Hello, and welcome to another episode of the Odd Lots Podcast. I'm Tracy Alloway and I'm Joe wisn't Joe? Do you remember armacgeddon? Oh? Wait, let me start over? I cried, I cried, keep that. Do you remember Val mcgeddon. Uh? Yeah. If you asked me exactly when that was twenty eighteen, okay, I wouldn't have nested. Maybe I would have said twenty seventeen or something, but yeah, something crazy happened. And like so I think with the vvgs and some ETN or something.
I don't this is a moment in market I'm still laughing. Sorry. This is a moment in market history that lives for free in my head because it was a lot of interesting things happened. So for those who might not remember all the details, there were these two little volatility products to exchange traded notes that basically ended up having this huge impact on the market and specifically the volatility index,
the VIX. And so you had this kind of tail wagging the dog scenario where you had two products that ended up impacting the overall market. Yeah, and you know what was really notable about the post twenty ten environment is that just keeping a steady short volatility trade on was extremely profitable for years, and people sort of just get rauled into it because, you know, by the dip
was like this sort of dominant thing. You had the FED sort of on your side, typically playing some role of you know, the FED put and all of that, and you had the residual anxiety of the crisis. So people were paying a large premium for protection, volatility protection. So being a seller of that and sort of being implicitly short volatility was just great until the one day it wasn't. Well. This is why these two exchange traded
notes came into being in the first place. It was because people wanted to be able to sell volatility, and I remember they became very popular with a certain faction of retail traders. There was even a sub credit called a trade XIV, which was the name of one of the notes. Yeah. Yeah, it has since rebranded to Trading Vault because we had this vall mcgeddon situation and both
of these exchange traded notes ended up collapsing. So not only did they sort of spark this wider move in the market, but they ended up dying because of it. What's interesting in retrospect and I hadn't really thought about this. But what's interesting in retrospect about this story is that, Okay, in twenty eighteen, the retail move was like, okay, trade XIV or go along XIV, and that was sort of
like how people played this post twenty twenty. Now you get the sense that retail is playing derivatives more directly, particularly call options, and so then rather than some note or instrument that implicitly did that. Now, of course, the story of the Robin Hood and all that is lots of people are just getting directly into options trading. That's right,
and the big story in options right now. And the reason I brought up val mcgeddon not Armageddon, which thankfully hasn't happened yet, is because eight thank you for the caveat. You never know, all right. So the reason why we're talking about val mcgeddon is because you have this new
type of option on the scene. They're called one day or zero day options, a zero DTE or one DTE, and they've kind of exploded in volumes in recent years, and there's a lot of discussion about whether or not they are going to lead to a similar val mcgeddon type scenario where you have, you know, this small thing, although they're not that small anymore, but you have this small instrument that ends up having a cascade effect on the market and leading to a bigger effect on the
SMP five hundred, the benchmark index. Right, And as always there are these concerns that any sort of derivative instrument which is you know, might be used for hedging purposes, could have this feedback loop. And of course the classic there's like nineteen eighty seven and yeah, and the Stock market Insurance sort of they called it. And the other thing you note, and this is sort of what's interesting
to me and why we're talking about this. It's like, in twenty twenty one, I think we had a very good story for why there was so much of this sort of zero data expery option trading. Right. This story is like all of these new degenerate gamblers and they're on robin hood and they're like trading these hypervolatile derivatives that you know, they're short term bets and they're just
being swings. We've had this cool and off of speculative activity over the last year, as clearly seen by prices, right, you know, Bitcoin and arc and all these things have come way down from their high and yet the level of trading in these instruments is still very high, which complicates the a story that oh, it's just a bunch of like retailer at home gambler. I was about to say, I think it hints that maybe it's not just retail and this is something that I've written about on All
Loots and you should all check it out. And speaking of what I wrote on a blots on the blog recently, we were going to actually be speaking to the perfect guest. We're going to be speaking with Nomura Cross Assets strategist Charlie McElligott. He was the author of a very very good research piece that I wrote up a couple months ago and has been writing quite a lot about this topic. So Charlie, thank you so much for coming on All thoughts.
Excited to be here, a long time listener, first time calling. I love it. Maybe just to begin with talk to us about what these options are exactly and how they came into being and also their intended purpose, because I think nowadays people talk about them as oh, it's part of this speculative betting frenzy, but I assume they're supposed
to serve some sort of purpose. Absolutely, So you know, I would I would almost start this conversation going backwards by saying, look at the stock chart of the CBO right now, right, which is almost a proxy on the explosive growth and usage of options, you know, from the investing community, whether it's institutions or retail investors, and it does fit somewhat tidily with this larger kind of speculative excess boom of the past two and a half three
years in that post crisis period, the Wall Street bets stuff that you guys just spoke about, you know, the stimmy checks and you know SPACs to crypto. You know, this kind of new world of leveraged, highly convexed payouts is a place where flows and money followed, and this is the type of return profile that people are really looking to looking to exploit in this day and age. And in that sense, that's the unspoken portion of why
these are have been rolled out and offered. Now there's daily expirations, there's an expiration for every day of the week, and the zero DTE product is now almost one out of two options the trade with the spy ETF for instance, right, So, and you know effectively there too for large S and P which is almost exclusively an institutional product, So the
demand is there. I think the official line, probably from the exchanges, would be something to the effect of, we want to offer the net end users more tools to manage their risk, manage their liquidity profile, things of that nature. And look, that is not wrong either. Right when did CBO actually launch things? You know, kind of call it mid last year? Okay, oh, okay, so they really have
not been around very long. So options, right, hedge risk, that's what they're all about in theory, and someone like maybe take some more spectative position. Someone needs the hedging, they trade an option, etc. How do you go about trying to decompose how the instrument is actually used and how much is it from Okay, you have a large portfolio manager that needs to hedge their downside, etc. Versus how much of it is being driven by someone who
wants to make a bet on what Tesla will do tomorrow. Right, that's a It's a great point, and I think that is where you know at this point, you know myself, my colleagues Anthony Antonucci and Johanna Wang have done some pretty quality work here. I think unpacking that exact idea, like just looking at open interest, just looking at volumes themselves is not indicative of anything. Right, we need to get a sense for you know, are the net end users buying or selling these? Right? It speaks to the
macro regime, speaks to the volatility regime. Right, you could say it to a certain extent looking back in the kind of QE era, let's say where we did or where FED was an active suppression of volatility mode large scale asset purchases zero percent or negative interest rates. You know, that was part of this idea. You create a wealth effect. Financial conditions are easy. It's a growth tail end. All that good stuff, virtuous stuff happens. The FED was telling
you to be leverage long assets. Right, so you had a need for hedges to a certain extent. So like a measure like skew right, which is a measure of kind of downside demand relative to upside demand, like the credit Swiss fear barometer right right to a certain extent right so or or even you know specifically put skew, which is like demand for a tailier or crashier put relative to something closer to the money. Those measures were very high skew was very steep back then because you're
long leverage, long assets, you needed downside protection. And this gets to the point though of why selling valld xav was so profitable, because if you have so much demand, right, you have the structural demand for protection, lots of buyers, a good market to be seller exactly. And what it does, I mean the way that you look at volatility, it's
kind of different from this um you know. I It's what I've learned from being in the vall space, specifically within the Numero Equity drives desk for the last five years, which is, you know, a top three market share player in the US options space, is that it's it's a consistent shuffling of your feet. You're trying to find value, trying to find kighie convexed payouts right, which to a certain extent, is why these options exist in the first place,
where there's so much demand for them. You know, you have a kind of a defined risk, but a much larger kind of multiple times implicit leverage you know on the payout right if this thing you know strikes gold, you know to a certain extent, so you're kind of range trading when something is cheap, or when Vaula is cheap is when you want to be adding protection. When Valla is rich, that's typically when you want to you know, flip positions and be you know, kind of short volatility
or short gamma. So those those are all part of the calculus here. I think what matters then, However, in this QT era right where the Fed has their hands tied in light of the inflation overshoot, in light of this dynamic where you know, they were clearly behind the curve. I mean it was just a year ago at this time they only stopped buying bonds, might you, Right before they even began, you know, their first hike, they were still buying bonds. So they've needed to tighten financial conditions.
They've needed to try everything they can in their limited tool kit to address you know, the wealth effect that was caused from these you know, legacy ten year plus easy financial conditions, and that means cramping you know, the demand side of inflation through tightening FCI. And in this case, what QT has meant was a very simple trade and that's why you know it was such a clear trend in twenty twenty two. It was kind of like long
dollar in short assets. That's why like CTAs for instance, were you know, thirty some percent, like there was a very clear defined trend, the FED was effectively telling you to be short assets. Right. What we saw then was this trade that still kind of exists to this day, even for the most recent Jerome pal commentary, which was kind of this view that when you're in a in a kind of a stretched equities valuation, the FED is de facto a seller of calls at the low end
of the equities valuation. They don't want to market crash per se either. Then they kind of talk you off the ledge and they're a seller of puts. We're bouncing around this range. But in QT right, in a QT era where you know, they're shrinking the balance sheet, where they're jacking up rates, they're trying to tighten financial conditions, it kind of perversely creates this situation where you're being told to be short assets. You actually don't need as
much hedge protection. So one of the big questions for the last year like why is VIX so low? Right, And that's part of this idea. If you don't have a lot of exposure on you're sitting in high cash you're sitting in low nets. You don't need a lot of like crashy downside. This is such a that clicks. This like finally feels like it clicks and answer. It's like a big question. It makes so much sense, right if you're if you're if the feed is telling you
hold more cash, don't be so leverage. Yeah, then you sort of have your built in hedge already cash is and at the money put it. Yeah. So just a really basic question. I know you've done some research on this, but what does the split actually look like between institutional versus retail usage right now? Well, I think that's part of some of the the you know, fuzzy assumption that
makes this an uncomfortable discussion. You know, I don't truly trust men, whether it's you know, cash percentage of the overall cash equities universe, or um you know, assumptions about options trading. With regards of this idea of what is retail versus institutional, I think a lot of people do kind of a naive analysis looking at the size of saying you know, as it pertains to the options discussion, looking at the size of options contracts, and then you know,
under a certain threshold. They will kind of label those as Okay, this is you know, retail type size, and then you get this, you know, potentially false narrative. I think the issue is that, particularly with this product, it's an electronic options product, which means it's a market maker. Is kind of the counterpart here. It's going to be my next question you get into that. But and and who who are the savvyest electronic options market makers with
the best algorithms, the best risk tools. It's these entities that you know, you know, no no specific names necessarily I'll use, but you know, are incredibly savvy with those algorithms. They're slicing and dicing up their risk all day. So you're not going to see huge, blocky types of flows that you know you could typically pinpoint and say, you know, because just because something is an odd lot does not
necessarily mean it's retail correct. I mean you're I mean I well, in my in my past career, on a cash desk when I started out of college, I sat at a dot machine and I had a time schedule for every minute of the day on a view op order, a tuop order, I had to send down one hundred and twenty shares at nine fifty nine at ten am, I had to send down one hundred and forty shares
at right. I mean, that's how this thing works. You're on a you know, this distribution curve, so that's kind of imagine that now times like a much larger risk order than you have. So I have a hard time
attributing retail institutional here. You know. One thing that I will say is that recently, what you have seen which proves out this idea that this clearly is an institutional product by and large, is you have seen kind of upstairs size premium spent, right, so the amount of money that the net end user is spending up front to directionally buy. In this case, recently we've seen some large put buying. Right. This is again you're sort of like
leading into all my next questions. But this is an unusual thing about these shorter dated options, which is that I think the split between put volume versus call volume, it's very skewed in one direction. Why is that? Well, I think the simplest thing I would say right now, and this will kind of go into some of the work though our team has done to kind of assign this idea and to kind of push back as it
currently stands, this is an ever evolving product. And look, each day, I like to say, is its own ecosystem now with these products. So there's not necessarily going to be a carryover of prior day trend, but generally so you could have a day where it's mostly puts where which it has been so far, and then you could have a day where it's mostly calls, well to a certain extent. But this is the deal. This is kind of at core of how these things are trading right now.
By and large, there's an inherent almost by definition mean reversion flow from these things, because whatever you're putting on intra day ultimately then if if it's moving in your direction ultimately then needs to be unwound and monetized. So the actual impact that you're getting. So let me walk you through kind of the way that one we're identifying these flows and trying to assign a buy or a cell.
The CBO handles options flows, let's say, for kind of you know, index and ETF options type stuff, and what we do is they assign a kind of an end user tag, right, so there's kind of a broker dealer traditional let's say like upstairs, big bank options tailers. Sorry, just before we go on, what is I think it's
the second time you've said upstairs. What does that mean? Sure? Sure, so just speaking to actual high touch sales traders and risk takers, not necessarily on the floor of the exchanges, right, but more associated with large balance sheet banks, the big stuff. If we if we did a subscriber only version of odd Lots, we could call it upstairs. Yeah, that's kind that's kind of nice. So in this case, you know, the broker dealer tag with these products is actually there's
no clear angle to these to these flows. Right. You can see everything that they're trading in these zero DT options, and some days they are long and some days they are short. Market makers right in this definition, are those electronic options entities that we're speaking to, right, the very tech savvy kind of newer players in the scene, I'll say, and they buy and large are the net sellers, right, they are the sellers. They are the source of supply
for the end users. In the final kind of category, because there is a broker dealer prop, which is I think an antiquity kind of term when you know prop desks were a thing, and it's it's no longer really particularly relevant. But the net end user is actually a
customer tag. So that to us, you know, are the people who are you know, trading at home, you know clients, you know, institutional clients for retail, etc. What we do is we take a kind of a trade pressure monitor, and you can do this with a you know, a futures contract, but where you're looking at time and sales and what is transacting at that time versus the bitter offer.
And what you then see is if something is kind of you know, generically, you know, assumption wise, if it's trading above the midpoint, right, doesn't even necessarily have to trade offer. But it's above the midpoint, that's somebody typically who's lifting an offer. That's a buyer, right, and vice verse right. If it trades below the mids, it's somebody
hitting a bit, it's a seller. And what we do is we net out all the trades over the course of the day, and then we get that and we look at buys of calls, cells of calls right by puts, cells of puts, and what we end up seeing is a very clear pattern that market makers are almost always net sellers and customer flows are almost always net buyers. And that is core to this discussion right now because you know, as it relates to this larger topic of valmageddon,
which we'll touch on a bit. You know, that's actually the setup that I am most comfortable with, where the seemingly you know, day trader, right the seeming kind of the buyer of this is more into creating a gamma a gamma flow in the market, of momentum flow in the market, and we can kind of unpack that, you know what that means. But but they have a defined risk they're spending the premium on the option. Most of these options are going to expire worthless as you kind
of push out of out of the money. Wait, so before we get into sort of knocking the valmac eddon argument down, can you talk like what is the val mcgeddon argument? Can you piece it together for us? And then I know you don't necessarily agree with some of the more extreme interpretations of it. And I know, for instance, there was a JP Morgan note recently where they said that a five percent drop in the SMP five hundred could basically snowball into another twenty percent drop because of
these options. Talk to us about the dynamics that would drive that cascade effect in theory. So in you know, to take it back to twenty eighteen and that valmcgeddon scenario, and you know, you guys kind of got the joke right. There was very steep skew at the time. Vall was you know, at times screening attractive as a cell because of this kind of fed macro suppression, right, and you had no yield and fixed income. So there was a lot of growth in val selling strategies and you know,
yield enhancement strategies. And this isn't necessarily from you know vall Arb you know, um, you know hedge funds, you know, in dark, opaque corners of the market. This was you know, the largest asset managers in the world, you know, with overriding foot Bill gross stood up on stage and said sell volatility, right, that was That's how he did it. That's how he did it. He was you know, the biggest ray Volve guy out there, you know, and just constantly mushing that stuff. You know. So this is more
than just an equities discussion. But so there was this build up, an accumulation of short volatility in the market and in particular with those products right their end of day hedging requirements. The larger that short vall trade got, which again, you know, everybody gets the joke it's a picking up pennies in front of a steamroller thing. You're just collecting premium, You're you know, collecting income, you know,
FATA gang, all those kind of euphemisms. That one day, and it happened to be that there was an actual macro catalyst. Over the course of that December and January, the Trump tax plan went from kind of zero delta, meaning like nobody thought it was going to get done, to getting approved in like the House or the Senate by mid December, and we were already at above trend growth and above trend inflation, and all of a sudden, now you had this big fiscal boom out of nowhere.
Over the course of January, equity equities was spot up, so the market was up, but VALL was going higher because people were buying upside optionality like crazy. So a spot up vall up, which is you know, a kind of a known term for an unstable market, I guess you would say. And over the course of that month, we kept seeing you know, prices paid beats, you know,
from regional Feds. There was a CPI release and at the day, the Friday prior to you know, Val mcgeddon, you know, February fifth, I believe we had this average early earnings print. I believe it was like a three
standard deviation beat or something like that. And for the first time in that QY era, there was a Holy smokesall there was a Holy Smokes moment, and there was an inflation scare, and all of a sudden, that seemingly very controlled forward path invisibility of the Fed keeping rates lower forever was no longer a thing, and that morning, you know, so THATSP traded down two and a half percent.
I think that Friday, that morning, we saw these things start to come unglued, and a lot of people were short these things right, and they had to turn by the end of the day. Well, the craziest thing is they were tied to VIX futures, and I think the week before you could see the VIX curve start to invert, and everyone knew what inversion would mean for these products.
And I remember, I will never stop bringing this up, but I remember tweeting about how VIX curve inversion would be really bad for you know, these two etns, and then it happened and everyone was shocked. They were like, oh, I didn't expect it, or at least you know, a significant proportion of retail seemed to be shocked, which was unfortunate. But you could see it coming right right. I mean I called it a for you know, I think that
at that time, like it was a neon swan. Yeah, we knew that you need needed a catalyst, and it was probably as always as we've seen with this most recent you know, multi year period as of you know, the volatility catalyst was inflation, because it shocks you out in this kind of lazy, you know, que mentality, zero bound rate mentality. Moving back to the present day, you know,
what is it? So, as you pointed out, there's good reason to believe this is heavy institution, institutional or active buyers of these UM zero data expert options, and clearly there's a lot of demand there. The demand is real for it. What is it? I guess what are they
used for? And by that I mean specifically, what is it about the characteristics of current large scale institutional portfolios that this sort of like standard length longer I don't know, duratial maturity option, I don't know what term, just whatever, longer data expery options are not as good for why do they need such short term protection? Well, so I think what you want to do is you look, you know, I spoke earlier about kind of the shifting vall regime and a Q E versus K TIERA right, and then
last year skew flattened to like zero percentile. Right, So that what that tells you? Right? And we said it was because you know, largely generally speaking, without going into some really technical kind of flows in the structure product space, there was this general underposition that didn't require hedges. It was a crash less sell off. It was a grinding
d leverage. Yeah, but why did they need the zero Like why why do they need such short term activities to get to get that same at the level of protection to say, so that so that's the perversion here is that if you were you know, so many tail funds stunt class year because typically tail funds are owning
you know, you're you're you're kind of you're you're. We like to say you're short the meat and you're long the heat, you know, like that's a kind of a generally you know, assumption of what works you need to finance paying for you know, the hedges that you put on by you know, being able to be shorts and volatility at the time, stuff that's gonna you know you're gonna be able to collect on. And then you want
to own like crashy stuff. Well because we never crashed. Yeah, like you know, owning Gamma into these event risks didn't pay out, so and owning puts didn't really pay out because it was this grinding, spot down vall down environment. Skew was flat. The actual only days we really saw Vault perform were on crash ups because nobody had it on right. Nobody was worried about a further sell off
because you had such low exposure. You're high cash, as we already said, you know, like if anything, you were hedging daily event risk, and that was a big thing. So much of the event risk last year was a CPI print, was an NFP, was an FOMC meeting, was an ECB meeting. So you wanted something that really looked alike and was going to be highly sensitive to that
day's move right if you were a header. So people were buying like at the money same day puts, a one month put or a quarterly put was not doing you any good. And owning like put spreads for some gamma or whatever, it was not doing you any good. So as the kind of the migration of the flow moved to these, to these, you know, each day to
that point early each day became its own ecosystem. And if you are hedging those risks, if you are a market maker selling into a kind of end user who has demand to kind of push the market around either way, whether it's buying puts or buying calls, which we were seeing this, you know the customer base do currently there they should be agnostic really about the direction of the market. To be fair, right, what they were doing are buying this.
If you're if you're now short this stuff, you want something that's going to perform just like those, and owning a Friday option, a weekly option, or a monthly option is not going to have the same umph kind of inhedging your risk. So part of the volume proliferation that we have seen this year is the market makers and broker dealers themselves using these products to slice and disk their own risk profile. Yeah right, it's symbiotic with the
kind of the underlying demand. So just on this note, we have this environment where maybe you're worried about a big intra day move because of event risk, and so you're going to buy a short dated option or a zero or one day option versus a weekly or a
monthly or something like that. What does that actually mean for the impact on the market, Because the whole Volmageddon portfolio insurance doom loop theory is that you end up in a situation where the whole market is basically short gamma, and what if it keeps to cli lining and then market makers have to keep selling in order to hedge.
But I'm assuming if you're talking about these ultra short options, I mean, maybe it could make the market volatile on more volatile on a one day basis, but probably less unless you get sustained selling for several days. Probably not going to lead to, you know, a nineteen eighty seven type situation, right, So you know, I think you know, in one of my you know, quasi recent notes, there was a span you know, at some point in February I'd say like over ten days, seven days, I want
to say seven days. I think we had fifteen or sixteen one percent moves in both directions, and like a week and a half, I mean it really was. I want to say it was like the first week and a half save like February, Okay, when when you know the velocity of mentions of this, you know, this became a very trending conversation. Yeah, and you at that point too, we were printing, you know, basically the high usage points of these options to date. You know, one out of
every two options was a zero DT option. And what you were seeing then was kind of that exact point that you're bringing up, Tracy. It was like you're getting this enhanced intra day volatility because when these options were net bought by the customers, the dealers have to go on had that gamma, right, So when and what that means is that you know, if I'm selling upside, if I'm selling upside to you, you're trying to induce a move in the market. You're trying to kind of push
the market with this accelerant flow. That's the lesson that we learned with the Wall Street Bets yellowing phenomenon. Right, And you know this it came part and parcel with the democratization of financial information, right, the democratization of trading and making it like a video game. This was that highly convex you know, low risk while you're doing is
spending your premium that lottery ticket phenomenon. Yeah, and this has become a powerful flow and people now get the joke from retail to former institutional folks that didn't think about options as a vehicle. Joe, you might remember I wrote about this in the news letter. But this to me is like the legacy of crypt Well, crypto is still here, but this is the big invalence of crypto to me, which is that people bet on ever shorter
term events and they're kind of agnostic to price. Right, it's like does the market go this way or does it go that way? Actually, this leads perfectly my next question.
It was like, how big is that activity today in early twenty twenty three in your view relative to where it was and say middle of twenty twenty one, because obviously a lot of those people must be gone or wiped out or something, but it's clearly I mean there's like this cultural thing and there's a lot of people still doing it and talking about it, etc. So like in your sense, like the sort of Yolo Gama squeeze trades that we talked about We've had on the show
multiple times, like how much of a force is that today? First, back then. So this is kind of the way I think about it. It's a very it's a very option centric phenomenon, right, And I'm not just saying, oh, like
zero DT options like shocking. What I'm saying is that in the absence of a clear kind of macro message, and you were seeing that with Jerome Powell and the Fed and the market really trying to come to terms, you know, by getting ahead of itself and anticipating the end of the tightening cycle and trying to begin pricing that in and then bang, you know, hot inflation data or hot jobs data keeps you know, the Fed having to readjust and the market reprices terminal rates and all
that stuff. When the trade becomes very challenging like that, where again on a daily to weekly basis, where you know we're completely held hostage by an individual new macro data point or a new central bank meeting, I think there has almost been I don't want to say a trade or boredom, but you need to exploit some other phenomenon where you're dealing with kind of binary outcomes and
what ends up happening. What we've seen is that if you are a market maker or you know, to a lesser extent, as I said, a dealer, and you have clients looking to exploit these intra day moves, which by the way, there's also you know, kind of a regulatory paper trail aside here as well, because you know, if I'm you know, selling, if I'm selling an option, let's say, okay, I don't at the end of the day, if it's not on my prime broker's books because that trade has gone,
I don't have to you know, do the kind of the the margin you know requirement right the collateral um you know kind of requirement. So you know, there's there's also this at as opposed to using a futures order, which, by the way, you would put a you know, like
for a stop loss or risk management tool. So often in this type of world, you put your stop loss out here down at this level, and you know, the market goes there and you execute and you're out of your position even though you want it to be long And then by the end of the day, the thing is higher and you just killed yourself. These sit out there live until four o'clock. They give you a chance to not get knocked out. Oh and I didn't realize
that about the margin requirements. That's interesting, Yeah, I mean so it's just you know, those types of things are all part of this tailwind to these to these products. But the thing that I want to say, as if you think about where a market maker is basically positioned, they're kind of they're short of put and short of
call on a daily basis. Our data shows for that customer tagging that almost every day by and large particularly and we look at you know, moneyness buckets, right, So and that sounds kind of intimidating perhaps, but just think about like calls in the up one percent to up three percent, right, is almost always a net customer buyer trying to create that gamma squeeze, okay, But so are
puts in the ninety seven ninety nine. So like down one, down three percent, almost always a customer buyer you're trying
to push these flows around. So just on this point, and you mentioned exploitation earlier, and one of the things about Vaal mcgeddon and those two exchange traded notes or products, was that eventually market participants became very very aware of their size and how they worked and sort of realized that they could influence those products so that the products in turn would influence the underlying which in this case
was Vic's futures. Is there a chance that you could see something or you're already seeing something similar here where sophisticated market participants understand how these options work, the hedging activity that they generate, and they start to sort of game them. Yes, but what you're doing is you're kind of intraday gaming them because again the inherent mean reversion
property of these things. If you're going to monetize, you got to do it by the clothes and what you're getting this is feeding into the intraday volatility expansion, right, the interday acceleration flow. I'm lifting a guy on upside calls, you know, and out of the money upside calls, and the market starts rallying, and then we get through a strike. He's short gamma, right, So the higher the market goes, the more they have to buy to stay hedged. You're
trying to help push, You're trying to get the ball rolling. Again, These are acceler and flows the same thing to the downside, and that is that is, you know, well within the kind of the bounds of fair play, right, it's the same thing as you have to go out and buy five yards of futures. You know you're gonna rip the market. It's going to leave a footprint. You know, you might be trying to do it kind of little profile, but
you know these trades. We've seen futures on options on futures trading of late where people are doing this clearly on the screens where they're buying twenty thousand options on futures down fifty points in the middle of the day and puts. And that was a big story a week or two ago where the market moved because there was two billion dollars of delta for sale. Everybody saw that.
Everybody knew it. Actually, maybe just as a way to sort of help me conceptualize this and understand the example that you just cited, like can you talk a little bit about payoff probabilities, Like can you sort of walk through a sort of a specific like type of bet that someone would make and this type of situation, like what are they risking? What is the upside? Everyone wants that's sort of like big lottery tickets type move et cetera.
Can you sort of like walk through like a sort of theoretical trade or theoretical like math behind how an entity would enter and think about the upside and downside. Well, I mean without even getting into like a complex option strategy.
Right if you were just simply buying same day call options, Okay, you know kind of through the end of January, You'm just running a systematic strategy of you know, of buying and closing like you're up you know, say, you know, five percent just on you know that alone consistently, and you had you know, an actual like positive sharp ratio too.
Like that's not a normal kind of environment because January was this like everything type of rally even though you know, there were times where we were rallying involved was going higher.
But it's more actually the view of why, in my mind, why market makers want to be are willing to be short these right, and that is you know, a critical part of this process, particularly in this VALL regime where you know, VALL can't squeeze yesterday, you know, barely barely ticking higher, right even or excuse me, on yesterday, meaning referring to the first day of the politicistimony on the sea.
But if you're looking at you know, a sharp ratio, right, so a measure of kind of performance versus a risk unit. You know, it's really a marketing tool, right, you know, it's not an actual like risk calculate, but shorting a daily straddle, which is what these market makers are doing. Right. They're short of put and short of call to a client, or you could say short of a strangle as well,
kind of depending on same strike or wider strikes. But you're talking about an S and P for the last ten days, that's a seven sharp selling that selling that straddle systematically on a on a twenty day, you know, it pushes up somewhere, you know, or it's still like a five or something like that in an S and P. So these this is a big pay out for these market makes. So okay, So what is the regime shift
scenario in which market makers could get run over? There's short puts and calls, so they're essentially making bets on not big moves, right, Like to a certain extent, Yes, in a world where we haven't had crash and there is not so right, we've had declined but not crashes.
And part of that is perhaps you know, due to these sort of like delevering people don't have people have more cash on this sideline so they don't have to like sell in response to selling, etc. But talked like about like what is the scenario in which a market maker with these you know, short straddles could get run over? Well, so in this dynamic that we're that we're talking about, that that has kind of been the setup for most days, right, you know where you know it's it's actually a good thing.
I want the short ball short gamma being managed by professionals, some sort of regulatory oversight, capital you know oversight you know, with more robust discipline kind of risk management process and not by the same day intra day scalpers who are shorting tales for income. Yes, right, that's that's critical to me. So when I'm speaking with regulators, which i am, you know, when I'm speaking with um you know kind of oversight type of entities and and you know things of that
nature that want to know is there a systemic risk? Yeah, this currently is the right set up to be you know, well managed. The thing that would make me uncomfortable would very much come from what would almost require certainly a different macroeconomic regime, which would be a much more highly speculative environment. It would probably require, you know, a resumption
of quantitative easing. It would be a very different world where there wouldn't be all this yield and sitting in cash and you had to go back to being risky by selling valls. Sorry, I don't want to keep pressing on this, but I'm trying to understand, like, yeah, they're really smart and their professionals, but smart professionals blow up
to wait, wait, wait, wait. So just on this point, I think like the biggest criticism of the val mcgeddon scenario is that if your put went up like a thousand percent in a day, you would sell it, right, which would like start to decrease some of the hedging needs or bring in buyers buying from market makers, and that would ultimately support the market. That's my understanding of
the sort of opposition to val mcgeddon thing. I think the sheer supply of short vall then versus this very tactical and then daisy chained hedged you know environment that we're currently in where part of these volumes once the dealers are short some of these you know, down to or up to types of scenarios are them Are they themselves hedging out these scenarios and slicing and dicing their risk.
Back then, that was the largest supply of kind of short vall that we had seen, and we knew mechanically it had to rebalance. That's why it was an extinction event. People begin to shoot against it now that of course, that can still happen now, but again due to this dynamic where if the trade is actually going your way, you are being incentivized to close it out. And that's why.
So if classic realized volatility is a measure of close to close volatility right right now kind of sort of say VIX the VIX future at like around twenty is implying a one point two to one point three percent daily move in the SMP like five of the last seven days. I know it's a random sampling, but have been like fifty bibs or less. But what you're getting
is one percent intra day moves. And this is the thing, right what you're getting is like from from a you know, a volatility measure that actually incorporates open to close or
hide to low. You're actually seeing vall expand at some times, but from a classic volatility perspective, because this mean reversion flow compresses from a daily change, right that idea of an ecosystem of each day its own ecosystem on a closed to close basis, these trades are actually helping to compress volatility and actually leaning into implied you know, volatility is kind of grinding lower, which is very much where
we're stuck right now. So I just have one more question, and it's kind of facetious but not really like the day to day takeaway from this is that like the CBOE and the marketmakers must just be minting money from this. And secondly, doesn't mean that if you're an equities trader, like you don't even have to be around for the full day. You could just be at like around present for the open and the clothes and those are the
most important things. Now. Well, so we watch, you know, there's a ton of mythology and wheel spinning based on you know, in recent years, and I've been you know, part of this process for certain with regards to getting a sense for the aggregate options landscape and where extreme long or short are the aggregate delta is across options and where dealers go short gamma, you know, versus spot and things like that, trying to find these acceleration points
in the market where things could go wrong or things could get slippery in either direction. What the proliferation of these tools is done. As we said, each day has its own kind of environment, and when we're looking at these things trading, these don't necessarily mean that it has to be an open and closed So as we've moved away from looking at the longer term impact of kind of the longer expiration options, and now it's so intra
day based. We have a lot of tools internally where I am seeing whether or not premium is being spent or premium is being sold. And that's meaning so if I see delta going higher and I see premium going up in a positive direction, on these tools, I can assume that calls are being bought right spending premium, and thus the delta is going higher on a day like this recent Jerome Powell, you know, hawkish kind of escalation yesterday,
what we saw, he comes out of the gates. There's a ton of puts bought, and then you get the down move. And this is a big theme in twenty twenty two as well, with a number of the big CPI upside surprises seemingly hawkish data points. People would monetize that downside. It would immediately put in a floor in the market, right because now you sell those puts, you sell those hedges or directional puts. It creates an impetus
now for dealers to cover their short futures. And then people would even further exploit that by buying same day calls to kind of create a further squeeze of that impact. So all day it was by puts, sell puts, by calls rally, and then we got that, we snapped, and we sold off again. It is a you can do as much as you want, right and you're not held
to close. You know, you can close them out midday if you got your two hundred percent return and a far out of the money thing that went in the money, And that's happened on multiple occasions intraday, you know you're good. But the overall point is absolutely not every day are we closing back to flat? You know, I'm not trying
to say that. With regards of this mean reversion dynamic, we have had a number of days, certainly after the rates repricing and some of the volatility in February, the policy of volatility in February and the rate volatility in February, where we actually did look kind of short gamma, meaning we either closed on the low or closed on a
high at the end of the day. You know, when I say we looked short gamma, it speaks to that dynamic where market makers or dealers are needing to buy something the higher it goes, or sell something the lower it goes, particularly at that end of day hedging period. Now you're getting this intra day hedging period and intra
day unwind period. So buy and large again with the customers being the buyers and the kind of the the dealers and the market makers being the managers of the options greeks, risks and the second order greeks, that is a far safer place to be in my eyes. It's when we see that resumption of selling tales intra day that my spidy senses will go up and say, I
don't like how this could go. Then you very well could have a situation where they don't know how to manage their their you know, their gamma risk, right that with the sensitivity of their delta to a move in the underlying the sensitivity of their delta to a move, and involve their Vanna risk. Right, all those things. These things have a shelf life of six and a half hours best. They're super sensitive. That's the reason that they're attractive,
because they're you know, lottery tickets on steroids. And again with a defined risk, you can spend eighty bucks to make eleven thousand or whatever it is I want to do that. You know, that's the kind of setup. You've learned nothing from this podcast. Spidey Sense for a spy impact is also very good, Charlie. We're going to have to leave it there. Thank you so much. That was a fantastic explanation. Really appreciate you coming on. Thank you
guys for having me so Joe. I found that conversation fascinating, and I think whenever you do have an explosion in volume of a new type of product, it does warrant some caution and additional scrutiny. But for me, the big takeaway there was this idea of every day is kind
of a new ecosystem. In this idea that more and more people and I thought Charlie did an excellent job of sort of crystallizing a lot of these ideas, This idea that if you don't have a defined macro environment or macro trend, then why not trade on a sort of day to day basis on things going up or down? There was a Yeah, I found that conversation to be
very clarifying. The big picture, like sort of aha moment for me is that you know when portfolios are less levered because the FED is sort of telling you to,
you know, use less leverage. They're raising the cost of borrowing, etc. Like, you don't need as much long term structural protection because you have a volatility hedge already, which is the amount of cash that you're holding, But you know, you still have these one day moves, so you have the less big macro crash risk, but you still have these one day moves around CPI releases or around FED speeches, and so yeah, intuitively, you think, okay, short term options, this
must be all just people who like to gamble betting that eighty dollars for eleven thousand payoff. But if the story is really about one day moves and one day risk, then you can see why institutional portfolios would like to trade these instruments. Yeah, well, I think there's definitely a
rationality behind it, especially on the institutional side. But I also think we can't ignore that just over the past few years, you know, with the advent of crypto and then the Wall Street bets phenomenon and all of that is we've kind of normalized the tokenization of everything, or the lottery ticket idea, and you know, I can just treat this as sure, go up or down and make a lot of money. No, I mean, like that's obviously
like such a thing. I mean, it's like such a part of the culture, the gambling culture, the sort of like take risks, the sort of like shoot for the moon, like that is like a real thing that I don't think we've felt to nearly the same degree five years ago or whatever it was, you know, even Val mcgednon. All that stuff feels like sort of like a quaint era and now within how people treat markets. But yeah, no,
I think that was fascinating. And then also I do think Charlie's explanation of like the sort of natural mean version of the people who participated in the markets was helpful and again sort of like reasons to think that even with a lot of speculative activity, that the nature of them is more towards curbing large moves rather than accelerating a large move. Well, it's kind of like the bad news is short. You know, one or zero day options might add to intra day volatility, but the good
news is it's intra day volatility. Yeah, it's only a day. Well, that was so fascinating, Like the idea that's like, Okay, something bad happened, so like everyone started to buy and puts that pushes it down. People immediately want to start monetizing their profits on that. I was like, oh, let's do the call squeeze and now, because we know that everyone's going to be monetizing. So you do sort of get that sort of like it's volatile, but it's sort
of also dampening at the same time. It sounds like exactly, shall we leave it there? Let's leave it there. This has been another episode of the All Thoughts podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway and I'm Joe Why Isn't All? You can follow me on Twitter at the Stalwart. Follow our producers Carmen
Rodriguez at crmin Arman and Dash Bennett at Dashbot. Follow all of the Bloomberg podcasts onto the handle at podcasts, and for more odd Lots content, go to Bloomberg dot com slash odd Lots, where we post transcripts. We have a blog and a newsletter that comes out every Friday. Go there and sign up. Thank you for listening.