Alex Orus - All About The Volatility Index (VIX)

[Music] hello and welcome i'm taylor pearson and this is the mutiny podcast this podcast is an open-ended exploration of topics relating to growing and preserving your wealth including investing markets decision making under opacity risk volatility and complexity [Music] this podcast is provided for informational purposes only and should not be relied upon as legal business investment or tax advice all opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of rcm alternatives mutiny fund their affiliates or companies featured due to industry regulations participants on this podcast are instructed to not make specific trade recommendations nor reference past or potential profits and listeners are reminded that managed futures commodity trading forex trading and other alternative investments are complex and carry a risk of substantial losses as such they are not suitable for all investors and you should not rely on any of the information as a substitute for the exercise of your own skill and judgment in making such a decision on the appropriateness of such investments visit www.rcmam.com disclaimer for more information in today's episode we talk with alex orris a principal at principalian capital based in zurich switzerland alex is one of the most experienced traders of the volatility index often called the vix or fear index having founded blue diamond capital which began trading the vix in 2007. in this conversation we talk about risk and how many investors measure risk in a way that actually increases rather than decreases their risk and we then dive into the history and structure of the vix and its associated products and how investors might want to get exposure to the vix to improve the overall performance of their portfolios there were a couple of terms that alex talked about the interview that i just wanted to briefly introduce alex mentioned a few times an event in february 2018. uh what happened was that on february 5th 2018 the vix went from 13 to 37 nearly a 300 move in a day which was its largest percentage move in history causing large losses or large gains for traders on either side of the market and then we also talk a little bit about mean reversion and mean reversion is just the idea that an asset moves back to its long-term average so the vix's long-term historical average is around 20. so if the vic spikes to 40 and then moves back towards 20 we call that move back towards 20 mean reversion so with that out of the way i hope you enjoy this conversation with alex as much as i did so i wanted to start off and talk a little bit about risk uh just broadly or generally and the financial times of the piece on you in 2011 where you talked a lot about the the financial industry and how the financial industry thinks about risk and has traditionally thought about risk you know particularly the sharp ratio which is a measure of historical volatility you mentioned an alternative measure that you look at a lot more a lot more called the the kalmar ratio that i'll let you expand on but yeah i'd love to hear you just speak sure generally you know how how does the financial industry generally think about risk and um you know what what would you sort of how do you sort of critique or comment on on that and maybe lead us into the kalmar ratio and why you think that's perhaps a better better measure sure basically a lot of the industry has been looking at risk from a perspective of price fluctuation and they uh they call that volatility and they basically think that that is risk um my view on it is that price fluctuation is a measure of risk short-term risk but much much better is to look at price as being risk so in other words if i'm looking at you know buying a house and that house is a million dollars to construct it so the replacement value of that house is one million and i buy for two i'm paying one million more than the replacement cost so to me price and not price fluctuation is risk so it's it's it's the the fact that i uh basically can uh lose money or or or or draw down is a better measure of um of risk along those lines with you know sometimes you know kalmar sometimes called the ma ratio and it's just basically your return over time divided by your max drawdown and as you alluded to in that ft interview too there's there's two things that the industry tends to do we tend to talk about nominal returns and we talk about like sharpe ratio or variance right and it's it's really interesting as an individual you shouldn't care about either of those those are more academic concepts where we should really care about absolute return our returns after inflation what can i eat at the end of the day and then my biggest risk is actually my drawdown because i don't want to lose money and it's interesting how the uh the industry has pegged to these nominal returns and they don't even count for inflation or they and then they use like you say in price swings or variance as a metric for risk and not drawdown um you know and then i know when you founded blue diamond that's what you guys are looking at more is like how do we maximize mar or kelmar ratio over time and has your thinking evolved on that is that still how you a metric you use for for principalium yes i mean one of the one of the issues um by using the the sharp ratio which is not not certainly not a bad measure when we just when you're talking about um a long-only universe basically of equities and bonds or balanced portfolios when you in in the sharp ratio basically is based on a normal distribution of returns when you start looking at hedge funds or alternative investments those those returns don't have a normal distribution so they might be skewed into one direction or the other so therefore the use of the sharp ratio is is certainly not that appropriate it's much better to use the kalman ratio where you look at basically the skus of your returns because you're analyzing whether or not a manager is good also not only going long in the market and equities or whatever but also shorting the market so therefore the the the fact that the sharp ratio is based on that normal distribution it misses the point that when you start looking at returns that are not normally distributed the it will not catch that so therefore there are the ratios that are more appropriate for uh looking at hedge funds it are the the the mar ratio or the kalmar ratio or or the sortino ratio which is a variation of the sharp ratio but it looks it looks at the downside volatility of of your return stream so yeah my my my view has not changed and that is on the how efficient is a portfolio secondly your other question alluded to what i was what what i basically mentioned in the fd article a few years ago which was having benchmarks like the like libor and looking at an absolute return to beat that libor i don't really make sense because at the end of the day there is no currency associated with that and if you look at inflation it's a much better measure to see what you basically in real terms what you return is in real terms so those two those two comments i made a few years ago have not really changed which and the way and this might be slightly off topic the way i think about it a lot of times is like if you just take a simplified ma ratio like i'm saying of returns divided by drawdowns for that to really make sense i would like to see you know like a two decade plus track record and i actually reached out to a lot of people on our network trying to ask around us like has anybody heard of a a manager that has more than two decade track record that's had like a mar ratio of greater than one or at least equal to one so let's just say their return after inflation was ten percent and their worst drawdown was you know ten percent and and people really couldn't come up with anybody besides maybe ed thorpe and some people said you know renaissance tech ren tech but i think their drawdowns have excluded them and it's just i wonder how like you think about that it's like do you need you know decades of track record for you know mar or kalmar to make sense uh for you to feel confident in them or how do you because you know that our worst drawdown is always ahead of us it seems to be that that's uh that's a good question i mean certainly um you know 90 95 percent of the times the markets are are moving up right so um we are just entering uh probably the 10th year of a bull market um and and therefore um a lot of the managers that you know um don't have a track record that's you know more than than this period or measuring measuring uh a calmer ratio which is looking at the drawdowns at the maximum drawdowns is certainly requires that one looks at further further time you know more extended time periods in that sense going back so this is the issue that i see in in today's markets um we have been if you look at the the hedge fund industry most of the hedge funds have made money by going long equities or going long beta and they haven't really been tested on during the drawdowns or have not really excelled during those drawdowns it's clear that if you're running a hedge fund during the last nine years that the way to make money is by either going long equities or what we would look at it from a volatility perspective volatility trading perspective we would you know go short ball so so the markets that the markets and the strategies and the hedge fund managers have predominantly been in short well i do understand it right because you're you're running a business and and that's the way to you made money in the last nine years which is not certainly saying that uh going forward that can change you mentioned your shortfall i wanted to dive into volatility a little bit more you've been trading the the volatility index usually abbreviated as the vix uh a lot longer than most people that are trading today have been trading it um i was hoping you just sort of talk us through you know what what exactly is uh is the vix i think most people know sort of like a a measure of volatility but but not exactly sort of how it's constructed and maybe some of the history there and how it became tradable um and just sort of how you you look at that space sure um the vix is basically an indicator that some people call it the vix the fear indicator and it basically uh it's constructed using a strip of call and put options so basically it shows what the current um what the option market sees as being the current price of volatility um it was established in 2004. it's very important to understand that it's an indicator and it's non-tradable it has a series of futures building a so-called term structure curve each month reflecting what the market thinks the volatility is the implied volatility so the volatility looking forward uh will be in one month two months three months four months and five six seven eight months so that curve when vic's and the first contract second contract is higher than than than the first contract third one and so on it builds a curve that is um uh income tango it's what we call in contango that means that the market players expect the future implied volatility to be much higher than the realized volatility so this vix was established in the future the cboe uh futures exchange the cfa uh basically provided the market uh players with an opportunity to trade the future implied volatility and just uh maybe i clarify a little bit the yeah you mentioned like the vix itself is a number i'm looking at you know it's say 17 right now and then there are you can't trade that this vik specifically but you can buy futures on the vix so there's one month futures at fx of 18 a vix of 19 and vix of 20 and those all have different different prices associated with them and sort of the normal thing is as you go further out into the future that the term structure slopes up because there's more uncertainty sort of going into the future more more things could happen between now and six months from now than now and one month from now is that is that an accurate summary or how would you sort of critique that that that's uh absolutely right uh that's the way uh that's the the way uh it gets reflected in the curve that as you move out there is more and more uncertainty about things and um so so they i would say that the market things that the future volatility is going to be higher than it is today so that's embedded in that curve in that term structure curve is then the risk premia uh basically that that you can capture and extract from this from this curve so it's kind of like the the insurance premia that people pay going forward in in the markets as you alluded to uh fixed futures are a relatively new product and like we were saying you're you're you've traded the space almost longer than anybody else and how have you seen that change over time where i'm sure in the beginning you were one of the few players in the space liquidity was probably pretty miniscule and then you know after 2008 2009 we see liquidity start to ramp up a little bit and then you have you know all the vix etfs and etns and you know more players coming into the space how have you seen the uh just the vix market evolve since you've been involved well certainly as you alluded to uh volumes have increased uh tremendously uh also there have been a lot of etns and an etf products based on the vix futures so that increased the liquidity of markets more market players went into it and and therefore the you know i would say first second and third maybe the fourth contract have uh substantially increased uh uh uh the liquidity at the the volumes have increased substantially in those on those contracts the rest of the contracts are not as liquid still still today are not as liquid the way the market has changed obviously you know that's that's great to have more liquidity and more volume for for trading it uh but the way the the the basically what has changed was um is is the patterns are is is are the patterns of um of how volatility moves so in other words in we started in 2010 uh trading trading the vix and we were extracting this risk premium was including before and if nothing really happened during the month there was a on average five percent risk premium on the curve more market players started coming into into trading the same uh sames into the space and and that you know that increased competition has made it more difficult to extract that kind of you know usual five percent from the markets but what has really changed more recently is after the elections is that you know prior to that uh you used to come up uh who used to come up with with the you know volatility used to come up with it with a with with the elevate you know with the elevator and used to come down the stairs so the patterns were were you know not as technical as they are today in in after the elections and you know due to some some of the tweets um you you can have some pretty erratic moves and very short-term uh mean reversions of of of the spikes of the volatility spikes so so the market has become much more technical in addition to that obviously if you look at the underlying and you look at the algorithmic trading firms they've basically also made uh markets uh more erratic uh and more technical uh by technical i mean that things move much quicker than they used to and so they're scalping whatever whatever alpha there is or they're making a certain uh move in in one or the other direction much more extenuating um so that's what's really changed is we went from obviously being some some of the first traders and extracting the risk premium to now having more mac market players and also having um the pattern of of the vix becoming much more uh shorter term uh for instance we take a february of 2018 and and there within one day you see you see vixx jumping to 240. and on february 6 2018 you see mix just dropping down uh massively mean reverting so that kind of pattern wasn't there before and so we we basically have undertaken some some steps obviously to trade very differently much shorter term i would say and that actually leads me right into the the following question for that because i've heard you talk about it before is that like you're saying if if it's changed where the it used to spike and then slowly drift down and now it's it's mean reverting harder than ever is if if you're if you're set up to capture those spikes you need to make sure you have some sort of monetization if it's if it's mean reverting just as rapidly it's like how do you think about capturing that before it mean reverts on you so quickly that you you can't even capture any of your uh profits that that's uh that's exactly uh an extremely important point right now uh which is um we we capture we have to have a trading systems or or ideas that work and that take 15 minutes snapshots whereas before you know we would look at and take three snapshots a day and and we will position ourselves now now you have to have part of your investment process geared towards 15-minute intervals or five-minute intervals so the intraday trading of these patterns are extremely important more and more important obviously the the the one one thing you have to consider within the vix or volatility universe is that costs the tick size of buying a trade a future trade is uh 50 so so your round trip is going to cost you 100 which means that you have to be extremely effective in the way you trade i don't mean commissions i i mean just the tick size of these contracts are extremely large there is a flip side to that which is uh because they're large um the short-term algorithmic trading programs um will have a harder time to enter into into the into the universe into the space so so so that's that's a piece of good news for for for us that's actually a great way of putting it yeah the thing about that all the time is like you also you have you have multiple factors on the vix that i assume would help you out one is like long gone are the days of uh rebalancing your fixed position at the close right and only looking at vixx at the close now you know it's the inner today so liquidity is improved in those front month contracts which means liquidity is improved intraday which makes it a lot easier for like you're saying to take the 15 minute snapshots but like you said you got that 100 round turn hurdle on just the tick size which keeps out you know the high frequency traders but also don't you think it also keeps out a lot of the capacity constraints keep out a lot of like you know the hedge funds you know that are algorithmic traders or trend followers that are in the tens of billions because the vix uh space is is a little more capacity constraint so that provides another maybe alpha source to stay small and nimble or how do you look at that absolutely i think i think that's that that's right and and that's our aim is to manage capacity obviously the big space has been attractive for some of your trend following ctas to capture just another market as if they you know an additional market like they have their equity and other commodities they they enter into into the biggest market but as you rightly point out the costs are prohibited to basically do too much of that on the other hand you you have some of the um the the fall arbitrage you know i basically started doing vol art um playing relative trades on the curve and extracting the risk premia that discipline is um is over you know is is has to be combined with some very strong technicals um and this is why i teamed up with uh with my partner who has a 13-year history in the cta and algorithmic trading combining the vol art fundamental way of looking at the term structure curve so that combination means that you know my partner brings in some of the more shorter term intraday or 15-minute interval ideas uh technical factors filters that will uh allow us to take uh very quickly a uh long or a short position within within the market i wanted to zoom out for a second just you know if you're sort of talking to to an investor that's you know vaguely familiar with the vix but but no experience trading it you know what why would an investor want to have some exposure to uh to the vix in their their portfolio why why would that make sense well uh there's been a lot of discussion whether or not you know volatility is an asset class i firmly believe that that it is an asset class and it's a very effective way to reflect going along the market or short the market [Music] or or running some sort of carry uh strategy so um i can you know the way i look at the universe is i can always attach um a volatility long or short or neutral position to to your uh traditional to your traditional markets for instance going long equities is going short of all uh you know and and that is extremely effective it is very very efficiently reflected in in the mixed market in the volatility market um so you can capture uh bear markets for instance and that you go long volatility so it's just buying a contract and and you're reflecting that in a very effective and efficient manner with the uh volatility universe the big smaller universe yeah i think we talk about that a lot you know i think we usually just talk about sort of in terms you know very similar to what you said just as as diversification you know volatility is an asset class and just the way you'd you know diversify across other asset classes it makes sense to diversify across volatility as an asset class and and most investors portfolios are are overwhelmingly short volatility uh absolutely yeah that that's i mean again you know you can look at uh the traditional universe of equities and bonds as um as you can look at it in terms of volatility going short long volatility you're being in cash um so it's a very efficient way to to to to to play that uh trade and it's a it's a very strong diversifier because it is a it is an asset class that has a different return pattern than your traditional asset classes er obviously you know this is uh this is your business you do this full-time and you're looking at detail you know for for the retail investor um that's just sort of interested in the vix like what are the options for uh for getting exposure and maybe you know speak to some of you know how those instruments are are constructed and the advantage is disadvantages well the the market came out if several providers came out with exchange exchange-traded funds there are several of those there are those that basically uh reflect uh short volatility and rollover continuously some other products will will go long volatility uh so some will go this you know version of short volatility and leverage that up uh some will have a version that will some of the etvs will do it on on the long side obviously we had you know a few blow ups because when you have a short etf and you leverage that uh and your your potential loss is is uh is unlimited you know it's unlimited you know you can you can lose you know 100 of your investment um for the retail investor you know some of these products and by the way you know certainly going short volatility leverage short volatility with an atf is it certainly um has a certain you know you know high risk associated with it uh obviously we spend 90 of the time in in a short volatility mode right but when when the event happens you you will lose you know you will lose um and you will lose a lot of a lot of money again i want to reiterate that that something similar happens that if you're if you're long volatility because as i said most of the time markets are going up and your low volatility will have a negative decay negative raw yields so so will cost you money and cost you money cost you money cost you money until that event happens where where your long long etf will will basically provide you with a return but if you look at now at the last nine years we have been in a in a bull market so so that is extremely costly and so what what is ideal though is to have some sort of combination dynamically moving from one to the other or having a combination of those two um there are products in in the market i'm not sure that there are a lot of etfs in that space but there are some and that actually it thinking about the etfs and etns in the space is there's been a consistent theme on this podcast and obviously through our managers and i think it shows our biases but um you know when when we talk about short volatility products it's really easy to go passive with anything shortfall you could just hit that buy button on almost any short ball trade but when we talk about long volatility trades it's we find it interesting that if you want to manage a long volatility position without bleeding to death it takes very dynamic active strategies and it seems almost impossible to replicate those passively like in an etf or etn space i i wonder what your thoughts are because you have a lot more experience than we do on this is like you know is that just part of being long ball you're going to have to have dynamic strategies with people that have been in the markets for hopefully decades and they're using you know algorithms and then their discretionary overlays to have you know dynamic active strategies that that is the good point that is a very good point and when we talked about what has changed in the last few years i mentioned that that the volatility moves are extremely erratic and going to my example of february of 2018 uh that the move was within is is close to being intraday so therefore if you passively try to or dynamically but in a in a passive rebalancing mode you try to capture that kind of event uh you're way too late uh this is this is a matter of seconds uh then you need to switch from one to the other and so here is where where the expertise and the algorithmic trading know how that for instance someone like like us bring to the table in that we can very quickly uh shift that position so so it's um it basically the change and then much shorter it's changing in volatility patterns uh the more erratic moves um it leads to uh having to choose uh a strategy that can very quickly uh reverse its sign and that you're sort of continuing on with that the theme of um you know as jason mentioned long volatility it seems to be a space for sort of having having active management makes more sense than uh than the short volatility space what are the the sort of primary um active approaches to uh to trading the the vix i know one is sort of pairs trading it with the s p where you go long vix long s p or short fix short smp or then calendar spreads um where you're trading the you mentioned sort of the front and back month of the the term structure i was wondering if you could if there's any others or other ways you think about that but what are sort of the active approaches to to trading the vix and how do you sort of think about the advantages and disadvantages of of each of those strategies certainly we could take the example of what you just mentioned so you can you know you can short for instance the first contract go short volatility to capture the negative role yield or that risk premia within the term structure curve and hedge yourself with a short smp that that is a that is a trade you know i've done in the past um and and you know it it worked quite quite well that trade uh there is really it is now a crowd trade and that what what i mean with that is that basically there are sometimes decouplings between your short and the smp uh that correlation uh breaks down so what you've had more recently in the recent years is that that trade has that the smp has not really hedged uh your position and by the way one important thing to understand about the term structure curve and the futures that that are displayed in that universe is that there's no natural hedge right there's no natural hedge of any of those futures what we're trying to do is a proxy by shorting bsmv because it has a on average a fairly high correlation but that has been breaking down so we we don't we don't do that kind of trade anymore um what we do is is basically we use techniques that are much more a term structure curve and they'll go you know short volatility with stop losses and with some pretty strong risk management or they may hedge but they'll have a very dynamic way of uh continuously hedged with the underlying market uh in addition to that also what is important is to diversify that hedge so not only going short the smp but also maybe not also making but going also long treasuries because the treasury is still when the unexpected event hits it really is um an additional long you know as an additional hedge to your position so the the traditional way as it's described now that we were doing uh you know we were putting the trades to extract the risk premium of the curve and hedging yourself we don't do those anymore uh in in that in that way because of the breaking down and decoupling of sometimes of the markets with the derivatives and just uh maybe just to clarify the uh and you correct me here if i'm i'm wrong you know the vix is as you mentioned it's a derivative of the s p it's calculated using um option prices on on the s p 500 and so the idea of uh you know going short fixed short s p or long vix long s p is you're trying to find uh ahead she mentions that there's no natural hedge that's used by many people and you mentioned you historically sort of use that as a way to protect that um that position in the in the vix is that accurate yes that's accurate there's no perfect or natural there's no perfect edge maybe natural it's not the right word there's no perfect hedge to your short futures position what you can do obviously because they're related obviously the futures are related to the options market and the options market is is related to the underlying s p 500 future futures market there is a relationship there but that breaks down every once in a while and so therefore you have to hedge yourself in a much more dynamic way than you used to do in the past you know why is it necessary to hedge that trade why not just go you know longvik short fix well because um it's uh you can think of it let's let's give an example let's say vixx is you know it's been fairly low in the last few years but let's say that vixx is at uh at 13 okay and you in the first contract is maybe uh that the first future speeds is maybe at uh 14 or maybe at 14 and a half so there is some risk premium right there is a difference between your your fix your spot and and your first contract okay so the market thinks that going forward uh there is going to be an implied risk premier that that that is there because people fear so so let's say that the vix goes from 13 to 15 16 17 that move is just not a few percentage points that is a 10 20 30 40 50 move so that means if you're short the first contract and that happens and that's what we call that the spike happens you will lose 30 40 50 67 so it's it's it's um it's exponentially your loss is exponential uh in that sense and that means that if you think you're hedged and you think you have a linear hedge and and that um exponential move spikes up uh your hedge your hedge is is diminished uh is eliminated pretty uh pretty quickly right so so that's why you you have to have a dynamic hedge or you also have to have all sorts of risk measure uh if you're short volatility um having said that it's you know it's you know we're on average we're 85 90 where you know that trade makes money until it doesn't and when it doesn't your losses is unlimited because because vixx can go anywhere you know it can go to 80 as we've seen in 2008 so you you can you can potentially lose a lot of money the the other thing that more and more too is is that that that's one tale that that is extremely um risky within you know managing volatility the the other is what we're forgetting quite often now in the last few years is that the other tale is also quite quite quite risky that means if you are going back to my example if you're at 14 vicks at 14 and you jump to 25 or 30 okay that's a huge move uh that mean reversion going back to 20 the next day or going back to whatever 18 the next day is also potential loss it is not the same you know it's not the same loss that you incur when when you get the spike but you have to consider that you know you will lose a lot of money if if if you buy or go long volatility once the spike happened and and uh volatility mean reverses the mean doesn't as a mean reversion the next the following day you know so so in other words you look at february 5th of uh last year and and the next day uh the volatility mean reverts 15 so you have to look at both what we call the tails of those returns uh but obviously much more dangerous is to go from a low volatility environment to a much higher one in in a matter of minutes or days and then just to because we just to reiterate and clarify so people would go okay if i'm short volatility and i'm capturing that uh voluntary risk premium i can get my face ripped off on the upside so people go okay i'll just go long volatility and capture those spikes so the problem is those spikes come you know once or twice every a decade and so in the interim you're losing on the you know could be average of five percent a month if you were long volatility so both sides of the trades have their trade-offs you either bleed to death or you get your face ripped off like you know so it's it's uh that's part of the dynamic uh inactive trading positions that that's right and and that's and and it's it's just your weight you know when it happens and and then you go long volatility you know the spike happens you go long volatility uh as you pointed out that it's just also quite quite risky to continue long volatility because of the mean reversion and you can lose a lot you know on on the way down so the and if the curve as you know if the curve is in backwardation meaning that the fix that the first contract is below the fix so the fix is higher than your first contract that means that the curve is in backwardation that means that the market thinks that the realized volatility now is higher than the expected volatility in the future the implied volatility if in a scenario uh if you want to go long volatility when when things are happening you're way too late in this in this in in this environment because you know volatility moves at the speed of light not only up but also down so the point here is uh the the the it's not you know i would say it's the holy grail would be to basically prior to a spike or prior to to a market downturn to already have a long volatility position finance that somehow so that when it happens when the event happens you are you are you you're in with a long volatility uh position make the event happens you make the money and and then you have to very quickly realize realize that the profits or reduce your position because that mean reversion can take place quite quite soon thereafter so it's a very dynamic way of anticipating um or being in early uh there are some early signs of trouble uh and and that is when you see that uh the risk premia in front of the curve starts getting smaller and smaller and smaller meaning also that your fear indicator vix moves up so the normal thing would be for your first position to move down as the time as time passes and settles on the vix if you're in contango if nothing happens you're extracting that rich premium but from up if if you want to be in early you have to see if that vix who is if your indicator which is a strip of puts and cause is moving up that is usually a sign that there are some there's there is potentially some trouble coming your way so you have to be early you have to look at you have to make sure that you don't bleed to death in when you when you do that kind of uh positioning you mentioned your term structure and contango and backwardation maybe i'll i'll summarize and you can correct me where not sure uh where i'm mistaken but so yeah as you mentioned sort of most in normal market conditions that the term structure is in what's called contango where as you go further out into the future say a one month contract a two month country or three month contract it goes up so to take your example of the vix is it at 13 today the one month futures contracts might be at 14 the two months might be at 15 the three month might be it at 16 and so on and so if you're if you're long you know that front month that that 14 and nothing happens um you you lose that bleed we know that difference between the the 14 and the 13 if the vic stays at uh at 13 at the same point if you're short that um that front month where the the short the 14 uh when the vix is at 13 and it goes up to 40 uh as jason said you know you get your face ripped off that's a you know huge percentage um huge percentage changed and so sort of the way you're talking about it is is what are the sort of the the indicators or how can you sort of look at you know um one hedging that position and uh so that you don't get you don't get burned too bad on either side and two sort of flipping back and forth being being long at some point and short at some points based on sort of different different factors or different different algorithmic indicators is that a is that roughly accurate or what would you correct no i think that's that's that's accurate so the i think the mindset of at least what we what we do is um we do want to very you know cautiously capture the risk premium within the curve and not to be too greedy because most most most of mostly most of the investors will have as part of their portfolio a long equity portfolio which which is short ball right that equates to short while it's pretty much a synonym of being short ball so you know our thinking is what why should we add to to the long equity portfolio with being short volatility more importantly is to be in early uh with a long volatility uh position to to hatch hedge an event uh that that should be the the objective and is the objective of the program that we do that dynamically without bleeding too much because that's being financed by other parts of the term structure curve but i think it's there is a certain discipline and this is why you know we basically uh code things and we do things systematically uh so we don't fall into the trap uh of uh of being discretionary and and you know in a moment of of panic making the wrong decisions so no the cook is the the the the objective is not to be too greedy to extract uh to to pay uh for the the the event of of uh or not to be too greedy when you extract the short volatility and to be very early uh in before uh things happen uh when you see you know when you see the there are clouds coming up in the in uh and when you see the clouds are coming up you go in uh long wall facility and try to finance that so i think i think it's a combination of those two things great and you know like you we've been talking about throughout this discussion since 2009 and even more recently uh volatility's been massively mean reverting but you've been in luckily been in the markets long enough through multiple business cycles so if we read our benoit mandelbrot he would say volatility clusters so it's really not that simple most of the time volatility mean reverts not lately it's mean reverting even faster but then there's going to be times when volatility clusters so i'm wondering how you think about setting up your trading for for that time when when may in the future we may see volatility clustering again yeah sure uh that's it that's an excellent question because um you know you have a lot of headphone managers a lot of managers that what they do is they have some sort of forecasting mechanism so they forecast the regime and say well now there's clustering now this kind of we're in we're going to be in this kind of volatility regime i have spent many years trying to forecast a volatility regime and i've been unsuccessful so the way i'm approaching it or we are approaching it is that the only way is taking the concept of um long volatility or what we call the spy concept or the mean reversion or the extraction of risk premia those are the three concepts that we that we trade to have each one of those concepts work in very short term intervals in medium-term intervals and in longer-term intervals so to give you an example so if so so there's three concepts and there is nine time intervals each one of those three concepts you know extractional risk premia the spike or risk on type of trade the long volatility or the mean reversion okay the risk-off type of trade mean reverting each one of those has three sub systems or three sub uh buckets that are looking at different time intervals so they will face in uh if if the if the spy continues and turns into a consecutive spike and we're going into a sell-off mode into a risk-on mode that concept will be extremely quickly intraday with part of it it will continue the next day putting on more positions and it will continue the the following day or the following month or the following weeks continuing to be a risk on at the same time you will have a set of systems that are looking at is this thing is there a reversal is there a mean reversion and is that mean reversion what i call a reversal which is a very quick return to normal levels of volatility so part of the mean reversion concept will be looking at reversals that are basically you know five ten minutes and and looking at strength of signal are we turning for example again sixth of february in the morning right uh we to 2018 are we churning today is there a reversal today so partially that concept will come in with a certain portion of its of its um of its of its of the con a certain portion of that concept will come into the market and start turning with with a curve uh for the for the normalized levels of volatility so the only way is to diversify the con concepts by time i found you know obviously there's plenty of people out there that you know can time the markets or can forecast you know the volatility regimes i can't because especially if you look at you know what we've been talking about that volatility just there's no way to predict how it's going to move i i cannot predict what the next tweet is going to be of uh of of of trump right right so and those do affect you know right if if trump tweets that he's going to get together with with the chinese and and things are going to be you know fine as far as the uh you know resolving a trade war then that has has an immediate effect that tweet has an immediate effect on volatility and on the markets yeah does it have an effect in that it's like you're saying most likely a spike but then it has the effect of the hardcore mean reversion that you've seen too because like yeah because the news gets rapidly out of the market as well absolutely and this is why you know i basically came to the together with with my with my partner last year who has the experience the technical experience and the algorithmic experience to really very quickly reverse that trait and just making sure you know that there's a robustness of signal that the thing is really changing direction right so there's all sorts of techniques uh sophisticated techniques that the that the algorithmic trading the cta trend following uh type of guys guys have and i didn't have that you know to if you asked me at the beginning of our conversation did we have that in 2010 no we didn't have it right because this thing didn't move there was there was no there wasn't a tweet right right so so now we have these things and and that's the reality things that the markets move much much quicker than they used to you just made me think about it in new ways like obviously uh trump is the paradigmatic example with his you know his tweets but what you're really saying is like this is the world we live in now it's it's it's a you know as the internet has come of age and social media has come of age like you're saying the markets move so quickly and in a global sense it's not just trump so it doesn't matter where your politics are it's just admitting that you know news uh cascades to the system so rapidly that we're in a a new paradigm for lack of a better term of how volatility can spike in mean revert due to the internet and social media age which is is very interesting way of thinking about it but just to recap real quickly i like the way you were talking about it is you look at it as as three buckets or three trading styles whether you're extracting that volatility risk premium you have another strategy to capture the spikes another strategy caps demeanor version and at the risk of oversimplification if we had volatility cluster for six 12 18 24 months wouldn't um most likely the volatility risk premium strategy would do exceedingly well in that environment don't you think absolutely absolutely i mean it's it's uh if we go sideways uh uh you know nothing happens uh then and then certainly yes yes it's it's become a much crowded trade you know it's become a crowded trade because there's more marketplace extracting the same idea uh but it's still it's still a trade yes and that would certainly uh certainly be the case but do you think we'll also do it doesn't really yeah sorry i was just gonna say when you think it would become uh if you have that spike to the volatility cluster you would actually get rid of a lot of those market participants so become a less crowded trade because they'd be so fearful of that spike and marine reversion so once volatility clusters the likelihood of most of them still being there is is it likely becomes that's what makes it an uncrowded trade or am i looking at that wrong yeah i mean what what what what was very interesting about last year about the trade that we were mentioning in february was that because one is you know has a you know early on a convex position uh you're a liquidity provider because you're long volatility and the market is is uh struggling because it's trying to to sell its short volatility so you become a liquidity provider in that sense perhaps one of the things that is very important uh not only the clustering but what is extremely difficult to manage at the same time is this back and forth of volatility so i go back to may of this year right where where you go back and forth but not only do you go back and forth the market drops by about six percent and your volatility doesn't really spike uh it remains at certain levels so so there's there's all sorts of uh strange uh unseen moves of volatility in the past what what is difficult uh for for for uh for us as as managers is really the back and forth and the whipsaw of of the markets and the the way we are trying to to manage that part is by you need to have strategies that are in different time intervals that that smoothes sometimes you know somehow your your return uh the other thing that you can do is is is is doing things off the curve where your tick costs of that we mentioned before fifty dollars within the you know tick cost of your of your future is much lower if you trade the s p back and forth uh so so the same behavior those you have to see in the market is reflect in the underlying market is reflected in the curve the problem of the curve is or the challenge of the curve is is the cost of trading that whiplash and and back and forth so so you do both you try to mitigate and and have some strategies that that work on on the back and forth of the curve but you also have some strategies that work on that on the underlying market which is much cheaper to trade but that is um that is a challenge that is a challenge that's back and forth uh having you know a lot of months where this back and forth it you know it makes sense to me right um you know if i put all my fundamental hat on um we have created the largest bubble in history on the fixed income side right uh uh and and obviously um the equity markets have had nine years of bull market um so yeah you have the two major asset classes which are richly priced to to say the least right so so i i i can see that you know a lot of the macro players uh macro managers hedge fund managers uh this is a difficult time uh for them because we're in a in a fairly directionless type of type of environment are we going to continue to drop interest rates in the u.s or are we going to normalize interest rates in the in the u.s so that's all reflected in in volatility in in that you know you get this back and forth back and forth so it's not only the clustering but it's also this this back and forth erratic moves which happened much shorter term than in the past well alex has been really helpful great conversation we appreciate your time and yeah we'll have to do this again sometime wonderful it's been a pleasure thanks for listening if you'd like more information about mutiny fund you can go to mutinyfun.com or better yet drop us a message i am taylor muniefund.com and jason is jason refund.com and we'll get back to you you can find us on twitter at mutinyfund and i am at taylorpearsonme

Channel: Mutiny Funds

Views: 491

Rating: 5 out of 5

Keywords: investing, stock market, portfolio diversification, portfolio diversification strategy, mutiny fund, taylor pearson, jason buck, long volatility, hedge fund, ergodicity, negative skew, volatility, futures trading, options trading, futures and options, finance, markets, economy, trading, investment portfolio, investment podcast, trading podcast, investment strategy, tail risk hedging, tail risk, trading strategies, Alex Orus, Principalium Capital, VIX trading, Volatility Index

Id: 5l1QzZGiEWg

Length: 63min 14sec (3794 seconds)

Published: Thu Sep 24 2020