In this episode, we talk with Diego Parrilla of Quadriga Asset Managers.
Diego is an engineer by training and has spent 20 years in the markets.
He’s spent most of that time in macro and commodities trading at firms including JP Morgan, Goldman Sachs and Merrill Lynch. He is the author of the bestselling books The Energy World is Flat, and Anti-Bubbles.
Diego has a really unique approach to the markets that we got into including why he holds his basis in gold and treasuries, how he uses exotic options to improve his opportunity set, and why portfolios should be constructed like football teams.
I hope you enjoyed this conversation as much as I did.
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Have comments about the show, or ideas for things you’d like Taylor and Jason to discuss in future episodes? We’d love to hear from you at info@mutinyfund.com.
Transcript for Episode 19:
Taylor Pearson:
Hello and welcome. I’m Taylor Pearson and this is the Mutiny Podcast. This podcast is an open-ended exploration of topics relating to growing and preserving your wealth, including investing markets, decision making under opacity, risk, volatility, and complexity. This podcast is provided for informational purposes only, and should not be relied upon as legal, business, investment or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, Mutiny Fund, their affiliates or companies featured.
Taylor Pearson:
Due to industry regulations, participants on this podcast are instructed to not make specific trade recommendations nor reference past or potential profits and listeners are reminded that managed futures, commodity trading, Forex trading, and other alternative investments are complex and carry a risk of substantial losses. As such, they’re not suitable for all investors and you should not rely on any of the information as a substitute for the exercise of your own skill and judgment in making such a decision on the appropriateness of such investments. Visit www.rcmaam.com/disclaimer for more information.
Taylor Pearson:
In this episode, we talk with Diego Parrilla of Quadriga Asset Managers. Diego is an engineer by training and has spent 20 years in the markets. He’s spent most of that time in macro and commodities trading at firms including JP Morgan, Goldman Sachs and Merrill Lynch. He is the author of the bestselling books The Energy World is Flat and Anti-Bubbles. Diego has a really unique approach to the markets that we got into including why he holds his basis in gold and treasuries, how he uses exotic options to improve his opportunity set, and why portfolios should be constructed like football teams.I hope you enjoyed this conversation as much as I did.
Taylor Pearson:
Diego what do you mean when you say your portfolio should act as a team? What does a reasonable team look like?
Diego Parrilla:
Well look I think there’s quite a bit to learn from sports, and what I mean by the concept of the team is that different components in the portfolio need to play different roles. If you take a soccer team, you have what we call strikers, the guys who are meant to score the goals and then you have mid-fielders that kind of create the game, and you have defenders, and then you have goalkeepers, and very often I find that people just build a team with just great players, you know? And I use this extreme example of a team with 11 Lionel Messi, I mean for those who are familiar with him as this Argentinian player probably best in history, absolutely phenomenal guy, but you know, if you have a team with 11 Messi’s, it would be probably an absolute disaster.
Diego Parrilla:
To start, you know, he’s not the tallest guy in the universe and I think he would struggle in every other corner, but … and that’s the idea, you know, when you build this portfolio and in fact this is the good time to check this out, I mean most people want their entire portfolio to have green lines, you know? It’s like, “Oh I bought 20 things and everything made money and I’m so smart,” and that could be a bit of a red flag because guess what? You could have all those 20 lines in red. So nobody wants to lose money at any time, but this is really about finding assets that will make money over the medium-longterm and that will make money through different paths. So when you actually put them together, you know, both end up, let’s say, in the same place, which is, let’s call it, plus 20%, but they actually do it in different paths so that the team is way superior.
Diego Parrilla:
And I think this has three parts. You know, the first one is can you choose your strategy? So you want to play 50% strikers and 50% in defenders or do you want to play 80/20 or 20/80 or 100/0 or whatever? So that’s the ultimate strategy you want to play, which should be a function also of your own wealth and your own … you know, the stuff that is not in the market, it could be your business, it could be anything. The second part is can you delegate to certain players some stuff you can do in-house? You might be a great equity stock-taker or whatever, but some stuff you’re going to do with people externally, and you want to make sure that those players that you have in the team behave the way you need them to behave.
Diego Parrilla:
So if you hired someone that is meant to score goals and doesn’t, or someone that is meant to defend and doesn’t, that could create problems for the team because you know, everybody was trying to score goals or everybody was trying to defend and you’re losing that positioning, but the third thing which is critically important and is less understood is the compounding effect, and this is what happens when you have a team of great strikers and great goalkeepers, you know, there will be times when your 50/50 basket becomes, let’s say, 60/40 in dollar terms, yeah? Or 40/60, and you could let this deviate ad infinitum, you know, you could have these things just moving in different directions, but if you’re actually rebalancing that portfolio back to 50/50, what it means is you’re buying cheap, selling expensive, selling expensive, buying cheap, and as these assets eventually both end up at, let’s say, plus 20%, but you were able to embrace that volatility of the market, then you actually compound the returns.
Diego Parrilla:
And that is hugely important, because this is not a game of, “I have a crystal ball, I’m super smart,” you know, it’s do you have a strategy? Are you dedicated to the right guys? And are you able to compound on volatility? And I think that’s key, and I think those lessons can be learnt from teams in sports and that have very direct application to the markets, and failing to do this leads to one of the big risks that we’ve highlighted many times, which is the risk of false diversification. Is this perception that you’re diversified because you have a bunch of different players, but the reality is that when the market behaves in a certain way, particularly a crisis, you might see that they’re all the same trade.
Taylor Pearson:
Yeah, I was actually reading … yesterday we were talking about this idea, you know, if people say, “Well I’m [inaudible 00:05:09],” you know, I don’t know, “Have moderate risk tolerance so I’m going to … I own a lot of … I have a team full of mid-fielders,” as opposed to, you know, it would often make more sense to have maybe less strikers and more defenders or how you balance across the team. I wanted to go into … you know you talk about you sort of play the goalkeeper, and that’s kind of the role you see that the [inaudible 00:05:31] plays in most peoples’ portfolios, what does the goalkeeper look like in terms of investment strategy or portfolio?
Diego Parrilla:
Well you want to be effectively a synthetic put. If you think about the industry, I would say that it’s very polarized between two worlds, between the long only world, and the absolute return world, and it turns out the long only world is great because you bought your SMP, you know, when the market goes up, great, I know what I have, when it goes down I know what I have, but obviously it misses out on capital persuasion, so long only managers, when the market goes up everybody expects it to behave like a long only manager, when the market collapses they want you to be absolute return.
Diego Parrilla:
The issue with absolute return is sometimes it’s a bit of a black box, you don’t really know what you own, and I think what we try to bridge is a little bit this idea that you want your strikers to be call option, you know, the idea of portfolio would be a call option on the Nasdaq, with zero premium, right? Or positive carry, and then the other half of the portfolio would be almost a call on the fix, yeah? Or a put on equities, and in that sense, you know, you could do it in multiple ways, you could … you know, how do you generate that predicted or predictable upside with the most leverage possible, whilst protecting your downside and with the best carry possible?
Diego Parrilla:
I’m effectively describing a call or a put, and I think this is part of the construction of the team, how do you choose these pieces? In our particular case we have three building blocks, we have … we think precious metals is … gold in particular, is an antibubble, it’s the antibubble of the paper currency, which I think it’s … in the current environment and the foreseeable future we’ll continue to see this dynamic playing out with money being printed and artificial low interest rates supporting real assets in general and monetary assets like gold in particular. We also see room for things like US treasuries, and this is quite controversial because obviously US treasuries are not artificially cheap assets.
Diego Parrilla:
Rates are also artificially low. Having said that, they are anti-crisis assets, so they … as crisis come, rates go to zero, they can perform well, and in this sense you know, the third bucket which is the more interesting one is the options bucket, it’s the insurance bucket, and there, you know, we have self-imposed risk management limits that effectively mean we only buy options, and as a goalkeeper we buy mainly two types of options, we could buy either puts on risk assets, like equity credit, high-yield [inaudible 00:08:52] commodities, or we could by call options on anti-crisis and anti-bubbles, this is gold, treasuries, the VIX, I mean, you know, dollar inflation, and then you could actually combine the two using … taking advantage of structural considerations or carry.
Diego Parrilla:
So ultimately the way we see our role as a goalkeeper is can we be that synthetic put? Can we generate this big payout during hostile markets? Can we do it with the … whilst protecting the capital? So the minimum draw down possible, and including benign or bullish markets, and that’s … you know, to do that you have certain pieces, like I mentioned, like pressures or treasuries or options that can give you, you know, a certain … a profile that is repeatable, that is predictable in terms of how the strategy’s going to behave, but then we have the ability to manage inside of those buckets, you know, buy the right insurance, when do we buy it? How much do we buy it? When do you sell it? How do you restructure? What are the best opportunities? And that’s what we do, so it’s trying to find that balance between, you know, creating a strategy that is predictable, investors know we’re long-goal, treasuries, options, but at the same time, having flexibility to be able to optimize and diversify these across underlines, maturities, strikes, payoffs, et cetera.
Taylor Pearson:
How do you … maybe talk a little about how you see yourself as different or [inaudible 00:10:42] think about being a goalkeeper differently than maybe most of the rest of the industry, and I think we’re … you know we very much agree, have this idea of sort of an ensemble approach to portfolio construction in general, and then you know, defense or goalkeepers in general right? You know, having a few different types of defenders with different streaks or different weaknesses you can sort of match up better depending on sort of what comes your way. How do you feel like you sort of are … you know, what’s your approach and how do you sort of differentiate it from [inaudible 00:11:09]?
Diego Parrilla:
Great question, and I think this came a lot at the beginning you know, when people were saying, “So we need to put you in a box, what are you? Are you a macro fund? Are you a precious metals fund? Are you a volatility fund? Are you a tail risk fund?” And the answer is we’re everything in some ways, and we’re trying to get the best thing of everything. So we’re … from a macro-perspective, look, as you know I’ve written two books, best-seller in energy, also coining the concept of anti-bubbles, and I think our macro views are independent, they’re respected, and you know, they’re robust. So we can take views and within this we can try to … as a bit of a chess player, we’re going to try to anticipate certain moves and dynamics, in many cases against the prevailing rules.
Diego Parrilla:
So you’re challenging the status quo, you’re a contrarian, so in that sense we are a macro fund, and some people have us in that bucket. Of course we see and we want to give investors this predictability so we’ve defined the buckets in which we operate and obviously, precious metals happens to be one of the areas we feel strongly about for multiple reasons and from a risk attribution, you know, particularly smart gold, will have a bigger contribution. The third possibility is look, we are pretty huge volatility players, but I think here, relative to the industry, the industry tends to play much more the implied realized game, it’s much more about theta versus gamma and realizing and delta hedging.
Diego Parrilla:
We obviously can do that, and know perfectly how to do that, but we think about options slightly differently. We tend to think about options more … less Black-Scholes, more Monte Carlo, we think more about look, there are … you’re on 100,000 paths, based on this, what is the outcome? You know, we’re risking one unit of premium to make X, and so we are letting … we can be more directional, we can be running these options, and ultimately we look for three things. We want the cheapest possible option in premium terms, that is the most asymmetric possible, we generally look five to one, 10 to one, 20 to one, and third with the best carry possible, and to do that we’re pretty active using not just conventional, vanilla things like a put on the VIX or a call on … sorry, a put on the SMP or call on the VIX, we’re actually pretty active using correlation and [inaudible 00:14:06].
Diego Parrilla:
I think one of the things that differentiates us is that extra level of sophistication, trying to implement this in the cheapest, most asymmetric, best carry, and that brings me to the tail side, which is, you know, when you buy tail risk, all you do is just buy ten delta puts on the SMP and sit tight, obviously that’s one way to do it, but I think part of the challenge here is how do you lock in profits? How do you protect the capital when you come from big gains? And I think this approach is something that tail risk funds don’t do because it’s not their mandate, I mean someone bought them and expect them to continue to perform as the market goes, and so very often you get to see that they still [inaudible 00:15:02] struggle and once they made a lot of money they give everything back very quickly, because the responsibility was on you to actually take profits, rather than the manager.
Diego Parrilla:
And so I would say that we’ve taken all this … these four pillars and just come up with being us, so now lately just people don’t seem to ask this question that much because maybe there’s a little bucket for us, but ultimately I think this is how we view things, there’s a lot to learn from all the best practices, but you have to be different as well and we favor a lot the transparency and predictability of how the fund is likely to behave under different scenarios, because that will help our investors know exactly what they own and how it’s likely to perform, even if, you know, having a goal keeper doesn’t mean you will never receive a goal, right? But at least you know that if someone is attacking and shooting, there’s somebody there watching for that part.
Jason Buck:
I think you just touched on the most important piece that we bring up often is that it’s the monetization of these strategies that’s incredibly difficult, and that’s historically … like you said, it’s been difficult for tail risk strategies because you know, volatility can cluster or it can mean revert just as quickly, and most of the time it mean reverts and therefore those were paper profits in that nobody every really crystallized those gains, so I want to come back to the importance of that, but I want to kind of look at the overarching portfolio and then maybe take a deeper dive, so to talk about it at a higher level, you’ve basically, without nuance, you’ve built a layer-cake right?
Jason Buck:
Your basis is held in gold and treasuries, and those are dynamically allocated, and then on top of that you have this sliver of exotic options trade, so I’d like to kind of dive into each of those a little bit, especially for using maybe the smart gold platform which holds a little bit more gold than the Igneo does, how do you guys … you guys don’t just buy gold and hold indefinitely, it’s a basket of precious metals that you’re using … a rotation of precious metals and you’re kind of dynamically trading the precious metals, so let’s start there. How do you look at holding your basis in precious metals?
Diego Parrilla:
Yeah so the starting point, and yeah, it’s layer-cake or Lego pieces, same, you know you just have certain levers or building blocks that allow you to hopefully capture some value and achieve your objective. So I would say in the precious metals bucket and the treasuries bucket, there are three key components. The first one is your core allocation, so in our case in the precious metals bucket is gold, okay? The second piece would be how do you deviate from gold? And this means we could potentially go into silver, platinum, palladium, or gold miners, okay? Now here the first important thing that we do is we run no leverage, so there’s no linear leverage in this bucket.
Diego Parrilla:
So if you have, you know, $100 you know, you will have maximum $100 [inaudible 00:18:15]. The second thing that is very important is we don’t run any shorts, okay? So the minute you create a long-short, yeah, super [inaudible 00:18:25] gold, super [inaudible 00:18:26] silver, this is subject to correlations breaking down and potentially open-ended risk. Anybody that was … let’s say long Ford and short Tesla knows that the risk could be much greater than you anticipated, right? So in that sense for us it’s more of a rotation, so look, you have 100, if you want to buy some silver, you’re going to have to sell some gold, okay?
Diego Parrilla:
And so this becomes a little bit more of a relative value play, where you say, “Well in what instances or at what point in time are gold miners, or silver, or platinum better than gold? And at what point do I switch back?” So that is subject to a third element, which is you know, we don’t want to be in a situation where we just put everything in platinum, okay? And then it turns out that gold is up a gazillion, platinum collapsed, and investors are like, “What happened here?” So you need to have a certain bucket of how much risk you can take on that and for us it’s roughly 70% precious … or gold, 30% on the others, so no matter what happens, gold will always dominate and even if you put the other 30% in gold miners or platinum, it’s not going to be big enough that it destroys your original [inaudible 00:19:53].
Diego Parrilla:
So this first building block of starting with gold and having the ability to do up to 30% and do it on a long-only, no-short rotation basis is designed to create a little bit of incremental [inaudible 00:20:08]. The third piece is you know, how do you create that asymmetry, and here you know, the idea is we have the ability to buy puts on gold, which effectively create a synthetic call, and this is something that … it’s not easy to do, it’s expensive, and in fact it competes the amount of premium that we use for put options in a healthy matter competes with puts that we could use for equities or calls on gold.
Diego Parrilla:
So there are times when we want to buy those puts and there are times where you don’t think you own them, rightly or wrongly, and that could be something that effectively gives us an extra element of relative value to play.
Jason Buck:
And how do you think about when you decide to buy them or not buy them? Is it a function of the costs of those puts or is it your macro outlook that you know, gold is at a much better linear position right now and there’s not as much downside risk? I mean how do you assess whether you create that synthetic call by buying those puts on gold at precious metals?
Diego Parrilla:
Well the general idea would be either you’ve made a lot of money and you want to lock in your profits, this is like the analogy I tend to use is climbing a mountain or a wall, you’ve gone up five, 10, 20 meters, perhaps you want to pin yourself to the wall and continue climbing, but at lease you know you’ve secured, that securing of the PML is also a function of where volatility might be, and other things. The other possibility which is where we are now is a bit more like, wow, there’s a train coming and we might get … you know, we need to be very defensive, and this is a little bit harder to play in the sense that you know, you’re already working on … potentially you’re under pressure, you have some … when you start buying these puts you are bullish longterm but you’re taking some short-term protection.
Diego Parrilla:
It’s very important to understand also what levels, I mean the way I think about this, we’re having this discussion as we speak, is I like to buy these puts and then once we reach certain targets just buy the entire delta and leave the call option. So if you bought a … I’m not saying we’re doing it right now, but you could buy an 18 50 put in gold, you know, and it’s going to be pricey, you know? It’s going to be … you’re leaving, whatever, 3% of your money just for the next few months, if gold stays or it does what it’s meant to do you’re going to bleed that money, which if gold rallies then it looks bad on you. If the market goes down then you still need to go down beyond 3% just to break even, and then the question is at what point do I, you know, effectively lock in my protection and I go, let’s say, unprotected again and can I monetize that call?
Diego Parrilla:
It’s not an easy thing, and depending on market conditions, you know, sometimes you find that the market will give you the cheapest insurance when you need it the most. We are in an interesting time, you know, the market is quite unease, despite all the bullishness and the good [inaudible 00:23:43] the VIX is still around 25 and not cheap, and implied well generally across the board, it depends what the asset class is, but it’s something that requires discipline and it’s not an easy thing to do, especially when you are very bullish over the medium-term because to what extent is this about protecting mark to market volatility or actually making money from these puts? And hey, I’m just going to use them as a way to take advantage of this short-term move and then boom, I load up again and here we go.
Diego Parrilla:
It’s much more natural for us to be buying the puts on a perfect take in, but you could be also on a defensive mode, or profit taking or capital is the same thing, but I’m just describing the momentum into how you buy those puts, you know, sometimes you’re happily pinning yourself to the wall on the way up, sometimes, you know, it’s really getting dark and cold and dangerous and even if it looked better before you may need to do that, but it’s a difficult thing to do, and it pays, I think, to be quantitative and systematic.
Jason Buck:
Yeah I think that’s … it’s fascinating to me that a lot of people miss the nuance of that [inaudible 00:25:15] a lot of times that buying those puts or using a different sort of hedge is a way of dynamic profit taking, not necessarily a hedge, and you know, there’s different ways that … it’s a dynamic stop-loss or a dynamic way to preserve the profits that you’ve already made on the linear long side. So that’s like the precious metals bucket, what about the treasuries bucket? Are you looking at different tenors geographically? How do you look at the treasuries bucket in that rotation, that relative value?
Diego Parrilla:
So the building blocks are pretty similar, we have a core position, in our case there’s a 10-year US treasury nominal. The second degree of freedom is can I or can we rotate across duration? So there’s been times where we’ve kept everything [inaudible 00:25:59] three months, there’s been times like now, we’ve been … or recently the last few months in longer-dated, like 30 years, and then we also have an ability to rotate into tips, and this is a contrarian view we’ve held for a while, and again, perhaps being challenges as we speak, but it’s the view that you know, artificial low interest rates have created these huge bubbles and the idea of normalization of monetary policy is like science fiction.
Diego Parrilla:
So ascending interest rates to 5% is just unthinkable, because the whole house of cards would implode. So yes, you could hike rates a bit, but ultimately you’re going to see that the amount of debt that is being built in the system is … you can’t service it, it’s unsustainable, and that is what happened in Q418 that everybody thought … gold mine was like, “Oh we’re going to hike four times in the next few months,” and then within two weeks they were calling for four cuts, right? Just because the idea of hiking this aggressively with this amount of debt, it just doesn’t work. Doesn’t work for anybody, for your mortgage, it doesn’t work for companies, it doesn’t work for anybody.
Diego Parrilla:
So we have the contrarian view that you might have low rates and inflation, and this is a little bit of a change in the rules of the game because historically we think that inflation is … higher inflation means higher rates and therefore lower long bonds. In this new paradigm I think you will have, you know, higher inflation and low rates, so tips in our view make a lot of sense, this is obviously a game, as I always say, that has three levels of difficulty if it was a video game, first of all you need to make money in nominal terms, so turn your $100 into more, that’s the conventional game. We’ve moved to level two which is you need to make money in real terms, yeah, your treasury’s paying you, you know, 95 bips, but you’re actually losing almost 1% on real terms, let’s say, and then the third level is obviously taxes, right?
Diego Parrilla:
So the unfortunate situation is it’s a pretty tough game, you know, difficult enough to make money nominal, let alone real plus taxes, and then we have the ability to buy the optionality, and that’s something we can do, and we do both in this bucket as well as the third bucket.
Jason Buck:
Yeah [inaudible 00:28:39] segue [inaudible 00:28:40] real returns, the second bit … touch on some other things you said, one is I just want to point out like how unique it is for you to hold your basis in precious metals and treasuries, you know, most options managers are either, you know, just spending that little bit of premium and everything else is in cash, or it’s an overlay to like an SMP equity-beta position, and that’s very unique, especially if you’re supposed to be the goalkeeper, it’s interesting to hold your basis in an inflationary asset like gold. So it’s a very unique perspective, but part of that thinking about moving on to real returns, and we think about the premiums spent on options though, I wonder though, as you were talking about this earlier I was thinking you know, with both the precious metals and the treasury buckets, are you almost like in a way negating inflation or deflation, you’re just going to basically carve out that the options returns are going to be real options returns?
Jason Buck:
Because whether we have inflation or deflation, the gold and the treasuries will kind of ride those waves, is that maybe a stretch of a way to think about it?
Diego Parrilla:
Well yes, I think the inflation deflation debate is … I mean we could spend the entire day talking about this and what it means. I think it’s important to understand that inflation is not about the value of your house or bread going up, it’s about the value of your money going down, and I think in that scenario certainly you know, the current monetary inflation, what we’ve seen with money being printed, I think it could actually definitely support gold. I think for the treasury side, theoretically it would hurt it because people think about inflation in that non-conventional way that it’s oil and things like that. I think overall my view is there’s no way out of this other then inflation or perhaps a stagflation, and the more deflationary pressures you have, which are coming through COVID and unemployment and technology and demographics and over-capacity and bubbles and all these things, the more money printing is taking place to offset that deflationary pressure.
Diego Parrilla:
So we’re in a situation that is, in my view, likely extraordinarily likely to lead to much higher inflation, and that doesn’t mean necessarily CPI, because that’s highly manipulated and it’s … I’m talking about real … you know, your purchase power diminishing regardless of what CPI says, and I think this is something that, again, goes particularly well with gold, it’s a contrarian view that it will work well with treasuries, and certainly when we look at the options, part of the longer-term bucket, I mean some of the stuff that we do there is very inflation-focused, and that could include anything that allows us to realize this, including even long-dated calls on equities and things like that.
Diego Parrilla:
So as you think about all those risks and what’s going to create this hostile market and how we create that synthetic put that Taylor was asking, I think inflation is one of the key things to look for as a medium-longterm risk.
Jason Buck:
So you have this base of the cake is in precious metals and treasuries, which we’ve been talking about, and then you have this frosting, this star goalkeeper of the show, the options bucket, right?
Diego Parrilla:
Yeah.
Jason Buck:
And so part of thinking about options is premium, and you use exotic options to lower that premium, but first let’s talk about how you think about premium spent on an annual basis, and then how do you think about premium spent over multiple years and the aggregate effect of how much you’re willing to spend on premium?
Taylor Pearson:
Maybe let’s just clarify sort of what exotic options mean, I think you know, most people don’t know what options are, and even people that know options typically just listed options, so-
Diego Parrilla:
Sure. So basically yeah, options are insurance contract, right? And the so-called vanilla options like you know, insurance against prices going up, or prices going down, yeah, a call or a put. Like any type of insurance, you could create insurance that is a little bit more customized, okay? So you could buy your car insurance, but it only pays you after the first $500, yeah? So that in a way is obviously cheaper because the insurance company doesn’t need to bother with all this small stuff, and so that kind of profile, you know, could be created with … using vanilla components, but you could create, you know, things that are a little bit more customized, such as your insurance will disappear if something happens, or your insurance is not only a function of what happens to equity markets, but also to gold markets.
Diego Parrilla:
So effectively what we’re trying to do and to both of your questions, macro is about probabilities, right? We live in a world just like a lot of the equity or fixed-income investing is mostly about discounted cashflows and somebody like Warren Buffet will think purely of cashflows and something that doesn’t give in cashflows is worthless. You know, the macro world is much more about probabilities and so it’s very complimentary, and when you think about the events, I can give you just an example, when I lived in Singapore and I was working for a bank at the time, I had this very comprehensive health insurance which was, yeah, paid by the bank, and then when I set up on my own and I wanted to continue and they told me how much it was, my eyes popped open, it’s like, “Oh my God, I didn’t realize this was so expensive. Why is it so expensive?”
Diego Parrilla:
It’s like, “Well you have global coverage,” and it’s like wow that’s great, but I … you know, if you ever go to the US then you’re fully covered, and it’s like yeah, but I rarely go to the US, and if I did … it’s like, “Oh,” and believe it or not, if you remove the US from the global coverage the insurance went down by two thirds. So incredibly enough, the cost of a global insurance package, the attribution was two thirds of the cost was something that could happen to you while you’re in the US, and so this is what happens sometimes in the market. So you could say, “Look I am …” think about the correlation between equities and gold, okay? The market has been trading in dollar-on, dollar-off mode, which means it’s all about the dollar, it’s all about inflation, so guess what?
Diego Parrilla:
It’s not risk-on, risk-off, everything’s up, everything’s down. You know, gold is up and equities are up, you know, absolutely nothing to do with risk or anything, it’s all about the dollar, right? So on that mindset, if you were to bet, okay fine, what’s the probability of gold going up, let’s say is 50%, what’s the probability of gold going up more than 10% in a year? And that might be, whatever, 25%. You could do the same thing with equities, say okay, what’s the probability of equities going up 50% or down 50%? What’s the probability of of a move of X? And so the market has these probabilities, the question is how about a move where gold is up 5% and equities are down 5%?
Diego Parrilla:
And here, if the two probabilities were uncorrelated, basically independent events, the expected probability of both things happening would be, you know, if you have … it’s like heads and tails in two coins, you know, it would be uncorrelated, then your gold up, equity down should be 50% of 50%, but when you actually have these correlations playing out, you could get things like for example we’ve been buying insurance where if gold is up 5% and equities are down 5%, we get paid 10 to one. So the implied probability in the market of an event, and you’re like okay, generally speaking you would think if equities collapse, then I would expect something’s happening, Central Bank’s going to come in with more money printing and perhaps gold’s going to go up.
Diego Parrilla:
But the market is looking at the distributions as look, they’re the same thing, so if gold is up, of course equities will go up, and therefore it dismisses certain conditional events. So when we use probability or correlation, it’s because there is effectively an additional cheapening that could take advantage. We’ve put together a trade that I think is fascinating, which is, you know, going back to the inflation play, is equity’s higher, I mean effectively kind of 5% in the money, so call SMP in five years above 30 to 50, and then five year rates below current level. Well, to me it’s perfectly possible that interest rates remain very low and equities remain very high as a sort of inflation, well, that trade is 10 to one.
Diego Parrilla:
You met a million dollars, and you risk either one million, or make ten, and these kind of trades obviously take advantage of structural issues in the market, and in the case of equities is … you know, five years is a long time, 5% is a small move, so it’s in the 45% probability, but on the rate side it’s interesting because your five year today might be … I’ll keep the number simple so that people see the idea of a forward-forward, if interest rates for five years are 1%, and interest rate for 10 years are at 2%, what that’s telling you is that five year interest rates, in five years time, should be at 3%, otherwise they would be free money. You know, you can choose between lending for five years at one and in five years at three, which means you made 4% total, or you know, four units.
Diego Parrilla:
Or you could lend outright for ten years at 2%. So the fact that the curve is so steep and your five year and five year is so high, means that the probability assigned to rates being below the current level, in this case the five year and five year below 1%, if volatility’s low and the forward’s so steep is really cheap. So that might be … it might be only a 20% probability of rates being below current level, even if intuitively you would think it’s 50/50, and when you actually bring the two together, you know, your equity higher with rates with negative correlation, which is what’s been priced today, then in fact you get these amazing odds, and these are things that we look for and again, they are quite structured in the sense that we … how do we think about you know, the cheap premium, the asymmetric risk reward and the carry, and these are fascinating trades that, yeah, they combine all these pieces and hopefully we’ll be able to … going back to your question Jason on monetization, you know, when you buy something at 10 cents on the dollar, whether it is your favorite baseball team winning or in the markets, once you’re up, once the market says you’re right and you are 90% in the money, what’s the point of risking 90 cents to make the last 10 cents?
Diego Parrilla:
And so you need to find levels at which you are playing with free money, so if you’re up three times, you know, and you’re at 30 cents now, you could sell one third of the position, pay for what you bought, and keep the rest, and once you get into these higher payouts you could potentially move into the next 10 to one, and that’s something we try to do, it’s not easy to find these options, it’s pretty difficult, and it’s something that, again, you’re dealing at the end of the day with events that are potentially, according to the mathematical models, low probability events, and therefore by construction sometimes don’t happen, and so this is something we need to … it’s part of the reason why you need to play this game for the long run, building these portfolios that are very diversified, and having this disciplined profit taking, but even then you could have streaks that are tough, you know, everything goes against you and so it’s a lot of fun, a lot of science, a lot of art, but I think these options are revolving around these views, and as you can see, we’re mixing the macro outlook with structuring of the market and the trade-in and all the pieces.
Jason Buck:
So like thinking about like … going back a little bit, the exotic options are really just, you know, options where it requires, you know, two things to happen, and they’re typically called exotic too because you’re … in just general terms, you’re buying then over the counter with an ISDA contract from investment banks, and that’s … usually retail can’t have access to these kind of exotic options, so part of that is correlation, so you know, previously I’ve referred to these exotic options, or you know … as similar to a parlay or accumulator bet, but I was just thinking that’s not actually accurate because a parlay or accumulator bet on sports, so those events are uncorrelated.
Jason Buck:
But what the baseline assumption of what you’re saying is that the market or the investment banks are actually getting the correlations wrong between these two assets, and especially because they’re using maybe correlations from a risk-on environment, and in a risk-off environment the correlations are completely different, a lot of times they’re flipped from the previous, so I want to maybe now like dive into what the definitions or the specific nomenclature of these options trades are when you’re dealing with exotic options. So you brought up … you know, SMP up, rates down, is that a worst-off or is that a dual digital? How did you express that trade and then let’s actually talk about what those kind of trades are and define those trades.
Diego Parrilla:
Yeah, very good questions. I think … give me one second. Basically yeah, I would say that look, exotic options are generally non-vanilla, so single asset, so let’s take the SMP, and you have a knock-in or a knock-out or a digital, whatever [inaudible 00:43:54] you also have what we call hybrid options, which is when you mix two assets. Now let’s walk through some examples, because this is like playing Lego, okay? So the simplest vanilla option is a call or a put, okay? We know that. One of the very intuitive things to do is … you talked about a worst-off is you basically look at … I’m going to use a stupid example but you know … well I’ll change … Ronaldo or Messi, okay they’re actually both really good players, right?
Diego Parrilla:
And so if you were to face, do I want to buy SMP puts or do I want to buy gold calls? And let’s say that you like both, and you know, these are real numbers okay? The cost of a vanilla put on equities could be 5%, the cost of a vanilla call on gold could be 5%. So you’re facing the question do I spend 5% in each? In which case I’m spending 10%, or do I choose just one? Or you could do something and say, you know what, I like both, I’ll take the worst performer of the two, I’ll just take whichever does worse, and here if you think about … you just plot like a matrix, like a two by two, very simple, you could have scenarios where you know, one is up, the other one’s down, in which one of them pays, the other one doesn’t, in which case the worst of the two is the one that doesn’t pay.
Diego Parrilla:
And so when you actually look at these worst-off, you know, according to the mathematical model, and according to the implied correlations, perhaps the mathematical model sees very, very difficult, it sees it’s very, very unlikely that this will ever pay, because it says, “Look, correlation’s very high, you so yes, you have a gold call, so gold is up 20%, you look great, but guess what? You have a put on the SMP on the other side, if gold is up 20% SMP’s up 20%, your put paid you zero, so tough luck,” okay? So in that case it would have been better to spend your money in the call option on gold, and even spend your money in the put in equity because you would have made a lot of money in the [inaudible 00:46:32] on the worst-off you might get things incredibly discounted, but for a reason, okay?
Diego Parrilla:
Because as we’re seeing now for example, we’re long [inaudible 00:46:43] options in worst [inaudible 00:46:45] we’re long calls on gold and puts on equity, and the last few months, to be honest, has been mission impossible because when gold was doing well, equities were up and so unfortunately correlations eventually broke out the wrong way for us because it was gold collapsing and SMP higher, but at least you risked that premium, you know your downside, but the asymmetry and the type of payout, instead of paying 5% for these worst-off, you could pay 50 basis points, you could pay 0.5%, or 1%. So yeah, you’re doing something that is a little bit more risky, is expected to pay in fewer scenarios, but if you were wrong … you were correct and both gold flies and SMP collapses, if the market moves 20% your 5% option would have paid you four to one, which is amazing, right? In a 20% move.
Diego Parrilla:
But if you bought it for 50 basis points, it would be 40 to one right? And also your breakeven is so much lower, you only need them to be marginally in the money for you to start getting your money back. So I don’t recommend that you do 100% of the book in this kind of stuff, because there could be scenarios where you know, if correlations don’t perform, and that’s something that has cost us in the last few months, is you know, whatever was betting on correlation playing out, it suffers because you know, it doesn’t pay, and so you need to find, ideally, the right balance to create or find enough insurance that is predictable enough, so I’m going to have a little bit of puts, a bit of calls, so if I’m correct then at least something pays me with … and then I’m going to add that icing on the cake with something potentially more explosive, and as you mentioned, crisis, and this is very important to understand, during crisis it’s a bit … I like to use the analogy with fluid mechanics as an engineer, right?
Diego Parrilla:
The world operates in laminar regime, meaning everything’s linear, everything’s predictable, until things go turbulent, in which case you know, you have your … suddenly volatility explodes, correlations explode, and things behave in very unexpected ways, and so crises, financial crises are a little bit like that, you’re moving from a predictable, linear world where everything is expected, to a world where these things explode. How do banks hedge this? Or other people, they’re not wrong, they just need to choose something so volatility, it’s easier to understand because you know, it goes up in crisis and whatever, but correlations could be hugely unstable. Think about the relationship between gold and the euro, okay? The normal thing is that euro and gold go up and down together, but what happened during the European crisis?
Diego Parrilla:
Gold flies and euro collapses, right? So correlation is just one example of an additional tool that we can use to fine-tune, effectively, the insurance that we buy, because at the end of the day we’re dealing with probabilities, but it’s not the probability of, you know, team A winning and something else happening, these are … there is a market for these things, part of it is because of supply and demand of these kinds of structures, part of it is because the market’s been, as you said, realizing X or Y, and also it’s a non-observable market, so how do you mark your book? How do you determine what’s the right correlation? So it becomes a bit more opaque. Good news for the banks is that correlation can only be from minus one to plus one, otherwise it could get a lot uglier.
Diego Parrilla:
But certainly I think this discussion is hopefully interesting because it shows that not only options can give you a very asymmetric profile, because you bought insurance, you spent one and it can pay you a lot, you can actually try to find ways in which that insurance cost is minimized that it gives you even greater asymmetry and also because you only put 10 cents, the way at which those ten cents decline should be lower than if you had spent, you know, 50 cents or something much higher. So this is something we balance very carefully, we spend … we have a lot of tools and do a lot of work and a lot of experience, but again, the key in my view is to find the right diversification, even within these instruments, so that you don’t get too exposed to any of these dynamics, because the crisis could come in any way, any form, any time.
Jason Buck:
And before we get into that, the portfolio construction of all the options [inaudible 00:52:07] like we’ve talked about vanillas, we’ve talked about worst-offs, let’s quickly find two more, what’s a dual digital and how do you express a dual digital?
Diego Parrilla:
So a digital option, or also known as binary option, it’s either yes or no, so flip a coin, heads or tails, you know? So you could bet … a digital option would be is the SMP going to be higher or lower than X? The answer is yes or no, and the price of this digital is just an implied probability, so if the market thinks there’s a 10% probability that the market will be up 20%, you know, this digital will be roughly 10%, so you should expect to be right 10% of the time and make $1, and wrong 90% of the time. So that’s kind of where the pricing comes from, there’s no free money. When you do a dual digital you do the same thing but with two conditions. So here we’re saying okay, I think gold will be more than 5%, equities will be down more than 5%, the individual digitals were 30% and 30%, and the dual digital is roughly 10%.
Diego Parrilla:
And that’s … the beauty of these dual digitals in some ways is that unlike the worst-off where you need both to perform, in the dual digital, once one of them performs, even if the other one doesn’t move, it’s great because you’re left with … you know, let’s say we said equities down, gold up, and gold goes up $3000, okay? So that condition now is met, what you’re left with is just a vanilla … is just a simple binary. So when you think about the hedging of this, they converge and they trade in a way that you might buy them very cheap, but if you’re correct, they start to converge to the single vanilla, and this is something that again, it’s … I kind of compare it to, you know, when you play golf you don’t just aim for the flag, you may go and fine-tune, go in a little bit to the right of the flag and putting uphill, avoid the water hazard, there’s second-order effects that you may want to add when you construct these options which effectively mean you’re trying to fine-tune a little bit that that bet is not just directionally, it’s how are the volatilities … how they’re going to behave.
Diego Parrilla:
So I’ll give you an example, so everybody’s going to be very proficient after this podcast, so if I am a … let’s say we’re betting on a digital, you know, that gold will be 10% higher next year, and the market assigns 20% probability, so that’d be five to one, day one, am I long or short volatility? Well of course I’m long because if volatility goes up then the probability of finishing in the money is greater, so I’m happy, volatility goes up, I’m happy, I make money, however let’s say that the markets [inaudible 00:55:34] is up now 20%, right? So I’m now happily in the money, am I long or short volatility? And the answer is I’m short, I want the referee to whistle the end of the match and say, “Hey game over. That’s it. Observation correct,” but if you’re in the money and volatility explodes, the model would predict the probability of you getting back out of the money.
Diego Parrilla:
So the interesting thing with this is that the risk profile can change very dynamically. In this simple example I showed you, you start long volatility and you go short volatility. So for example that’s something you may want to be or not, you may say look, I think the market’s going to explode higher and then it will settle there and volatility will collapse, then you want to play your golf ball to the right and get it there, here’s the same. So if you did a worst-off or other things, you might see that volatility will continue to go higher in that environment, and so these are things that you balance when you use these Lego pieces and decide okay, what is my directional view? What is the current implied forward? What is the current implied volatility? The implied skew? Which is the cost of … relative cost of options in the correlation.
Diego Parrilla:
And when you put all these pieces together, hopefully you come up with something that you think has a 50 or 70% probability of happening, but the model is giving it a 10% probability, and that would be amazing. If you can find those things, then you know, you will make a lot of money because you’re getting unbelievable odds, and I’m sure this is something people do in sports and whatever, finding those relationships, but I think here in the markets is something that … it can be done, and always, always, always from a long option perspective which means your worst case scenario’s your premium, you want to be in that situation where you can sleep at night, in my case, and know that yeah, it could be tough to lose and lose and lose and lose, but you know how much you’re risking.
Jason Buck:
And then part of it is the other reason you like a dual digital is because when one side goes deep in the money, a lot of times the investment bank will want to pay you to get out of that trade, so you can almost dynamically monetize that, even if just only one side’s in the money, you can determine now the probabilities of the other side going in the money or not, and you could still have an exponential payout on that even if you didn’t hit both sides of the dual digital.
Diego Parrilla:
Absolutely. I think at the end of the day the banks know exactly what they’re doing and they don’t really … under normal conditions they’re perfectly hedged and they just … look, I … yeah, I knew my risk was gold going up, a buy a [inaudible 00:58:19] I hedge it, the problem for the banks comes when you have this big change of regimes, so you know, it’s like selling options, right? You could sell options and be very happy, delta hedging and you know, yeah, the market’s moving 1% per day but you know what? Theta is paying me for a 2% move so I don’t care. So you could be short options in a normal world and say happy days. The problem with your short options is vol goes to 80, there’s zero liquidity in the market, you’re paying ginormous spreads to delta hedge and before you know it you’re in a position where you have to buy back your option because it’s unhedgeable, and that’s it, right?
Diego Parrilla:
And I think the problem when you do some of these exotics is if that happened, you get the compounded effect of volatility going up and correlations breaking down, okay? And this is what makes, you know, gold and euro to look like, “Oh they’re both very calm and they don’t move much and they’re correlated. It looks like gold and euro are the same thing,” to beasts that start moving like crazy with a lot of volatility in opposite directions, and that’s a scenario where it’s almost like resonance, right? In physics, where this thing just goes … you know? And that sweet spot of volatility exploding and correlations breaking down, it’s a nightmare scenario for anybody that is short [inaudible 00:59:50] of these options because they can lose incredible amount of money, it’s like let’s say that as a commodity guy, you know, Brent and WTI are the same thing, you know, and you play your spread and your long-short futures, and in the market people traded … let’s say you trade the futures in 10 lots, and then the spread, because it theoretically has less risk, you do it in 100 lots.
Diego Parrilla:
Turns out that that’s true until correlations break, because when correlations break, you’re long 100 and short 100, so what you see is that someone that is used to trade directional risk in 10 lots, might be fooled into trading spreads at 100 lots, which effectively gives them, under a situation of stress, a 200 lot directional position which is 20 times bigger than they thought, okay? And this is what happens when vol explodes and correlations break and this is how people blow up, and so in my humble experience, you know, I think whilst selling options is super tempting, I think you need to know what you’re doing and that’s why I think anybody that is thinking about options, in my view is, I know it’s tough, but you need to be ready to spend premium, understand your downside, and play from the long side, which is way safer, in the right size and the right manner than selling options which could be catastrophic.
Jason Buck:
Yeah I want to … and I think in that analogy too is LTCM would have been selling 1000 lots down that Paris trade, but I digress, and you know I wanted to get more into exotic options but more importantly I actually want to just tie this all back together, and the way you think about portfolio construction. So typically what happens if … a degenerate gambler, they’re looking at that parlay or accumulator bet, they’re like, “If these four things happen I’m going to be rich,” right? But they’re not thinking about the cumulative losses at a portfolio level. What’s interesting is you use an ensemble approach to these options, so not only are you using, you know, vanilla options, you’re using all these different exotic options, but you’re putting on dozens, and dozens, and dozens of options trades because by using that ensemble approach you may not hit these specific path dependencies with any one given trade, but you’re trying to hit the meat of those path dependencies across dozens of trades.
Jason Buck:
So you create this book of options that you put out for this year, and then you know, subsequent years afterwards, and so when you think about those dozens or sometimes even upwards of hundreds of options, how do you think about spending that premium though at the portfolio construction level? What amount of premium are you willing to risk on an annualized basis? And then over the entire portfolio construction, what premium are you willing to risk on the entire portfolio?
Diego Parrilla:
Very good question. I think similar to the discussion on the relative value, where you don’t want, necessarily any one bet to completely distort your view, so you turned out to be just platinum or just silver, you don’t want any single one option or one strike or one maturity or one payoff to completely distort your portfolio. So the rule of thumb we use, the soft budget, it’s about 5 to 7% per annum. That’s a level where it gives you sufficient amount of premium to actually do something relevant if you can find the five to one, 10 to one, 20 to one, there’s significant upside, and if there are opportunities further down the road, as we’re seeing now, you may deploy some of that into years ahead.
Diego Parrilla:
So in our case, we’re running … the indication we give is we have roughly about 20, 25% in premium, but that comes … you know, part of it is 2020, ’21, ’22, ’23, and even … we have some options that go out 30 years. As things move inside of the portfolio, perhaps gold and treasuries will go up or down and you know, on a relative basis these weights will change, or even inside of the portfolio things that are … the average ticket might be, let’s say 0.2%, 0.3, 0.4, so as you build all these different pieces, some of these might go boom, you know? And what was 0.3% might be worth 3%, right? And so as you take profits on these you’re looking into the new trades, and so you want to find something that … you described the ensemble effect, it’s also a bit like a domino, right?
Diego Parrilla:
Because crises follow a bit of a domino pattern, you know? Or you could see perhaps credit markets … sorry credit markets or emerging markets getting a little bit ugly and then things start to happen there and then there’s so contagion into the credit and then it goes and then eventually you know, things blow up and then volatility’s been going up and then treasuries start to rally and then central banks come in and gold goes up. Or it could well be that it’s inflation that is driving things like gold and others and then it actually hits you back, and so you don’t know exactly … it could be China blowing up tomorrow, it could be geopolitical issue in oil.
Diego Parrilla:
It could be anything, it could be … so in that sense that portfolio effect, you know that things will ultimately be correlated, but you want the options to pay hopefully at different times in a way that as you take profits in one you’re okay with that, because you know you’ve got the next piece of the domino coming, right? So if you were, you know, long … puts on SMP and that starts to go down, you know, that rates are going to go down and treasuries are going to go up, and as you take profits on your treasuries you know that gold is going to go up, but in the immediate time, as equities go down, gold could go down with it. So yeah, your SMP put pays you, but your gold call doesn’t.
Diego Parrilla:
But as things are getting uglier, you actually want to load up on that gold which is an even better entry because you know it will pay later, or what I’m saying is I don’t have a crystal ball, nobody, I think, does, we know however that there are some predictable patterns and things that will pay and others that will not, and the challenge in what we’re trying to do is can we create this portfolio that will be … you know, as a goalkeeper there’s no … it’s more like having lot’s of little goalkeepers that cover the entire goal, rather than this really huge guy in the middle that is moving left and right.
Diego Parrilla:
So that approach is what we aspire to do, it’s certainly not easy, or something that you can achieve in an easy way, especially in environments where, you know, volatility’s already very high, and the cost of carry’s very negative, and that means, you know, you can buy fewer options, and so it’s something that is very dynamic, it’s fun, but it’s not easy. I think any goalkeeper will sympathize with me in the soccer pitch, it’s not the easiest of the jobs.
Jason Buck:
Well yeah I think for most goalkeepers it’s a lot of boring times, right? It’s 88 minutes of nothing and two minutes of excitement, and so that’s … the key to what you said though too for us is that I think by having so many different options overlayed on top of each other, it’s almost like a forced monetization process as those come closer to expiration or you go to restrike them, and that’s the fascinating part is like you’re forced monetization. So you know, last time we talked I took you deep into the Spanish night, so I don’t want to do that to you this time, but we really appreciate your time. I think your breakdowns are always amazing, people should definitely follow you on Twitter @ParrillaDiego, and your books are phenomenal, I highly recommend all your books.
Jason Buck:
Taylor do you have any other … are there other questions or can we let Diego go on about his day?
Taylor Pearson:
No it was great to speak with you and yeah, we’ll have to do it again some time.
Diego Parrilla:
Look guys, it’s been an absolute pleasure. I didn’t say this, but needless to say I hope we can all go through these times healthy and you know, despite being hit as a goalkeeper by the recent announcements is fantastic news, so I’m hoping the best for everybody, let’s continue to do our jobs the best we can, but first things first, I wish every listener the best and lots of health, and it’s been an absolute pleasure to catch up with you guys, and I look forward to, you know, doing this again in person some time, COVID allowing, you know, and if you guys come over to Madrid, please, you’ll be most welcome and again, thank you so much. I hope you guys found it helpful and any further thoughts or whatever drop me a line or [inaudible 01:09:10] touch.
Taylor Pearson:
Great, thanks Diego.
Diego Parrilla:
Thank you guys.
Taylor Pearson:
Thanks for listening. If you enjoyed today’s show, we appreciate if you would share this show with friends and leave a review on iTunes, as it helps more listeners find the show and join our amazing community. To those of you who already shared or left a review, thank you very sincerely. It does mean a lot to us. If you’d like more information about Mutiny Fund, you can go to mutinyfund.com. For any thoughts on how we can improve the show or questions about anything we’ve talked about here on the podcast today, drop us a message via email. I’m Taylor@mutinyfund.com. And Jason is Jason@mutinyfund.com. Or you can reach us on Twitter. I’m @TaylorPearsonMe and Jason is @JasonMutiny. To hear about new episodes or get our monthly newsletter with reading recommendations, sign up at mutinyfund.com/newsletter.
