The amount of leverage and the risks in the system at this point are such that, on the next decline, in order to prevent a secular decline again, they’re going to have to roll out anything that they can. I wouldn’t put it past buying stocks. I wouldn’t put it past selling volatility products directly. I don’t think anybody really talks about that. But I think those are things that ultimately can they…the “don’t fight the Fed” thing is…all that matters is what limits are placed upon their ability to do things. Right now, they can’t legally buy stocks. But will Congress eventually give them that ability, if things are bad enough, maybe? I think things will get a lot weirder and a lot more upside-down than you could ever possibly imagine, as is almost always the case.
Meb: I mean, that is definitely a non-consensus view that 2020 is gonna get weirder than it already is. This has been I think, for many people, an entire decade fit into nine months. And by the way, we still have three months left. So, rest of the year, what does the world look like right now, as far as vol strategies? I mean, normally, this is the time of year when things start to get pretty jiggy, October through December. Everyone seems to be back from summertime in whatever sort of weird pandemic normalcy they find themselves in. As we look to this year, any general thoughts on what the world looks like today and a few months into the future?
Cem: Yeah, look, there are some really crazy things going on and on the volatility surface, historically, you have a situation where long-term… When I say long term, December, January vol during the election, given the fears of contested election are pricing at dramatically higher than something we’ve ever seen. The election straddle, like the one-day straddle for the election itself is only running at about $80, which is not that high, which given $80 for the S&P 500. So we’re talking 2.5%. If anything, if you ask me, that’s cheap. But behind that, the pricing in $110 to $115 daily moves, which we’re talking, you know, 3.5% daily moves in the S&P throughout December and January, those are dramatic moves. We’re talking about risk perceptions, especially given that there’s a real possibility despite common perception that when one side wins outright, as in this election, everybody just assumes it will be, these vol levels out there are really high. And if you think about the fact that volatility being compressed, particularly in the indexes right now is what’s been holding this market together, you’re seeing a lot of stress and pockets across the market. But moves are being compressed by index volatility being relative to realized, because if you actually look at realized versus implied right now, they’re almost right on top of each other. There’s almost no risk premia in these volatility markets. And that’s just because they’re very oversupplied currently and in the front of the curve. So, yeah, my point here is at the end of the day, right now risk premia compression is holding this market from anything dramatic happening. But if you look forward in post-election, that’s not the case. That vol, implied vol is priced incredibly high. And so, imagine a situation where you have these pockets that are starting to really blow out and now you no longer have risk premia, that feedback loop calming the market, allowing it to function without stress, and instead being a tail where that can promote a tail.
Meb: What’s the takeaway there? Because there’s a couple of different moving parts and speak to your layman, which I am, say is it people are expecting a contested election, one, through their views in the derivative markets, which, by the way, I don’t really do politics Twitter, but it doesn’t seem like a consensus view. Maybe it is. And then second, is there anything to take advantage of or avoid when it comes to the next three months?
Cem: Great question. So, time gating this is important. But really the last several days into this decline, you’ve seen interesting dynamic roads in the recent history with calendar spreads really expanding dramatically. That should continue based on where election vol is, given the compression feedback I keep talking about that’s happening in the markets due to low implied vol. And implied vol is very low. It’s allowing people to hedge at relatively cheap costs, but in the short-term, but like I said, long-term, that’s not the case. Eventually, we’re gonna move away from the short-term vol. And if you expand these calendar spreads, if you expand long term Vega, and make that really high and make the curve very steep, eventually, over time, you’re gonna keep trending to higher and higher volatilities. And eventually, that pinning of the market, like I was saying, can cause a disruption, allowing of these other factors. like credit spreads beginning to increase, which is happening in the last couple of days to really start taking over and risk to kind of snowball. So things to take advantage of, I would be positioning, and we are positioned to take advantage of a volatile move, potentially post-election. There are great opportunities to do this for very low cost because there’s a lot of inefficiency in the curve, structural inefficiencies, not a 30 day per se. But because of these fears that are happening for a contested election, you have situations where February vol is very low relative to December-January, as well as kind of November monthly election vol being really cheap, based on probabilities of a contested election, etc. You can really put on structured fly trades in the indexes versus kind of VIX, ETNs, and ETFs that allow you the long volatility, while still being…collecting, kind of harvesting some of the extra what we believe is mispriced volatility in that December to January period. Again, the key is to be long vol, position yourself for a tail because I think it’s likely to happen in that December-January period.
Meb: Feet to the fire, gun to the head, Cem, what’s the percent odds you’re putting on a contested election?
Cem: I think it’s over… If you look at what the market’s pricing, the market’s pricing a north of 65% chance.
Meb: Oh, Lordy.
Cem: Which is crazy. I agree with you. Is it a real risk? Absolutely. I don’t want to be dismissive of it. I’m not saying, “Go sell that vol in a vacuum.” I’m actually saying the opposite. Be long volatility or position yourself to be able to take advantage of an increased likelihood of something happening, just because implied volatilities are high during that period and the constructed risks that exist out there going forward with fiscal policy, etc. But in terms of specifically contested election risk, I believe it’s high. If I was to define, what is a contested election? What does that look like? Is that something that gets resolved relatively quickly, within a week? Are we taking this to December 14th, which is when the electoral college meets? Are you taking it to…? Is it a tie and you’re taking it to January to a congressional vote? And Bush versus Gore Supreme Court settled on December 12th because the electoral college met the next day on December 13th. So, you have to understand these dynamics, understand what’s possible, what’s not, what the odds are, what the magnitude of the mood might be in those given environments and structure yourself accordingly. That’s a big part of positioning and preparing for these situations is understanding event vol, not just “Hey, what’s high? What’s low on the curve?” It’s really understanding, where is this thing being priced? Where’s the skew in this event being priced and why is that efficient?” There’s a lot of mispricing of skew that happens during an event vol and I don’t want to get too wonky on that, but there’s some big opportunities in skew for that, that you can take advantage of as well. And so, yeah, I think a gun to my head, I would say the odds are 25%, somewhere between 5% and 65%.
Meb: I was tweeting about this the other day, because I was curious. Again, I try to mute just about every political variation of phrases on Twitter and elsewhere, they still seem to seep in no matter what. But…
Cem: It’s inevitable.
Meb: Well, it’s inevitable. But it’s funny because I look back four years ago, I had a tweet, where there was academic paper. It’s a little bit tongue in cheek, but it demonstrated, like stock market has, like, an 85% accuracy in predicting the election just based on if it’s off, I think, of three months going into the election. And I think the 12 months is similar. But I had tweeted November 1st last election, I said, “Team Hillary better start buying futures because the stock market’s down and if it continues to be down, the simple indicator is if stock market’s up, incumbent party stays in, vice versa.” But it’s funny, because this year, as of I think this podcast getting recorded, it’s right at 50/50, which is right where the betting markets are. But so I was trying to assess what the probabilities are, and at least try to place an actual bet on it. But most of the prediction markets only let you bet like $100 or I think predict only caps out like 800 bucks or something. But the rules they had, which is a little different was I think December 4th was priced at about 10 to 1, but their criteria for the determination was when like Fox and CNBC both call the election in favour of one person. And I was like, “I’m not sure if that’s as trustworthy or accurate as I would hope the bet would be.” Anyway, listeners if you’ve got any good ways to place this bet, I’m curious because I think it’s a pretty decent chance, given all the variables going in. But anyway, it’ll be interesting to watch. That’s for sure.
Cem: All right, I think an interesting way to play it is really without getting into it too deep is I think the value versus growth trade, which obviously has been a widow maker for years, it’s so stretched I think and there’s, like, structural secular reasons why that trade looking forward many years. I’m not talking one month, two months, will mean revert. And just because of the need for greater fiscal stimulus and without getting into too much detail there. But clearly in a Biden victory, that will happen quicker. The push for fiscal stimulus infrastructure spending, social programs, will be much quicker based on the current Zeitgeist and what people feel is necessary in the Democratic Party. So I think one of the best ways to play this is to really kind of look for ways to structure vol trades around that kind of value growth factor. You might put yourself in a position where if Trump wins, you may take a small loss on it. But I think the potential upside to a trade that expresses that, especially in a convex way, and a Biden victory could really pay dividends if that happen. So, that’s one place kind of we’re looking right now. There’s some interesting trades, given where growth vol trade versus value vol.
Meb: That’s interesting. I never even thought about that from a derivative standpoint, being a value guy at heart, as well as a trend follower, and a long vol guy all mixed in, the value community has just been facing that pain trade, as you mentioned, and it seems to just keep getting worse by the day. But that’s an interesting thought I had not considered.
Cem: I mean, again, it’s a good kind of cheap way, I’d say, very inexpensive way to get a levered bet on the election.
Meb: Cem, big picture question, backing up a second, to the extent you guys do most of the vol arb just on S&P. Is that accurate or…?
Cem: It’s across all indexes, but I’d say the flagship is S&P. I mean, that’s kind of the centre of the vol world. You kind of have to normalize everything to that because that’s where the greatest volume happens. So, clearly, we’ve been having a lot more retail volume. We get into as well on the big growth names, which has changed that a little bit, but it’s still the 10,000-pound gorilla. You know, it’s still what ultimately pins and moves markets and relative value to that is kind of how you have to structure so yeah. We trade a lot of products, but we do it through the lens of SPX vol.
Meb: Yeah, because I mean, I was thinking theoretically, at least the diversification across other markets, whether it’s fixed income, commodities, or just other financial markets, and equities, it would seem that there should be some broadly similar brushstrokes across them. Although, we were talking Turkish stocks and investing before we got started. There’s clearly differences in different markets. Is that something you would say is more accurate than not, that vol sort of concepts apply across markets or do you have to be pretty deep in the weeds aware of the structural differences? Or is it both?
Cem: Yeah, absolutely. So different markets, both foreign inequity markets, as well as just kind of debt markets, foreign exchange commodities, you know, they all experience the risk premia compression dynamics that we’ve talked about, particularly in interest rates. But there are some dynamics that are very unique to equities. They’re obviously, one-sided skew in the equities. And the way that skew is always highest, pretty much in the world and here domestically in S&P because this is where people come to hedge, really allow for some unique opportunities in equity land, and that’ll translate over to some of the other vol complexes. I guess the answer is, in some ways, like, the universal kind of liquidity and compression issues are across all products. They all are related obviously. Being an ex-market-maker, I think of everything as the massive four-dimensional matrix. Everything is related to everything. Risk is filtered from one product to the other and has factor exposure across each factor relative to one another. But there are certain things that can only be properly hedged in equity land for equities.
And I think that’s why I think it is complex, both in terms of opportunities for relative value, convexity trades, as we saw in March. Actually, in March the best performing vol was S&P vol, Equity vol. You’re allowed opportunities here that you wouldn’t get elsewhere and outperformance. I also think that at the end of the day, if you take on too much correlation basis risk on a long vol trade, and you’re trying to get relative value opportunities, but capture a tail, then the tail basis can really eat you up, especially given this liquidity environment and the potential liquidity issues that arise into these moves more and more with kind of unmatched tail liquidity out there. So, I think it’s critical if you’re really focused on performing in the tail, to not put too much basis risk on the books. So we really try and not get too cute with some of the strategies and really take advantage of strategies that don’t have as much basis.
Meb: What’s the impact, if any…? We’ve certainly seen similarities to other times, but the media loves to cover all the shenanigans going on in Robin Hood and Portnoy, not ours, the other one, shout out Portnoy, and Masa-San or all these other things that may be going on. Are these having an impact? Is it something that’s kind of, you know, you brush aside as minor players or minor effects? Are they creating opportunity?
Cem: Anybody who’s been kind of following me on Twitter for the last three months would kind of see, kind of the ability to call market direction based on these volatility factors and how important they are to understand, and then kind of structure reality as to how this market works. One of the things we haven’t talked about is kind of gamma effects from these indexes, from these vol products.
Meb: Let’s talk about it. What does that mean?
Cem: Yeah, so there’s been a lot of talk about it in the last month or so. But essentially, all this retail buying of calls, it was actually much more the retail buying of calls than it was the Masa-San and SoftBank, but they also played a role. But all that buying of calls forces dealers to take short gamma positions in those stocks, which is only increasing leverage in the direction of the trade. So with all those calls being bought, dealers were forced shorter and shorter delta into that rally that ended at the end of August. And that ultimately led to a situation where, you know, there’s greater and greater stock buyback, raising of vols into a rally, which was very unique, the extent to which the VIX and vol was rising, and really necessitated kind of an unpinning of, again, as we were talking about before, the vol complex and allowing for some of these other risks and factors to kind of ultimately push the market down. In late August, I was very public about kind of, when you see volatility rising into a rally, it’s just a matter of time, because that, especially in this market, which is liquidity driven, again, an unpinning, for lack of a better term of the forces that have largely been at play, that have allowed this market and growth in particular to outperform. And so when that vol rises in a situation like that, it really loosened the market and allowed it to decline. That having been said, the sophisticated players know this now at this point, as dealers were forced to take on shorter and shorter gamma, in these products, they were hedging it net long vol by buying calls and puts both in the S&P 500 and across the rest of the vol complex. So the positioning really got to a point at the top where people were long vol in S&P and across the non-growth names, and shorted those growth names and they were extra-long vol.
So, not surprisingly, the pain trade is always where the market tends to go. And the pain trade was for growth to rotate out. I probably called for a rotation out of growth at that point, and a massive rotation out of growth and into value beginning when that started happening. And you had a compression of volatility into a drop because people were extra-long index volatility. So, we had a massive decline in the market, which was, again, not a surprise. We got a vol compression broadly in the market, which is not a surprise as you move away from the short calls that people had, and the dealers had in the NASDAQ. And you had a massive decline in those growth names and that rotation happened. So, this is the beauty of understanding vol markets. It’s multi-dimensional. You not only get to colour on which way will the market go based on these dynamics, but what will vol do likely? Where’s the pain trade vol? Where’s the pain trade in the market? Where’s the pain trade in dispersion trade? Where’s the rotation likely to happen? All these things, in terms of time, when are things likely to happen and how are they likely to play out based on gamma and vanna flows that will occur during this time? The more you understand these vol markets and where the supply and demand imbalances are, and how the street is positioned, the more you understand, not just where the market will go, but where and how the dynamics will play out in the weeks, months to come.
Meb: Well, it’s gonna be fun to watch. That’s for sure. Not gonna be boring, no matter what. As we look past the horizon and start to wind this down, any general thoughts on…? You talked a lot about instability. But any other just general thoughts on markets, your firm? What’s y’all plans over the next decade or I say the rest of this decade? 2020 should have its own, like, separate year. But the rest of the decade, what are you excited about, anything on your mind you’re researching, studying, thinking about?
Cem: Yeah, I mean, in terms of the business, I kind of mentioned this before, but I’ve really started to focus a lot more on kind of the vol effects on the market itself. We’ve done a lot more kind of analysis to that effect. And we have a proprietary strategy that has been very successful in the last year since we’ve launched it using these vol effects to predict kind of market movements. That’s an area I think there’s not as much capital in it, not as many people understand those effects, as well as we do based on our experience. And measuring these supply and demand factors is really the kind of secret sauce in being able to predict markets ahead of time. It’s hard to measure supply-demand. You have to be on the inside. You have to have good information. You have to track flows, and you have to have a good framework to take advantage of those. But that’s an area I’m trying to focus more on in more directional vol. We’ve really been good at the vol arm piece, and kind of drawing distributions, and understanding where vol is cheap and expensive, and how to take advantage of it for a long time. But adding the directional expertise in really in the last year has been the revelation and I think obviously much more scalable strategy than some of the vol arm strategies are as well, which is a big benefit for us as a firm. So, we’re gonna probably launch a product, a CTA product based on our performance on that end under kind of a different moniker Chi Maltoni Advisors in the next six months.
Meb: What’s the sort of capacity for the vol ARB? I mean, you’re trading in a pretty big pond. Is it really high or is it actually not that high?
Cem: It’s less than you think. You’d think S&P 500 vol is an incredibly deep pool, but the key is that you’re dealing with the tail. Like I said before, to get the least liquidity during times of stress, that mismatched liquidity based on the amount of imagined people are across the street are short 5, delta 10, delta puts that when you get down there become 100 delta, these are already leveraged positions, and everybody’s trying to get out at the same time. So, real liquidity in these situations, we’ve seen it time and time again in the last five years, not there in those situations. So that really limits some of the… Despite being on the long side, there’s still only so much you can do. The capacity of our long vol strategy is around $500 million. And we’re managing about half of that now. So not as much as you’d expect. That’s also a great reason for us to really try and benefit from some of the alpha and edge that we get from understanding these markets in much deeper equity markets.
Meb: All right, listeners, you gotta get your wires in before Cem closes on you before the election. What’s been the most memorable, you could say investment or trade during your career, it could be good, bad, long, short, in between, anything come to mind?
Cem: I made the majority of my net worth in 2008 during the financial crisis. That’s kind of when I made my name, when I really kind of developed a lot of these strategies that I now use. And a lot of the things we still do in the long vol strategy are lessons learned from that experience. What I believe is an oncoming separate, different, but similar experience, you know, in the next year, will be better. But until then, if that materializes, if I have to hang my hat on that, that was the best trade I’ve ever made. We took what was a couple of million dollars and turned it north of 35 in a matter of a couple of years. Those aren’t big numbers compared to some of your guests. And again, not scalable strategies, but the risk-reward on these types of positions that you can put out there are incredible if you get a secular decline. And that’s really the key. And, again, like you mentioned at the top of the program, those haven’t happened really since ’08, and the window is definitely opening for them if we do get higher inflation. So, yeah, I think that I won’t get into the details of the trade. But, again, it’s very related to some of the things I talked about, in terms of how we position and take advantage of kind of structural inefficiencies in the indexes and position ourselves long vol.
Meb: Well, the takeaway is, you only have to show up once every 10 years. You just go take a vacation, once a decade, have a month or two of work, monetize it, and go back to bed.
Cem: Yeah, the amount of, like, brain cells I’ve killed in the last 11 years trying to wait for that coming is, you know… I wish I stayed on break longer than a year-and-a-half. I tell you that but …
Meb: Well, good, Cem, we’re gonna have to hit you up next time we want some deep due diligence on Turkey, as well as what’s going on. We’ll have to revisit and see kind of how this year ended. I imagine it’s gonna be a totally peaceful next three months. Virus is gonna disappear into the ether, peaceful political transition, and then back to business as normal in 2021.
Cem: I’d love to come back. I will say the one thing I didn’t mention, I don’t mean to just be all fear-mongering, I do think when people are expecting something, in terms of an actual expiration time, like, we are seeing in December, January, unlike the theory that like you mentioned that the intelligence of crowds existing, because there’s a feedback loop in vol markets, a lot of times for structural reasons why the events actually don’t fully play out at that time. Because as vol compresses after the event, you’ll get… It’s what you got in the Trump election in ’16. You could get a really kind of short-term period of stabilization. So, I wouldn’t be surprised if we get some initial volatility, and then it amounts to some type of compression towards the end of the year, only to come back after the new year or something into spring of next year. So, that’s my general framework, I would say. Who knows? We’ll see again, we’re positioned long vol for the event, but I do think that there’s a better chance we get some movement on the election November, maybe some stabilization in December, January. Once there, we’ll all know who the next president is. And then when the whole idea of, you know, growing fiscal policy, as well as potential inflation, depending on who’s elected President, I think we could see a real beginning of a secular move into next year.
Meb: I think, and we didn’t really touch on this, and it’s getting too late to go deep. But, you know, I think an undercurrent of a lot of discussions I’m having with advisors who are more and more consistently getting concerned about where bonds are in the portfolio, with bonds yielding 60 basis points and the potential if they do go to 0 or negative, what other strategies can they sell and that have some sort of protection to the rest of the portfolio? So going from 60/40 to maybe 80/20, or 70/20/10, and that 10 being something like a strategy you’re talking about, that hedges some of the equity but doesn’t give you the negative carry bonds? I don’t know. That’s for next time. We’ll talk about that. Let’s talk about that next time. Always leave the audience wanting more, Cem. Otherwise, this is gonna start to be a Roganesque length long podcast.
Cem: I definitely think that should be part of anybody’s portfolio. I think the convexity mismatch, given the leverages represents a real opportunity, obviously. But I’m talking my book, so we’ll leave it for next time.
Meb: All right, perfect. Where do people go if they want to find you? Twitter handle, website, all that good stuff?
Cem: Yeah, Twitter handle’s cem_karsan.
Meb: I just wanted to hear you say it. We always put in the show notes. So, I just wanted to hear you mentioned the Twitter handle.
Cem: Yeah, obviously, my name Cem Karsan and most people see it spelled they don’t understand. But yeah, it’s kind of been a nickname for a little while. So, Cem Karsan, website is gcapital.com we’re in the process of like I said, launching a CTA product under the moniker Chi Maltoni Advisors and that website. It will be live here shortly as well and something that you can hope to hear a lot more about in the coming months.
Meb: Awesome. Cem. Thanks so much for joining us today.
Cem: Thanks for having me, Meb.
Meb: Podcast listeners, we’ll post show notes to today’s conversation @mebfaber.com/podcast if you love the show, if you hate it, shoot us firstname.lastname@example.org. We love to read the reviews, please review us on iTunes and subscribe the show anywhere good podcasts are found, my current favourite is Breaker. Thanks for listening friends and good investing.