Welcome to U Got Options, an exciting series right here on Top Traders Unplugged, hosted by none other than Cem Karsan, one of the sharpest minds when it comes to understanding what's really driving market moves beneath the surface. Inthis series, Cem brings his deep expertise and unique perspective, honed from years of experience on the trading floor, to candid conversations with some of the brightest minds in the industry.
Together, they unpack the shifting tides and underlying forces that move markets and the opportunities they create. Aquickreminder before we dive in, U Got Options is for informational and educational purposes only. None of the discussions you're about to hear should be considered investment advice. As always, please do your own research and consult with a professional advisor before making any investment decisions.
Now,what makes this series truly special is that it's recorded right from the heart of the action on the trading floor of the CBOE. That means you might catch a little background buzz, phones ringing, traders shouting as Cem and his guests unpack real world insights in real time. We wouldn't have it any other way because this is as authentic as it gets. And with that, it's time to hear from those who live and breathe this complex corner of the markets. Here is your host, Cem Karsan.
Welcome to the first episode of U Got Options. Here we are at the heart of the CBOE trading floor, and for our first episode we get no other than Mike Green.
Mikeand I sit down and talk about 0DTE, its changes in market structure and how the 60% volume is playing a role, the reflexivity of the space and, importantly, dispersion and the role it's playing not only in this market sell-off, but likely in the year or two ahead, and lastly, a bunch of wonderful anecdotes drawing from our rich history of experience. I hope you enjoy the episode. HeyMike, thank you for joining us. Excited to have you here for the first episode of U Got Options.
Icouldn'tthink of a better person to get started with because I know you and I share kind of a background, kind of starting here, kind of in the belly of the beast. I'd love to kind of get the listeners a little bit of insight into kind of how you started in the business to start with and go from there. Well, it literally was the belly of the beast, although in New York.
So, when I was an undergrad at the University of Pennsylvania, I actually had the opportunity to work on Wall Street, for Spear, Leeds & Kellogg, as a market maker on the New York Mercantile Exchange trading crude oil futures. We were talking about this before, this was 1989.
I was trading crude oil futures to offset primarily house option and market making positions for Spear, Leeds & Kellogg, and I'm sitting there, in the summer of 1989, and Saddam Hussein invades Kuwait, and in the oil markets it was an absolutely astonishing experience. And how many years in were you at that point? Literally, I started that summer originally as a clerk. And on day two of being in the summer intern program, my boss got fired.
The guy running the program turned around and said, you know, hey, do you think you could pass the clerk test tomorrow? And I'm like, give me a night to study. Sure, I can. And next thing you know, I'm headed towards trading on the exchange. Mine was, ‘98, ‘99. So, it was literally a year before the tech bubble. Yeah, exactly.
Well,you were also trading financial products, and I was trading the physical products which had the unique qualification that I brought to the table there was that that was giant, right? I was, on the New York Mercantile Exchange, relatively small. We've talked about this before, but that was also a super formative experience because I'm trading crude oil futures in the New York Mercantile Exchange, and about two days into it, I realized I'm bored.
Andwhat I want to be is upstairs with the guys who are saying, what's going to happen next week, not what's the execution that happens today? And so, it was super formative for me, but it's been a long time since I've been sucked back into the belly of the beast. But it's fascinating, right, especially with derivatives and options now becoming so, I won’t say dominant, but much more critical to the outcomes of things. You and I end up talking a lot about those effects, right? Well, absolutely.
And again, going back to that time period, when I went upstairs, it was to talk about OEX options, not to talk about S&P options. When I started, the OEX was just as big as the SBX. That's exactly right. And part of that, we forget, that a lot of this is about the latency and the calculations in order to do options trading on the New York Mercantile Exchange. I literally had to install a math coprocessor into an intel, what is it, 8088 microprocessor.
You had to install extra RAM, which you picked up at PC Richards. So, you went and bought it retail. Youhad to print out sheets, and the really crazy part, for me, that I will never forget about that, is the way I learned that Saddam Hussein invaded Kuwait. It was, it was 4:30 in the morning and I'm walking through WTC 5 and I happen to see the headline on the newspaper. There were no smartphones, there was no Internet, it was all completely analog.
And the thought that went through my mind was, I better run the option sheets extra wide. It's funny you mentioned that. 2001, right. We have, you know, the planes at the buildings in the World Trade Center. I come down to the trading floor, and we see it happen on the screen. My first response is not to run from the building. Yeah. First response is to run upstairs to the computer to print out your sheets. Yeah. To get ready for the day. And they ended up shutting it down for four or five days.
And you know, we actually evacuated, had to run. I don’t want to get into all of the emotional stuff from that time but you're right. At that time it's like you'd see something and then you're like, I got to get my sheets back in order. Yeah. But yeah, this whole pit was basically everyone standing with sheets and every time futures would move, you'd be switching it. And to your point, I was 5’ 11”, you're much bigger than I am, among 6’ foot 3” guys just trying to get to an order.
Things have changed quite a bit. Well, the guy that stood next to me in the pit was 6’ 8,” and a former Cornell basketball player. At one point he lost his temper and went like that and literally sent guys flying out of the pit. So, you know, even at my size, I was relatively small in some situations. I was glancing on shoulders for sure at that point. But things have changed, You know, we used to really focus on quarterly.
When I started in the business there were only quarterly options expirations, and only in the indexes. Right. Think about that. And by the way, strikes were 25 points wide with an index at 400. So very illiquid, dispersion wasn't even a thing yet. Right? I didn't have a sophisticated option chain, if they even existed at all. And so, now we have daily expirations, we have 0DTE, which is I think now 60%... By far the most successful product launch I've ever seen.
Ever. It's just absolutely incredible. And a huge component to what's happening in markets writ large on a daily basis. Dispersion,which we often talk about because it really does affect the single stock movement and also, kind of depending on what vol is doing, how things are moving away from each other. And I think we'll get to this a little bit later but it is particularly pertinent to what's happening in this sell-off, in this market right now.
ButI really want to dive in today and think a lot about 0DTE and how that's changed the landscape, in your view. How are these things interconnected? As I mentioned, 60% of option volume is now 0DTE. It's not 30 day vol in the VIX, it's definitely not one year out, et cetera. And why do you think that is? Let's starre. Well, so, I think that there are a couple of factors that ultimately have played in.
I mean, you remember two years ago, or three years ago when 0DTE really became common, there was a ton of focus on like, this is going to cause the end of the world. Andyou and I both looked at it and we're like, yeah, actually I think this is largely a risk reducing phenomenon because by far the largest users of 0DTE are these guys. They are using it to hedge exposures in ways that are far more efficient. It allows them to stay on this exchange as compared to the futures exchange.
So, there's not the need to move off platform, there's lower transaction cost for them. Thesecond component is because it is, itself, a convex product. It radically changes delta hedging characteristics and that's super important. It plays through in a lot of the other phenomenon that we see.
Butif you think back to those 30-day, or 60-day, or (God forbid) quarterly options that we used to have to deal with, as you approached expiry on those, your delta hedging, your offsetting the futures became incredibly frantic. And the quadruple witching days were just these unbelievable events in which you would basically have to decide, I'm going to print my option sheets extra wide.
Alotof that goes away when I have a convex instrument that allows me to conduct my hedge with another option. And so, that's been a really critical innovation. At the same time, it has opened up a lot of markets that had been closed for a while. So,actually, the interesting thing about dispersion trading was it existed, but it existed as an esoteric off-floor activity, back in the 1990s, that was largely about exploiting the unique idiosyncratic volatility of some of the dot com stocks.
Firms like Pimco and a couple of others actually had very successful businesses built around the dispersion trading. Itwas a much slower business back then. Now it's actually bigger and faster but it actually, I think, has a lot of the same underlying characteristics with the rise of idiosyncratic volatility tied to many of these super large single stock names.
What we colloquially refer to as the Mag 7 but kind of extends out to anything that's kind of 500 billion or above or that has levered products associated with it, that has significant options volume associated with it. Tesla was one that was a clear component there, et cetera. It's the same stuff coming back, just in slightly different form. And you're getting to see a lot of the impacts that, in many ways, look an awful lot like what we saw in that time period. Yeah, I agree.
Ithinkpart of the success of 0DTE, in my mind, if not the biggest part in my mind, is actually the removal of the implied vol correlation issue. A lot of your average traders want the optionality of options. They want to be able to bet on the distribution of outcomes and hence not take the whole risk of the underlying. Which is, I think, the biggest thing driving actually growth in options writ large.
Butit's being concentrated in 0DDTE because too many people have bet on hedges that have underperformed over the years. They may overperform, they may underperform but is much less predictable for the average entity. AndI think 0DTE, because it's pure gamma essentially, really allows that distribution of outcomes to be realized on that daily basis in a much more direct way. And I think that's been a big driver of this.
Options,we've talked about this before, but in my mind are a much better way to bet on any outcome. People think of them as hedges or risk management tools, but they really represent the full distribution of outcomes. And anybody who has a piece of information and wants to kind of choose an outcome and really have that information be expressed properly is better off going and choosing that point of the distribution than they are betting on the whole expected value of the underlying.
Well, what you're highlighting is, by going to the zero day, you're reducing the vega components so dramatically. It's effectively a coin flip. Is the market going to go up? Is the market going to go down? And that opens up a range of distributions. Andtoday was a perfect example of that. We had extremely elevated implied volatility going into the CPI report, which of course turned out to be relatively nothing in its underlying framework. I often use the expression a hedged pot rarely boils.
So, if everybody is out there protecting themselves against the event, what you need to be worried about is the event actually being either far greater than everyone was worried about or simply that everyone's wasted their money. Ifyou had used a 30-day option to hedge against an event like today, what you would have actually seen was a compression of your volatility, after the event, that meant that there was almost no way to win in the trade.
Whereas the zero data expiry actually kind of went in both directions. You went up and then you went down in terms of the response function to it. Andso, I agree that that is a driver of it. I do think that the completeness factor, right, we talk about the idea of completeness in markets. The introduction of 0DTEs has dramatically enhanced completeness and that, I think, is actually one of their key components. Younow are seeing attempts to bring other markets in here.
We were talking about the Russell or the VIX et cetera. Some of these are weird. What does a zero data expiry VIX mean when it's a 30-day forward contract? I'm not sure that it has the same relevance. But this idea of completeness in markets, particularly on exchange, is certainly something that I'm generally in favor of. I think it is important, particularly for risk management and expressing direct outcomes, more specifically. There is a question, we do think, and we've talked about this.
I can speak for you on this, that it probably reduces bigger tail long-term outcomes, because if more people are playing the 0DTE, that expires today, and that risk is now off the table. Thething it does most likely increase is one day move potential. Because it's so hard to hedge a 0DTE, without 0DTE, it's a bit of a closed loop. And that's why I think often, most times, it's very balanced in here. Market makers go home. There’s pretty flat vol, pretty flat gamma.
There's been a lot of data behind that. Butthere is the issue of, if there is a cascade, and everybody needs a hedge in the 0DTE, that the thing can be a reflexive thing. So, these options are, quite frankly, just like anything else, they're reflexive to their construction. And a 30-day option is reflexive to 30-day vega and implied vol. 0DTE is very reflexive to gamma and short-term gamma.
So, I mentioned when I started my career at Spear, Leeds & Kellogg, which was primarily a specialist on the New York and American stock exchanges. Their primary role was playing a specialist. The market making activities on the New York Mercantile Exchange, we were a little bit of a backwater. Oneof the unique features of the specialist system was that you actually had a contractual relationship with a company whose shares you were making markets in.
That meant that you were willing to lose money. And when you look at high frequency trading today, the focus is all about I never lose money. It's an optional market participation. Tome, one of the most interesting things that happened in the last 12 months was August 5th with the dispersion unwind. Speaking of that trade, a lot of people colloquially talk about it as the yen carry unwind, et cetera. I think from our perspective, it was all about a dispersion unwind. Right.
And you saw this incredible bid that emerged for index volatility or index options in the immediate aftermath of some of those portfolio unwinds. An implied correlation (I actually shared this on Twitter the other day), it went to 240% before the market opened. Nowmost people would look at implied correlation and say, well, how could it possibly go above 100? That's just telling you there's basis risk between the two. (And excitement.
There we go.) Thepoint that I would emphasize about what happened on August 5 is exactly what you said. We have become dependent on these systems for risk management. And market makers here don't have that obligation. Theyhave an obligation to their P and L. They have an obligation to their family. They have an obligation to their friends that they've made a relationship or a trade with. They might be there for that, but they stepped away that morning.
So, I often liken it a little bit like GPS. Youknow, when GPS first came out, we would make fun of people who would drive off, you know, a road without understanding that they were following something that was incomplete. I'd say the vast majority of us today would do exactly that because we just follow the GPS. We're dependent on it. And that's why these pits still exist. Some people are like, why the pit in this day and age?
Because exactly for that reason, when markets do break down, this is the fallback. And here there's a different approach. Yes,they are going to offset risk but you are also willing to stand in and do something. And it is a system that still works. Haven't been hit by a cyber attack, haven't been, you know, any number of things. This group of guys and girls really look at markets and hey, we're willing to take X risk at this point, step in and do to support the market.
So, I think that's important. Togo back a little bit to what you were saying about 0DTE and vol and particularly dispersion on August 5th. I think it's really interesting that if we look back at recent history, let's go back 10 years, August 2015, we get Yuan devaluation, massive vol event. Then we get February 16th, oil blowout, low vol, market down event. We'vetalked about this before, together, and the sine curve of what happened.
I think after Covid, right, we had 22, which was a vol similar to what we're seeing now - market down, vol down type event. And we were set up for a vol event. Ifindit interesting that that happened so quickly in August. I thought, we thought maybe it might be a bigger event. And you had this historic kind of vol dispersion kind of breakdown. And here we are right back to that other market down, vol down. Wewashed out all the sellers of vol, all the short convexity.
People are back to hedging. And this also played into the fact that, you know, largely well communicated by the administration and others as well. ButI do see us now in this kind of period where implied vol might not work for a while. And I think that's also pushing more and more people again to 0DTE because that is working. And I think that fear of 22 again or you know, vol not performing again has really driving a continued increase there. Well, I mean we are seeing this.
So, you know, quantitative investment strategies, QIS, colloquially as it's referred to, many of these strategies will have protection mechanisms that are built on a VIX response. So, I actually was just looking at one the other day that has so far failed to deliver the protection response because it's effectively an S&P delta trade against a VIX delta trade.
Thosestrategies, as people become reliant upon them and they fail to perform, it causes a lot of the stuff that we're seeing, which is portfolio unwinds. And a lot of the behavior that we're watching right now, this kind of vacillation where one group of stocks is leading one day and another group of stocks is leading another day, in both directions, up and down, you and I recognize as de-grossing.
That's somebody taking down, that's books being forced to be taken down, etc. That is absolutely playing out here. Butit's happening with a lack of vol response that I would suggest because you don't hedge the unwind a market neutral book with 30-day options. I want to unpack that a bit because I think this is a perfect time to do it. You don't get many better opportunities than what's happening right now. And I want this to be evergreen. But like let's use this as an example.
We'vehad a real breakdown between implied vol correlation to underlying move. Right. Market's down 10%ish as of today. The VIX still is still trading at a very muted level right now. Interestingly though, we have a lot of stress under the hood. Not in the vol markets. Butunder the hood. And can't really name names here, but there are several really big hedge funds that are having, for them, four or five sigma losses this month.
And when you talk to them or you listen to kind of what's happening, it's really idiosyncratic. It'slong/short equity, a lot of pairs just blowing out. And there's a lot of hand wringing kind of scratching the head like, why are we getting a four or five sigma event in that space? But to you and I, it makes a lot of sense. It ties into this volatility dynamic and that vol is very well compressed.
Almostby definition you have to get vol (and you still have idiosyncratic risk, mind you), you have to have things moving more away from each other. So, the stress ends up being the pairs and the entities moving away from each other causing the stress. Nowironically, last thing I’ll say, ironically, as that happens, if the losses are big enough, that'll be self-perpetuating because movement away from each other begets more losses, begets more deleveraging.
And the only factor there is not real true factor, it's positioning. Yep. Much like the positioning in the vol markets are driving the kind of vol compression. Andso, I find it incredibly fascinating that then there's this feedback loop that, eventually, that de-grossing can cause stress in markets and push markets down, ironically, because deleveraging generally will force a full deleveraging across the market. Butthat it may actually re-emphasize the short vol trade on the way down.
So, it's almost this reverse loop where vol selling can beget more vol selling can be got more breakdown and correlation. And often it's the logical trade that everybody's taking because it seems obvious that then, because it's all the same positioning, pushes everything away from each other. And I think it's really what we're seeing right now. I completely agree with that. So, to use that example of the strategy that I just highlighted.
So, there you are short a put, or put spread on the S&P, and you are long a VIX call or call spread. Yep. Right. Ifyour VIX does not respond, for all the reasons we've highlighted. People have chosen to use zero data expiry options to hedge as compared to 30-day, for example, breaking with historical patterns. And all of this stuff is built off of historical patterns because that's the only thing we have.
Wemay say the future is not representative of the past, but that's what we have to work with. And so, when you build these types of models, now imagine unwinding that position because it failed to work. I am short a put spread on the S&P. I am long a call spread on the VIX. The offset to that position is a dealer has gone out, or a broker has gone out and bought effectively calls on the VIX to protect themselves against that scenario.
And they have simultaneously recognized that I have sold them a put on the S&P. And so, the unwind of that involves, actually, the position blowing out even further. So,this absolutely plays through. We see this type of dynamic that occurs when stress occurs. But the other thing to remember is that the people that we're talking about, to do this, do it with leverage. And so, losses are magnification vehicles.
And once you realize those losses, unless somebody is willing to step in and provide you with a new line of credit and new capital, you're now an impaired player. Andso, we tend to see these components persist for a while, as we did after August 5th, which wasn't particularly extreme, but that unwind of that renewed positioning and hedging, et cetera, really characterized what a lot of people treated as effectively a Trump rally.
Whether it was tied to Trump sentiment, whether it was tied to underlying components in terms of the volatility surface, we'll never know, but the simple reality is, we lean in that direction. But,on the flip side of it, we are actually starting to see some meaningful flows that are playing through, which tends to be the area that I focus a lot on where, because of the political dynamics, we're suddenly seeing Europeans take their ball and go home, take their money and return it to Europe.
This is causing US Dollar weakness at the same time that we're seeing relative outperformance of European stock markets versus the United States. Theseare factors that we've talked about before. The unwind of everybody crowding into the US and the TINA framework of US Technology stocks runs a very real risk that it has much larger macroeconomic implications.
And I think part of what we're also seeing is a dramatic rise in political uncertainty as we're watching various events play out on the political stage that then turn to markets for validation. Dowe really want to do this? Maybe we should put tariffs on, maybe we should take them off. What's going to end up happening is it's a little bit like the anecdotes that we hear from the 1930s about Roosevelt setting the price of gold from sitting in his bed.
And I think, ultimately, we've known that that volatility is coming from this administration. That's not new. We saw it before last time around. I think it's the mix. It's a mix of those factors paired with a structural set of other things in the vol market. The amount of leverage we've seen, the amount of positioning that is net long now, coming into this from retail and passive, which you talk a lot about.
Yeah. Andthe key point that I think I would emphasize on that is that we went through a period of relative stability, the growth of option dominance, passive flows, et cetera, all of that is facilitated by a complex that exists around it. This helps facilitate the options component. There's a tremendous amount of leverage that is built in here.
None of these guys are… There might be one or two here in Chicago that are operating in the nine-figure club, but the reality is that most of these firms are accessing lines of credit to allow them to do large trades with relatively small margin for error. And they're incredibly good at what they do.
Butwhen the uncertainty rises and you're forced to degross portfolios, whether that is a hedge fund that is running a long/short factor portfolio or whether it is a market maker, that's where the stress starts to show up. I think your average long/short fund, which are a lot of ones that are having stress, have 2 1/2 to 3x leverage. Absolutely.
And to your point, these things are diversified enough, you know, maybe they have 200, 300 pods, that you would think that there wouldn't be an issue with the leverage. But what happens, ultimately, is the market is very efficient and if that much leverage cannot be absorbed, and there are, again, a lot of different funds that have been launched doing long/short in a similar way, from a lot of the same entities, that have increased that leverage.
Andso, when liquidity becomes a problem, that leverage matters. I've called it a sumo market. Things can sit like this for a while. Because you have all this leverage, but you do have a ton of potential energy. And just a little shift sometimes can cause much more pain. I love that description of potential energy relative to kinetic energy. Those sumo wrestlers locked against each other; there's a ton of potential energy that can be released the minute that hold breaks. Right.
I think that's a very good way to think about what's going on. Theother component of what you're describing, there was a headline, I think it was in the Wall Street Journal or Bloomberg today, that was highlighting the growth of J.P. Morgan's business around effectively replication, or factor replication. They've built a hundred billion dollar machine around this. Well, I'm known for saying, why are you reading this now?
The point that I would emphasize is that we all see the same price signals. These are the things that are universal. Andso, the ability to figure out something truly unique and truly divergent is pretty low. And it tends to basically boil down to having a cast iron stomach when other people don't. Agreed.
But when you're thinking about the behavior that we're seeing, and we talked about this a little bit before we went on air, this just reminds me so much of the risks in the quant quake from the summer of 2007. Completely. In which people had crowded into factor trades that they knew worked because the factors made sense.
The value factor, the size factor, all the stuff that we now laugh at and kind of say, well, you know, it's awfully cute that you're talking about it, maybe it'll eventually come back. But the simple reality is that everybody has access to those same factor models. Everybody sees the same thing. And when you go through a period of relative market stability, people crowd into these components because they work.
And them crowding into it reinforces their working until you suddenly discover that positioning is out over its skis. Yeah. Andthe great irony, when you think about this… I mean, I already kind of referenced it, but I really want to highlight it. When something is obvious, logical, this doesn't make sense. This thing is valued here, this thing is valued here, and they are identical otherwise. Ironically, those things are sometimes the biggest risk.
Yeah. Because ultimately that's correlated with positioning. If everybody knows something to be true, then everybody's going to be willing to take risk with leverage into that trade. And then the real factor is positioning. And that's why dealer positioning, which we talk a lot about, is so predictive these days. Thesystem has gotten so leveraged, so financialized, and yet the whole system is very much offsetting risk with leverage in real time.
And so that leverage, as you mentioned, can be the ultimate driver, particularly when dealer positioning gets really big. I absolutely agree with that. Theother thing that I would emphasize, or try to maybe take a slightly different wrinkle on it, is that when you think about the behavior that is occurring, my putting on a position requires you to sell me that position.
If you are unwilling to sell that to me, and I have a fiduciary obligation to put that position on because my factors tell me it's going to work. I'm going to cause prices to move in a pretty meaningful way. And I think that is a really critical component. Imean,a lot of my work around market structure and the growth of passive is really about this idea of identifying increasingly inelastic behavior.
The ultimate expression of inelasticity is somebody saying, I don't actually care what's going on. I'm investing into an index fund. Just buy me this stuff in proportion to the index. Isit a good deal? Is it a bad deal? That didn't enter the equation. What's the forward expected return? Well, I'm not actually even thinking about that. I'm in a target date fund, et cetera. Alotof these systematic rebalancings, a lot of these components contribute to all the phenomenon that we're talking about.
And when those waves enter or leave, they become magnified by that inelasticity. I wonder how ultimately… We've talked about this. I think we'd be doing our listeners a disservice if we don't mention passive a little bit and talk about how you think, if that ever kind of unwinds, what that looks like. Does that have any correlation to volatility? How do you think the volatility space plays into it? Do you have any thoughts about that? I know that's… Yeah, I know, it's a hard question.
Like you said before, it'll keep going until it doesn't and then it'll end spectacularly. But I'd love to hear your thoughts on that. Well, I'll give you a really simple example. And it's one of these things where my interpretation events may be slightly different than yours. So, you mentioned the Chinese devaluation in August of 2015. Well, interestingly enough, the Chinese devaluation occurred on August 12th and the meltdown occurred on August 24th.
So, part of my joke is, like, wait a second, did like the news of this travel on a slow boat from China? You know, we live in a world of instantaneous information transfer. Was there something else that actually happened there? Andon August 24, 2015, Vanguard rebalanced their target date funds and all hell broke loose. Now since then they've moved away from a five-year rebalance point to a continuous glide path that is rebalanced on a monthly basis, et cetera.
And so, they've worked very hard to reduce the impact. But the complex has also roughly tripled in size. So, all of these factors can play through. How does it look when it unwinds? Imeanthe really simple answer is, you know what an order book looks like when effectively it becomes overwhelmed in one direction or another. You gap down and you're looking for that next component. The immediate reaction and volatility surfaces to a gap down in a discontinuous market is you have to explode.
And so, I do think, ultimately, that there is a volatility component to it. Butman, like I'm actually trying to imagine a 1987, which can't occur because they just shut the market. We didn't institute circuit breakers first. But can you imagine being the guy who sold the 3% out of the money zero day to expiry put option on the S&P on a 10% decline day? Like, I mean, you're gone. And that's a case for using them actively, for hedging actually.
And I think that's, that's what a lot of people are doing. Getting that convexity in an ultimate gamma type product is truly valuable, particularly in an environment where you have headlines every minute that could drive a major change. Well, and to be fair to these guys. I mean, what is more likely to occur in that scenario is that they will have actually sold a put spread.
Yeah. Financed that tail from, let's call it a Canadian pension plan that is saying, well we're picking up free money by selling these tails. Now again that's harder in the aftermath of 2020, but 2020 feels like forever in financial markets. So,I guarantee you that people are stacked back into uncapped variance type exposures that are going to get super interesting at some point. I agree, I agree. There is going to be some interesting one-day move.
Yeah. I will say sometime in the next year, I would say, especially if… A completely unremarkable forecast by the way. No, no, but I mean in the sense that like is historic one of the top… You can smell it, you can smell something out there. There's, there is a disturbance in the force. August 5th was an example.
Some of the events that we're seeing now, or all these warning signs, it's telling you that the system is over levered, over specified, and when that goes away you're playing with, basically, a bad position in chess. And I think the other thing is options are, in my mind, a superior way to position. We talked about this. It allows you to manage risk relative to your return, very specifically to the exposure you want, not just taking the whole distribution.
So, I think without understanding that or knowing that a lot of people are using them because they are getting the better risk adjusted returns as a function of using them. Thatsaid, I think the industry is still going so quickly relative to the infrastructure, relative to the liquidity, given the leverage, that I think it's only natural to have these kind of shocks that then kind of help the infrastructure evolve and move from there.
Well, I think what you're hitting on is a really important point. It is in stress that we actually create new approaches, we identify new issues, we expand our body of knowledge, use the world of AI for it. Our training models increased dramatically with the global financial crisis. Our training model has increased with August 5th. So, new insights emerge and oftentimes those show up as reduced risk taking capacity which tends to feed into the next stage of the cycle.
People are quicker to back away. Butat the same time, it is absolutely an adaptive system. It's one of the most, you know, interesting and robust environments. And it is exactly why, like we were talking earlier, it's part of the reason you and I gravitate to it. Because there's always something new to learn. I think it's always, in 2008 the vol markets were incredibly important because of variance.
We saw 10-year vol, prior to the crisis, trading at 16 vols, which the long-term average is 17.5. So, that doesn't sound so low. Butthe reality is 10-year vol, having the tail, being able to be hedged for a credit essentially, is pretty insane. Importantly, where did it trade? Do you remember? Do you know where it traded in 2009 on the bottom, what was the max? Actually, the peak was in 2012, believe it or not, around the euro crisis. It hit as high as 47 on 10-years.
Well, no, it traded 60. The variance of the 10-year variance swap traded 60. Very briefly, very, very briefly, I want to be clear, it was I think a day. If you blinked, you missed it. If you blinked, you missed it. But it traded 60 in 2009 on the bottom. Got it. But again, obviously insane. Like 10-year vol trading at 60. So that's a perfect illustration.
So,the origin of those long-dated variance contracts was an academic insight that emerged in 2005 from a couple of academics at NYU who identified that there was a higher return potential associated with selling variants that looked exactly like being long equities. Andso, the demand to offer this product emerged before anyone was actually interested in hedging out there, which then forces the price, effectively, below what is the actual historical level at which those returns were generated.
And of course nobody stops to say, well, is this still a good idea? No,now I've got people who are paying me to execute this strategy, I have to do it. So, all of a sudden into that there emerges an actual need for it, which was a revision to the variable annuity space. And the demand for these products began to emerge. And famously Warren Buffett became the clearing party on the other side of the table.
Whenhe stepped away in 2008 and failed to emerge, the pricing on those contracts exploded because suddenly the demand was actually from entities, variable annuity providers, who had to hedge. And all of a sudden the risk taking capacity on the other side was gone. Andit's tough to explain to people What a variance of 47 or a VIX of 47 means. We were literally pricing 10-year contracts, as you say, at 60 for a few minutes.
We had an extended period in that euro crisis in which you could have sold these things at 42 and above, which basically implies every day for the next 10 years looks like the three days after 9/11. Yeah, never mind the tech bubble and stocks trading at a 40 P/E, that is a structural statistical thing that can't hold. It literally just cannot. It's not possible. Absolutely. For 10 years, so, markets can get very inefficient.
And again, I think there's an echo here in things that we've been talking about. Thinkabout long-term capital management. It’s not too different. Theoretically, absolutely correct - long dated skew is theoretically dramatically overvalued relative to short dated skew. Not only is it upward sloping and there's more skew in it, all the things we know, but short-term volatility tends to be higher than low term. So, it's a, you know, Scholes was right.
But there's reality, and reality is positioning. It's supply and it's demand at the end of the day. Andif you take your eye, for any period shorter than a year or two, off of where the rubber meets the road, that's a good way to go bankrupt. Well, it's an easy way to end your career. But the point that I would make on this is that we often think about prices as conveying information. What prices are really telling you is where transactions occur.
And what you actually are saying, when you look at something like a long-term capital management, is what is the price of somebody taking you out of your position in the worst possible circumstances? Samething occurring in 2008, 2009 or during the euro crisis when French banks, which were the leaders in selling these long-term variance contracts, are suddenly saying, you know, ‘merde’, I'm done. I'm being tapped on the shoulder. I can no longer have any risk taking capacity.
AVAR doesn't work in those cases. AVAR doesn't work. That's the problem. Nor does a normal distribution or anything else. Yeah, all those things tend to break down into those conditions. And that is part of what I think ultimately is the really key takeaway. Iusethe analogy of, you know, GPS. We become dependent on these systems functioning. The idea that long dated variance would continue to function as a theoretical framework where it's obviously less risky than short-term.
There are some real advantages when I think about zero data expiry options relative to a 10-year variance contract. Witha 10-year variance contract I'm locking myself into, basically, term financing. Silicon Valley Bank did something very similar in 2021 through early 2023. In the case of zero data expiry, I'm not worried about these guys. I'm worried about guys like me or others who are dependent on them being there. That's the August 5th experience.
Whenthey back away, suddenly nothing can get done. My GPS no longer works. I can't figure out how to get home. Those are the challenges that I think are going to be interesting. We highlighted variance swaps, and we highlighted long-term capital management, all those have the more long-term in them. And that's kind of why 0DTE, again, is probably more stable in some ways.
I think, as a product, it's dramatically more stable because people have used the phrase derivatives or weapons of mass destruction, 0DTE is more like a game of Russian roulette. You either survive or you don't. But your prospect of a mass killing with Russian roulette is actually really low. It's not mark to market at the end of the day. At the end of the day it is… You're either dead or alive. One of the two. I agree, and I think that's a big reason why people have moved to it.
I will say though, not to paint all the positives, when you're at the end of a distribution where you can't hedge the product as well. There is also a risk there. Thinkabout GME and AMC. You can’t hedge GME or AMC with anything other than GME and AMC. They're a liquidity little bubble. And that can lead to cascades. And it happened with the long term of the distribution of variance and long-term capital management. But it can also happen at the front of the distribution, I think.
And I think that's the other thing you have to be mindful of. That can be reflexive. I totally agree. In terms of a loop on underlying the market. I actually had not thought of it in that context before. Iusedto work for Peter Thiel. And Peter has a very famous approach which is. it happened this way last time, therefore the opposite will happen next time.
Right now, it's obviously not quite that formulaic, but a really good example is, World War I, the solution to it was, let's build the Maginot line. So, World War II involves, well, let's actually do something really clever like go around it. 2008was all about long term exposures. It was those 10-year variance contracts. It was mortgages that suddenly became very short in duration, and high credit risk after having not been credit risk for so many years.
AAA securities that broke down because the waterfall models did not properly calculate the correlations over long periods of time. Mygut tells me that this cycle is going to look a lot more like August 5th, and it's going to be much more focused on that short term. Again, my key fear is, we turn on our car, GPS doesn't work, and we're suddenly like, man, how do I get to the office, how do I get home, how do I do all the things that I'm used to doing in a normal basis?
We'll eventually figure it out and we'll build band aids around it. But boy, that's disruptive that first day. Yeah, I think this dispersion trade which has gotten so big, there's a lot of really interesting feedback loops that are really going to play out here in the next year or two, particularly as it relates to vol markets. By the way, we’ve had twice the volume of structured products than we had two years ago. To give you a sense.
I think that's only going to increase more with core market performance because people are looking for more non-correlated ways to invest which then, ironically, has a volume compression loop. Yep. And if that's happening into a decline because, ultimately, people are moving away from equities, a market down, vol down, but an exaggerated form of it could then lead to dispersion blowout, which then continues to push things down.
So, it could be a very unique, different type of move this time around. Particularly because the amount of leverage that we're seeing. Yeah, and again, I would just emphasize, anytime you start introducing things like zero day expirys because they're very small dollar value, if I sell a 10-year variance contract, there's a large dollar value associated with it.
If it's a very small one, my temptation to lever that, because of the high predictability of it, the repeating component of it, et cetera, is very, very high. It does open up some risks that haven't existed historically. Theother thing that I would just emphasize, in exactly the framework that you're hitting on with the dispersion component, part of the reason for the dispersion trade is because of the relative size differential.
So, the bid for Apple, Microsoft, and Tesla, and having taken them to the point that they're now 30% of US equity markets, US equity markets are 55% to 60% of global equity markets, you're talking about a very small number of companies that make up a giant fraction of overall market volatility. Iffor any reason that changes.
And let's just imagine a scenario in which AI turns out to be truly disruptive and disintermediates and turns Microsoft or Nvidia into the intel of yesteryear, or the Cisco in the networking space. That actually changes the character of that behavior and means that many of those trades become a lot harder. And so, imagining that forward space is, I think, pretty interesting and, candidly, challenging in this environment.
Agreed, and you mentioned AI, but I think we've seen these… The reflexivity is why guys like Soros, some of these guys, have really been so successful over the years. The contrarian idea that reflexivity is probably more important than the actual logic of the trade, to begin with. It’s an old idea, but it's really embodied by a lot of these mechanical features we're talking about. Well, it's funny. So, you and I both know Kyla Scanlon, on Twitter, and she's written about the vibe session.
And vibe session is just another way of saying reflexivity. Weall feel terrible about the economy, therefore we all behave in a certain way, therefore the economy reflects that. This has been talked about forever. Right. John Maynard Keynes, the market can remain irrational far longer than you can remain solvent. Isaac Newton, I can explain the movement of the bodies of heaven, but not the madness of men's minds. Right. All of these components play through.
Andat the end of the day, again, I think it's fascinating that you highlight that the reason that this physical exchange still exists is as a backup. It's the human connection that ultimately is there. Isometimestell the story around the crash of 1987. As I began to build a lot of my trading techniques and styles in the aftermath of the global financial crisis. I recognized how disconnected the derivatives markets had gotten particularly in these longer dated variance contracts.
And I reached out to Mark Rubinstein, of the Cox Rubinstein model, Leland O'Brien Rubinstein portfolio, insurance, et cetera, and talked to him about some of the distributions and shapes that I was seeing. And I'm like, Mark, I just need you to… He's like, I don't do this anymore. Heactually left finance for a while and became a theology professor at Berkeley. And he looked at it, he's like, yeah, you're right, this is really a mess. He's like, but let me tell you a story.
Andso, he shared with me the actual story of his trading activities in the crash of 1987. And exactly like we were talking about earlier, the model is, well, when events like that happen, you run your derivative sheets extra wide. He was running it in reverse. He was effectively delta hedging off those positions as compared to pricing options. Andthe system was spitting out orders, and the orders get bigger, and bigger, and bigger.
And finally, he hands one to his trader and his trader turns to him, he goes, Mark, if we try to send this to the floor, the entire thing's going to zero. And Mark said, well, then don't send it. Andso, actually like a critical component of stopping the crash of ‘87 was Mark Rubenstein, at Leland O'Brien Rubinstein, saying, we're going to take the loss. I wonder how much that's going on right now. I think there's a fair amount of that happening.
Certainly, it's more of a tapping on the shoulder at this point, where people who don't really have agency are being told, take off risk. Butthat is absolutely… I'm sure they're very much thinking about liquidity in that process. And I think that's, you know, off the record here, kind of just… I think that's why this is kind of a slow-motion train wreck as well. I totally agree with that. Andthe point that I would emphasize on that is that everybody believes in their position.
Everybody wants to hold it. The people who really last tend to be people who actually cut those positions, recognizing the reflexivity component. As Scott Besson, now our Treasury Secretary, taught me long ago, if you're going to panic, panic first. 100%. Yeah. AndI think it's actually pretty interesting too, that if you look at vol in markets that decline when vol is lower, they can actually cut much deeper. Yeah. I mean, again, we talked about that August 15th was not that big a move.
February 16th was worse. Yeah. With a much lower vol. Volpocalypse, February 18th, was only 9%, 10%. Huge vol drawdown, fourth quarter, 2018. Yeah, 20% 19% in markets, with almost no vol. And part of that's because you don't get that response of that critical last move that expands vol, brings in all those Vanna and Charm flows that I talk so much about. Absolutely. And the decay of that skew.
The mechanical component of this, I mean, you've done a phenomenal job of educating people, Vanna and Charm, et cetera but the other thing to remember is that as vol rises, delta doesn't rise proportionately. If basically the outcome is, I have no idea, then what is my delta hedge? It's actually pretty low. You price it in the form of Vega. Inthe form of the volatility price, it gets compared to a directional hedge component to it, when you don't get that volume response.
Now, all of a sudden, what do I need to do? I need to sell more of my position. That's exactly right. If their hedges aren't working, that's actually more painful for those who are... Instead of my puts picking up delta, I have to reduce the delta in my portfolio and that becomes that feedback loop. A lot of the world is long stock trying to hedge with puts. So that's, kind of, almost a worse outcome for markets.
Well, it's one of the things I laugh about because I tend to orient towards a long volatility strategy because I see typically greater opportunities in terms of the mispricing. It's a terrible strategy if you want to become a billionaire, by the way. The solution to becoming a billionaire is actually selling volatility and kind of being in the process. No,that's exactly what I mean. By definition, if you're an insurance company, you have sold volatility.
It’s one of the biggest sellers or was one of the biggest sellers of long dated puts since time incarnated. Yes, absolutely. Andso, when you think about that underlying framework though, that long volatility bias, it tends to lead you to think in terms of what are the possible extreme movements? What's happening right now is not anything resembling panic, or extreme, or we're just not seeing the vol response bigger component going back to the dispersion trade.
Like we're still pricing implied correlation for wingy puts at levels that you and I used to think of as floors in dispersion. You know, in terms of implied correlation. So,there's no sign yet of the panic component that's going to break in. Will it hit in this cycle? We're getting down to levels that there is definitely some exposure, to say the least.
Well, and if you get these bigger entities that are to some extent the glue that's keeping everything together and if you get them stepping away. Yeah. Now there's just less liquidity next time around, and maybe you don't get the same type of blowouts, but maybe you just have less liquidity in general and that's an important factor. Well, yeah, we're only down, give or take, 10% off the all-time highs - slightly more than that, I guess right now.
And if I look back at some of those historical responses to this, the front of book liquidity in the EBONYs has evaporated. It's down to a couple million bucks. I would guess it's under 2 million bucks today based on the price action that we're seeing. Wedidn't see that until we were down 15%, almost 20% in Q4, 2018. And then it becomes, again, a question of how wounded are the players in the game? Can they actually efficiently make markets that can cause an extraordinary rebound?
It can also cause continuation to the downside. So, the fun part is figuring out where that next step is going to play out. That's where you watch the flows. Right. We talked about this, February into March being an issue. We're lucky enough to get it.
I will tell you one more funny, quick anecdote, which is 1991, I'm on the floor of the New York Mercantile Exchange and a reporter comes through and he's talking to people, and he says, you know, one of the things that's my big takeaway is like, nobody here is really trustworthy. We're like, what are you talking about? Everybody is like, incredibly trustworthy. Your word is your bond on this floor. Andwhat he was actually reacting to is the fact that we don't make eye contact.
You and I are looking at the screens over our heads and trying to take in information while we're carrying out a conversation. The screens right here, by the way, we're both watching as we're talking. You don't notice it until you've been off the floor for a really long time. I'm watching you and I'm like, holy shit, I'm doing the exact (excuse my language), I'm doing the exact same thing that you're doing, which is looking away and trying to incorporate what’s going on.
It’s old habits of standing down. Absolutely. Last of all, I kind of want to touch a little bit on, you mentioned something today when we, when we first caught up, about some things going on in Europe and potential wealth taxes, you know, or at least the inkling of it. We talk sometimes about passive, and how important that is, but also try and educate a little bit on how illiquid markets actually are relative to perception.
I'vehighlighted this before, but, you know, the US equity market, give or take, $50, $60 trillion dollars, the global international equity market is similar, $50, $60 trillion dollars. And then all kinds of products, whether it's private equity or other things that are tied to that equity market, you know, wave your hands at it. $200 trillion, $150 trillion of long assets - long equity assets.
Yetthe daily volume that's incremental, that moves markets, is somewhere around $100 billion, give or take. You can judge that in different ways. Maybe you say it's $150. Either way, if it's $200 billion. $200 billion relative to a $200 trillion dollar market. I mean, people talk about venture capital deals where the float is, oh, there's only 5% of the float trading. This is 0.1% of the float incrementally. On any given day.
On any given day, and so your passive kind of argument is so critical, because the amount of flows, if that that kicks off, is dramatic relative to the average daily liquidity. But what happens if you start to pull off some of those passive flows? And I think that's an interesting kind of… Well, I mean, to your point, on any given day, there's somewhere in the neighborhood of $100 to $150 billion that is actively traded.
The imbalance on that day, meaning the net flows, is typically only about $1 billion to about $1.5 billion dollars. So,there's the old adage, you know, for every buyer there's a seller. That, of course, is true in settled markets, but the way I obtain additional sellers is by driving price higher, or theoretically by driving price lower, enforcing leverage selling. But that type of imbalance is actually even more incredible when you think about that net order flow dynamic.
Andthat's where it becomes really interesting on the passive framework, because passive, at its core, relies on the market's functioning, and those transactions, and that liquidity. And when we start looking at the net flows that enter firms like Vanguard or BlackRock, you're talking those firms individually are taking in $1 billion dollars a day at this point. So, if they ever shift to an outflow, that suggests that imbalance could move in a pretty significant direction.
Policy could play a big role in that. Like, we're talking about Europe, you know, these are things that we don't think about. We assume that things work in a certain way, but those things can change very quickly based on a shift in policy.
Yeah, I mean, that was part of the way we got into the conversation is that increasingly I'm doing things like using ChatGPT to explore some of these concepts because nobody else in their right mind would have a conversation with me about what are the implications of collectivism versus individuality. By the way, you know, when I first walked up to Mike today, he was sitting on chat GBT asking it these existential kind of questions?
Well, the framework is… Nobody else will talk to me about these things. But no, the framework that I would just encourage people to recognize is that our near history is one of intense individualism. We think about my 401k even as we talk collectively about, oh, we're all invested in the S&P 500, or in the Total Market index, or whatever. We've never had more collectivist outcomes in terms of aggregate potential for extreme events.
Weall talk about national politics, we don't talk about our local politics. We all talk about geopolitical events, as compared to, did Bill get his horse shoed recently? Is the cow still delivering milk? We'vemoved into these realms in which we have to admit that we're increasingly collectivist in nature and yet we all imagine that we are individually empowered in this framework.
What tends to break those cycles, this cycle of collectivism versus individuality is either a breakdown of the collectivism or breakdown of the mirage that we are individually capable of protecting ourselves. Andall my weight seems to be headed in the direction of, yeah, we're fantasizing about how much we control this and we control our individual outcomes.
Completely, and things like social media, education, even like this, can have huge effects that I think are way quicker than people expect. Absolutely. We are contributing to the tipping point by introducing some of the discussion. Full circle reflexivity, right? Once these things start to unwind, given the leverage, sometimes the door's not big enough. And all that matters is the positioning. That Mag 7, passive investing, I can't think of a bigger, more leveraged, one-sided positioning.
It was a super popular concert. But, you know, now we're all trapped inside the stadium. Yeah, I'm done with the concert. I'm ready for the next show. As am I. And so, I spend an awful lot of time criticizing crypto, et cetera. It's actually interesting when I run the scenarios with ChatGPT, it highlights crypto as an individualistic trait and the potential for effectively concealing your wealth from the group, et cetera. And those are all factors that I think are important.
It's one of the reasons I actually became interested in bitcoin super early. But, the challenge becomes, can we allow the old world to die before the new one is born? And I'm not sure. Not when the worldisstill incharge,atleast.Youwouldthink there'dbesomelevelofcollectiveself-preservation thatwedrive.... That is actually the fight. Right. I mean, it is institutional self-preservation. The US Government's not going to go down without a fight. Europe is not going to go down without a fight.
Theheadline you are actually referring to is a statement that there is potential for $10 trillion of European wealth to be taxed and confiscated to pay for Europe's new need for defense. Man, we think about this as, like this is some brand new concept, but just imagine it's the American Revolutionary War and the red coat coats, or the revolutionary soldiers, are going door to door and saying, hey, we need your blankets. You're like, those are my blankets.
Well, we've talked about, you know, structured politically, the move from taking from the rich, giving to the poor during a populist period. That can drive secular inflation, which can be very disruptive to markets. We are doing the opposite here, currently, with the Trump administration. Partially because I think they see that it's a structural problem in the short term and they need to deal with that. Butwhat if the inflation comes from Europe?
What if the inflation comes from other places where the populism is embedded? And clearly, if they need to raise money, that's not coming from their populace in a socially democratic… It's a different type of populism and it has a different framework to it. And so, economic nationalism, or regionalism, which we're clearly seeing rise of, that disrupts trading networks.
It reduces the potential for a framework in which we're using a Ricardian principle to maximize the benefits that we're all experiencing from it. The West is not unique in breaking this down. Chinahas been exploiting it for an extended period of time. They've been using it to enhance the power of central authorities, effectively, in China, buying wealth and influence by exporting to the rest of the world. It's understandable that the West needs to break that cycle or wants to break that cycle.
But that doesn't mean it's going to be easy. Yeah. And the people may not want to. And people may not want to either. That's the problem. Mike, what an incredible conversation. Thanks. So much fun. Thanks for coming out for the first one. I really appreciate it and I look forward to many more. I look forward to it as well. And I'm honored to have been your first. Thanks. Thanks for listening to Top Traders Unplugged.
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