Jerry Haworth – LEAPing for Cheap Convexity
In this episode, we talk with Jerry Haworth, CIO and co-founder of 36 South. Jerry has over 32 years of investment experience, and is well known for his thought leadership in the volatility space. He often represents 36 South as a speaker at high profile educational and professional events, and is a frequent guest speaker and writer on volatility in the financial media. 36 South seeks out long dated, pan asset class, global, convexity in the most cost efficient manner.
We talk about Jerry’s background, starting with the nascent options market in South Africa. We go through the highlights on how options markets have evolved over decades. Why does he believe that long term options are the best way to play Vega. How to construct an options book and overlay with other assets. Jerry is always full of great anecdotes and analogies from a colorful personal trading history.
I hope you enjoy Jerry’s insights 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 29:
Taylor Pearson:
Hello, and welcome. This is The Mutiny Investing podcast. This podcast features long-form conversations on topics relating to investing, markets, risk, volatility, and complex systems.
Disclaimer:
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Jason Buck:
This is Jason Buck from the Mutiny Funds, and it is my severe pleasure to sit down with Jerry Haworth of 36South. Now, Jerry, to me, is the distinguished racontour of the options space. A lot of times we talk to vola traders and it’s rare to find volatility traders that go back to the foundation of the VIX index from 2004 to 2006. It’s exceedingly rare to find people that go back to the nascent option markets of the late ’80s, and that’s why I always love talking to Jerry. He has a vast amount of experience, and we’re going to talk about that throughout today’s cycle. Not only that, coming from Zimbabwe to South Africa, to New Zealand, to London, to Bordeaux, not only does he have vast option experience, he has vast life experience, and he is always a pleasure to talk to. So Jerry, thank you for coming on.
Jerry Haworth:
It’s an absolute pleasure, Jason, as always.
Jason Buck:
So I want to start, you grew up in Zimbabwe, but your foundation in the markets came in South Africa. Tell me about what was your entree into finance and just how did you get into the trading space?
Jerry Haworth:
Well, I did my thesis on the viability of an options exchange in South Africa. I discovered options very early on. I realized they were amazing, but at that stage, I don’t even think the Black Shoals model was available. It was available in Chicago, but not anywhere else, so I knew that’s what I wanted to do. I eventually joined the Johannesburg Stock Exchange as the product development manager responsible for investigating and launching of futures and options exchange with a view to end up trading. Eventually, I got a job as a bond trader for a discount house and then, moved over to equity derivatives, which is just starting. I got on the board of the New Futures Exchange and it was right there at the beginning and it was very interesting. It was a bit of a Wild West. We didn’t really know what we were doing, but the margins were high enough to cover all sins. It was really interesting. They were equity linked bonds that you could arbitrage with the futures. It was surprisingly sophisticated in that time, and it was great fun.
Jason Buck:
Besides, obviously, fat spreads always help, but in general, was it just a absolute intellectual curiosity and complex problem solving that hooked you?
Jerry Haworth:
Yeah. Because it’s five-dimensional, it’s a lot more interesting than traditional stocks and there always seemed to be that all the models are correct given the assumptions, but the assumptions aren’t correct. So it always seemed to be that it was definitely an intellectual challenge and still is many years later. The market has grown enormously, but it is still as fascinating as the day I first looked at it.
Jason Buck:
Yeah. I think we’ll get into overpriced to underpriced throughout this discussion and the creativity involved there, but there’s also, you had a story about trading options via whiteboard at the nascent market. So tell me about what was the whiteboard and what were you guys doing?
Jerry Haworth:
Yeah. So there was no portfolio management system for options. In fact, we wrote one. But before that, we just simply, board options put it on the whiteboard, which we had behind us and try to keep roughly square, which just by looking at the whiteboard, that’s how we looked at it. We came in one day and the cleaner had wiped the whiteboard, so effectively, we didn’t even know what our positions were. It was a
bit of the Wild West.
Jason Buck:
These days, everybody talks about these FinTech solutions or everybody’s got Excel sheets and has advanced beyond that in machine learning. But I really wonder, a lot of times just handwriting down things over time, even though it’s a pain in the ass, it’s like you build that intellectual dexterity or you build it almost into your kinesthetic memory that you have much more facility with options and you find where the mistakes are. Is that true, or am I just overexaggerating?
Jerry Haworth:
100%. I literally have most of the portfolios in my head and if there’s a performance figure that doesn’t match, I go look and see why, so I know what it’s going to do in my head. That’s just from years and years of doing that, I suppose.
Jason Buck:
Yeah. I think because your subconscious raises alarm bells for a number that’s off and then that’s where you go investigate?
Jerry Haworth:
Yeah. Yeah.
Jason Buck:
Yeah. That’s that’s fair enough. Then, so why did you move from South Africa to New Zealand? Jerry Haworth:
Well, we had a startup called Peregrine that went really well, and I had visited New Zealand a couple years earlier. I was very impressed with it and I decided that’s where I wanted to raise my children. So I left and literally arrived in New Zealand not knowing anyone and I really enjoyed it. I still think it is one of the greatest countries in the world.
Jason Buck:
Well, that’s aspirational. How old were your kids at the time, just to give people an idea?
Jerry Haworth:
Seven, five, and three, I think. Yeah, they were small.
Jason Buck:
That’s the almost exact ages of my sister’s kids, and I can’t imagine them upping stakes and move to New Zealand right now, but it’s, I guess, a different time, but it belies your sense of adventure and intellectual curiosity.
Jerry Haworth:
Yeah, and then I did a music degree for a couple of years and never passed, actually. They didn’t have high regard for my musical ability.
Jason Buck:
If I recall, that was in jazz, right?
Jerry Haworth:
Yeah.
Jason Buck:
So I don’t want to draw too much of a parallel, but what do you think about the relationship between, or correlations between jazz and options and riding waves and thinking about improvisation?
Jerry Haworth:
Yeah. They all have a common thread. They’re all intellectual puzzles that generally cannot be solved. You can get closer. It’s like golf, I suppose. You can get good, but you’ll never get to the end.
Jason Buck:
Do you think that, obviously, these days there’s a lot of machine learning AI conversations and, “Will the machines take over humans?” But part of that idea is they always talk about closed loop systems, right? AlphaGo can be chess and you have a constrained rule set, but then, when we talk about life and options and financial markets and jazz, they’re just open-ended and you have so many variables it’s like without a closed end rule set, you think they can ever catch up, or it’s man plus machine is the future?
Jerry Haworth:
It’s a massive debate. I think in terms of options, options are predicated on future volatility, which is a guess, and future volatility is a function of unknown unknowns. So AI cannot know, and we can’t know
what the future’s going to bring. So it’s going to be remarkably difficult for AI to, like you say, and a closed loop system is fantastic in things like I’m fairly confident that AI, it’s almost impossible to predict volatility. We know that it’s persistent and has certain characteristics, but it is generally unknowable. The only thing you know about options is they are mean reverting around a unstable mean, and that’s over the long term. So short-dated options, it’s a lottery ticket; long-data options, if you buy yourself enough time, you have generally a better idea of what the volatility footprint is going to look like in broad ranges.
Jason Buck:
Yeah, and we’ll come back to that or the difference too, between the longer term volatility, et cetera, and how you view that. But like every great story, you stumbled in or forced into starting a hedge fund when you’re in New Zealand. Why did you start up a fund when you were there?
Jerry Haworth:
Yeah. We were just running our own capital and we were quite happy doing that, but in order to get ISIS, we needed to start a fund. So we got a couple of friends and family and just to make up the numbers, and that’s how we managed to get our ISIS from the banks. In those days, it was a lot easier to get ISIS than it is today, so we were off to the races. So we had access to the OTC option markets, and we were up and running.
Jason Buck:
Just to provide some context, what years were those? What was your strategy at the time?
Jerry Haworth:
Well, we started off in the listed space in ’98 and generally got our faces ripped off ’98, ’99; caught court, 2000 pretty well; 2001, and then we decided we didn’t want to just deal equity options with that. The opportunities were a multi S-Class and we needed to go OTC, and so we launched at the end of 2001 our first fund, which was basically taking 25% of the portfolio and options and long-dated options putting the rest in cash. At that stage, interest rates were a pretty good carry there. I think there were eight or 9%, the cash, basically, carried the options. So it was, yeah. [crosstalk 00:11:54]
Jason Buck:
The good old days when 90-day T-bills actually had some [crosstalk 00:12:02] to them, but well, on longer dated, it’s a bit different, but isn’t it also factored into RO. So it’s also priced into the options as well though.
Jerry Haworth:
Yeah. But RO, it is, but it’s not really taken into account by option traders, especially now with [crosstalk 00:12:27]
Jason Buck:
No, I know, especially now. Yeah.
Jerry Haworth:
Yeah.
Jason Buck:
Nobody even talks about RO as [inaudible 00:12:31] RO, but that’s why I was asking you is in the ’90s is RO prevalent, because I keep wondering if RO is going to come back, but nobody ever mentions it at all. So I was curious that it’s not part of the process. So then when you decided to go to London, is that just a sense of adventure again, or is that just better access to capital markets and investors, et cetera, or … ?
Jerry Haworth:
Well, again, 2001 to 2008, we did pretty well and then 2008, we did really well. In particular, we had a dedicated Black Swan fund. We were marketing it throughout 2007 with, actually, very limited success. I remember thinking at the time, so it was a 2 1/2% of your portfolio spend. The in five-year options of bleed was 50 basis points a year and we expected to make 10 X. So we expected to make 25% return for the overall portfolio on event. We got some money in it, but to my mind, it doesn’t get better than that. The ball was really low and it ended up in 2008, it did really well.
Jerry Haworth:
On the back of that, what really set us off to London was we had a Bloomberg News story that ended up being the top news story in the world by algorithm, I think, it was just [crosstalk 00:14:09] because it was a local Singapore news story that just got bumped up to the top pages. that had created a lot of interest and people said, “Look, great idea, happy to invest, but get to London, Chicago, Singapore. We’re not coming down to New Zealand to do due diligence,” and so we decided, “Yeah, let’s go to London.”
Jason Buck:
Yeah. do you think that’s a lot of those, especially at the time institutional allocators check those boxes, they want to visit your office. They want to see it’s in an economic and financial center, but don’t you think it’s crazy that now you could be in New Zealand and do just fine, don’t you think, especially in Zoom culture?
Jerry Haworth:
Yeah. No, probably the same. I think we only had two institutional clients come to New Zealand. One had a girlfriend there and one loved trout fishing and that’s the only way we managed to get them to come down there. So they need to kick the tires, and that’s fair. Especially, in 2009, it was critical, post Madoff, post-2008, it was critical and I think it still is critical to do good due diligence. So yeah, I think you got to be in one of the main centers that make it easy for people to come and kick the tires.
Jason Buck:
In relation to 2008, I want to bring up something that’s interesting is in 2007 or even 2019, we have this beautiful serendipity when you’re buying options or especially buying leap options, is that volatility compresses right before the event, right? So those options
Jerry Haworth:
Yeah.
Jason Buck:
… get cheaper and cheaper in a Minsky sense right before the event happens, which is unbelievable serendipity. So it’s great when you’re buying the options, you can really load on that inventory, but at the same time, I think you’ve talked about that’s when your investors start capitulating. So it’s a leading indicator to you when people are pulling their money, you’re getting excited, in a way, even though you hate losing that AUM.
Jerry Haworth:
Yeah. It’s one of those tells when you get a rash of predominantly retail, and I consider myself a retail investor as well. The temptation to do the wrong thing at the wrong time seems to be overwhelming in a very short time window, and I noticed that trading over the years in all asset classes. So when there’s a rash of investors redeeming from the fund, particularly retail, that, to me, is very interesting tell and generally, near the bottom.
Jason Buck:
As it always is. It’s like that the shoe shine boy problem in reverse.
Jerry Haworth:
Yeah.
Jason Buck:
I also wonder in 2008, one thing that always makes me nervous is about, is there OTC, understandably, is the counterparty risk. So in 2008, you make a bunch of money, but you need the counterparties to still be in business and pay you out.
Jerry Haworth:
Yeah.
Jason Buck:
But I’m curious about how you handle that with diversification, cash sweeps. How do you handle that process to make sure your counterparties are good on that bet?
Jerry Haworth:
Yeah. Well, we were extremely lucky in 2008. I suppose that’s the only way you can describe it, but subsequent to that, there are some horror stories where you’ve made the money and the bank just refused to pay you. I’ve heard of other guys who said they had winning positions, that their margin got increased 32 times on them, and they were forced out at less-than-optimal prices. So the first thing is to make sure you have excellent ISA contracts. So we spend a lot of time making sure that we are very tight, very good, ISA contracts. Then, if you’re comfortable with the ISA contracts, a lot of it is now margined. So OTC contracts are, I would say, they’re very similar to listed in terms of risk now, because if you look at the cascade of obligations in a listed exchange, the same counterparties that we deal with, the JP Morgans, [inaudible 00:18:29] they all the clearing members of the exchange as well, and they’re third or fourth tier, they’re holding in a can if the top three levels fail.
Jerry Haworth:
So I’m very comfortable with the risk. Now, there is margin pretty much on all OTC contracts. I think just on that point, it’s good for me, it’s good for all OTC holders of options, but it has created a bigger systemic risk in that in OTC options alone, I think what, 60 trillion outstanding? Before 2008, the market moved a long way and there was no margin payable, no collateral posted,. But now you’ve got 60 trillion, you’ve got a 10% move in the markets, you’ve got an enormous amount of collateral that needs to be posted that never used to need to be posted. I think that was one of the big problems in February, March 2020, but no one really discusses that as a risk. But I think liquidity risk by the shortage of collateral is partially due to the fact that OTC options are now margined. So I’m quite happy with the risks of running either listed or OTC options.
Jason Buck:
I actually love this type of conversation, because like you were saying is the intertwined nature of the counterparties on OTC and then their involvement in the listed exchanges. Now on the listed exchanges, they consolidated to four players that are really getting that payment for order flow on the option side, so that’s where liquidity’s only coming from four players. So as long ball guys, we had to think about end of the world scenarios, we have perverse mind. So I’m curious, we’ve never seen the list exchanges shut down. Do you think that’s a possibility, and what are the commensurate risk of that, because if liquid exchanges go down, it’s probably going to cascade into those OTC contracts and it’s like, who’s the buyer last resort? Is that governments? How do you make good on those on your options?
Jerry Haworth:
Yeah. I don’t see that as a real risk. If a client can’t meet his is obligations, it falls on the broker and the broker hasn’t got the capital to meet those obligations, it falls on the clearing member, or the exchange reserve fund first, then the clearing member. Then, it the clearing member can’t, and that’s joint clearing members, then it falls really to the central bank. That’s the financial system gone. So I think with initial margin and variation margin, it’s a good system. It is quite robust, unless you had a catastrophic event where the market was off 30, 40%, or a market moved 30, 40% and it was a huge market. So I don’t see that as a great systemic risk.
Jason Buck:
Yeah. That’s why we like listed exchanges, because as you just illuminated is the trenched levels of margin that are covering those positions from the actual traders to then, the primes, to the FCMS, to the exchange, and then, my answer always is, if the exchange goes down, that’s obviously too big to fail and the government steps in, it’s our best guess in that scenario.
Jerry Haworth:
Yeah.
Jason Buck:
But once again, it’s a timeframe, though. You might be tied up for months to years, but hopefully, you get paid back. So I want to take a step back for a second and let’s start at the basics of what are leap options and why do you love leap options?
Jerry Haworth:
Well, leap options are long-dated equity options, but I like leaps as well, but I like long-dated options, per se. There’s three good reasons for that in that the longer you go out in time, I think the more the
square root of time as it’s lucid out in the formulas, it tends less to hold. So if you look at an option contract over three months, you can be wrong on many things, and it’s not really critical. If you buy a 10- year option and you’re wrong on your parameters, it can make an enormous difference. You can go and do it on a normal pricing model on Google, take a Google option at the current price, double it and do a five-year option on that price.
Jerry Haworth:
If you price it at the lowest Google has ever traded in volatility terms, you might pay 30 cents for that five-year option. If you price it at the highest it’s traded, you might pay $300 for that option, that’s the only variable is implied volatility, or forecast of future volatility. So you’re tell telling me the pricing model can, basically, tell you it’s anywhere from 30 cents to $300, and if you sell it at 30 cents and it goes to $300, you are out an enormous amount of money. So I suppose where we look at it and say, “Okay, we are not sure where it’s going to trade, a five-year option is,” but we can look at its quality footprint in this range.
Jerry Haworth:
We can say, “At $30 it’s probably it’s fair value.” Over time on without prior knowledge of what’s going to happen in the markets, if it gets to a dollar, we’ll start being interested. If it ever got to $100, would we sell it? I’d be tempted, but like I’ve always said, you never get killed jumping out of a basement window. I don’t like selling even expensive options. It’s a valid strategy. They’re overpriced, [inaudible 00:25:16]. If you did that for a long period of time, you would make money. I’m quite content buying undervalued options and holding them in a portfolio.
Jason Buck:
Yeah. There’re several things you said that I want to break out. One, like you just said, even selling options at a high implied volatility of what you think is, obviously, you have the counterintuitive fact that as implied volatility expands, actually you’ve widened the distributions. So now you have even higher probability that you could get your face ripped off. Going back is leap options for retail is probably about two to two-and-a-half years out, but like you said, you like long-dated is does, and that allows you to get seven to 10 years out, which is unique and a lot of people wish they had access to. But I think, going back to what you said initially, is if you think about Black Shoals formula, et cetera, is the one thing that’s a guess is implied by vega so this is what essentially you’re isolating with long-dated options, and that’s why you think you can have an advantage there. Is that fair?
Jerry Haworth:
Yeah. Yeah, and a lot of times it’s just uncommon common sense. In about ’04, ’05, the banks were very keen to sell gold call options, and the very good reason on the other side, the gold mines get the premium and they don’t really mind. They’ve got a program to sell call options to get some yield in and they’ve got the gold in the ground, so they’re not really that bothered. They had been doing that for a long time and the price had been coming down, so you could buy a five-year gold call option strike 500 and the spot was 450, you could buy a five-year option strike 500 for $30.
Jerry Haworth:
I sit there thinking, “Well, if I wanted to buy gold spot, I would have about a $30 stop loss anyway, so why don’t I just buy the five-year option and leave it? If it goes down, I’ve lost my $30. If it goes up, I’ll run it.” So we loaded up on those and twice gold dropped back to below 400 and our P&L took a bit of a
hit. I think the option price went to $20. It didn’t massively change, and then it started to run. Then, at that stage, we had three-and-a-half years to run every $30 we were making 100% on our options. So, once it gets to around 700, you’re happy to keep on running it. So that is clearly a cheap option. Sometimes, they just shout at you.
Jason Buck:
Well, part of that is there’s a lot of argument if options are overpriced or underpriced, and then you said fair value, but is it as simple? Obviously, you have modern tools and techniques to assess those values, but at the end of the day, is it classic value investing of almost like you have a margin of safety, they shout at you, they’re so cheap that you just want to load up on those cheap options?
Jerry Haworth:
Yeah. Yeah. Yeah. No, because we are scanning the whole world looking for option, we like to buy options we think are massively undervalued. [crosstalk 00:28:44].
Jason Buck:
And that’s part of what you [crosstalk 00:28:45] Sorry, go ahead.
Jerry Haworth:
For one reason or another, the reasons can be many and varied. It can be interest rate differentials. Interest rate differentials, make some options extremely undervalued and some extremely expensive.
Jason Buck:
That’s part of why I’m really fascinated by what you guys do. You guys call it pan asset class or cross asset class. Like you just said, you searched the go globe for cheap convexity, essentially, but tell me about how you put together a book of using all these different asset classes and how you think structuring the book that way?
Jerry Haworth:
Yeah. Well, running a portfolio of options is like trying to herd cats. It’s not a particularly easy exercise. So we started off with a trader’s mentality. We just put a portfolio of long-dated options together we thought were really good, and then we started thinking, “Well, we want to run a UCO. We want to make money in any market environment, so we want some options that’ll benefit if the market goes up and we want some options if the market goes down.” So we started to bifurcate where we felt the correlation to, call it S&P was. It was positively because we were trying and balance positively correlated and negatively correlated, so in any environment, we’re going to make some money, except a quiet environment.
Jerry Haworth:
Then, that was the first, and that takes some working out. Then, the next evolution was we discovered a whole raft of options that carry positively that we can use in the portfolio to carry to offset the theater that we are doing on our convex options, which are the high convexity options. So now, we blend the carry options with the high convexity options and then, you are looking at correlation. You want to make sure that over every market environment, given certain correlations, that you have a robust portfolio that you won’t lose on both your carry options and your options. If you are going to lose on your carry
options, options will kick in and overwhelm them. You’ll overwhelm losses and still make profits and, I think, that’s approaching the holy grail of running an option portfolio.
Jerry Haworth:
If you can run an option portfolio like a Dutch book and running an option portfolio is lot more like a book maker than it is a traditional investment manager. So you want to try and get a Dutch book, which is, basically, no matter if you’ve got a 10-horse horse race and you’re the book maker, no matter what horse comes in, you’re going to make money. It is possible, it’s doable, and that’s a holy good rail of options is to get that blend and understand your correlations well enough and boldened enough resilience in the portfolio that you make money in pretty much any conditions. So, there will be volatile, sometimes there will be losses, but we look at it over a rolling five-year period, we are really confident that it’s a robust portfolio if we decide we want to carry neutral and make a certain amount of money, or we want to yield 5% and have slight convexity, or we just want to run extremely high octane port portfolios and use some of the carry just to mitigate some of it. So that’s where we at now.
Jason Buck:
Yeah. I want to come back to how you structure the carry neutral book, but then, thinking about just on the long convexity side of pan asset classes, do you think about constraining any particular asset class, or is there an aggregate constraint on those options, or
Jerry Haworth:
Yeah.
Jason Buck:
… how do you layer those in?
Jerry Haworth:
We’ve got risk limits. We constrain counterparties to 25%, that’s pretty common sense. We constrain asset class limits to 50%. So we could be totally invested in two asset classes only, which is pretty broad, but it gives some diversification and 30% in any one particular position, which is also wide, but is fair.
Jason Buck:
Then, as you referenced before, what’s nice about trading a long book of options is like when you referenced the gold option. When gold sold off, it went from maybe 30 to 20 is like you have concavity to the downside and a truncated downside, because you’re paying premium and then you have an unknown convex upside, but the whole point is it’s unknown. So then, we start to get into this position of how do you think about roles and monetization? So the interesting thing is that if you’re buying seven to 10-year options, it’s not terribly different from buying a bond. You know the terminal value, but it’s the football in between that we play, right?
Jerry Haworth:
Yeah. Yeah.
Jason Buck:
It’s how the P&L just can dramatically expand and contract, so it begs an interesting question. If I have a seven-year option in year one or two, all of a sudden vega dramatically expands, but it can also mean reverses as quickly is how are you thinking about rolling monetizing, maybe trenching effects, I know that you guys use? That’s the really tricky part, right?
Jerry Haworth:
Yeah, it is. It’s tricky, but we stumbled across our methodology, and it’s been pretty robust for many years in that we’ve got two basic regrets when you buy an option. You’d buy an option, well you regret if you buy it at a dollar and it goes to zero, but that’s a risk you run. That’s the price of doing business. But the main regrets, if it’s profitable, if it goes from $1 to $10, then goes back to $1, that’s a big risk and a huge regret. You can buy 10-year option, it could have gone to $10 in six months into the option and you decide, “I’ve got nine years left. It’s going to go more,” and you leave it and eventually whittles down back to zero. The other one is you set a price target at 10, you get out of the option, and it goes on to 40, and okay. It’s a less of a regret, but it is a regret.
Jerry Haworth:
So what we do is we put profit stops underneath it so if an option goes from one to three times what its original premium was, we put a 60% profit stop. If it goes to four times, we tighten it up five, six, seven, eight times; eight times, it’s got a very tight profit stop of 10% under it and then, after eight times it’s discretionary. So we can get out of it, but there’s a hard stop at 10% under 8 times. We find in that way it takes all our thinking away from us. We know if it keeps on running, if it goes 12 times or 15 times, we can let it run, but we’ve got a hard stop at just under eight, and if it gets to eight and falls back, it’s out. If sometimes it gets to four times and falls back, it’s out. So we know at every level in the heat of battle, it’s hard to have a plan. So in this way, with a lot of options pointing in different directions get really volatile, we don’t have to try and outthink when to monetize a portfolio.
Jason Buck:
I think you have these contradictory forces, too. It’s like when the price dramatically expands, obviously, you want to monetize as a business, because it obviously helps your P&L, but at the same time that people are using you in their overarching book to pretend against one in a five-year sell off or once in a 50-year sell off. So that’s the really hard part about monetization, because you need to have some of those on the books. Like you said, if you monetize a 10 X and runs the 40 X, then you haven’t provided that protection, and that’s a really difficult process that people don’t realize.
Jerry Haworth:
Yeah, that’s right. Yeah. That’s right. That’s a dilemma.
Jason Buck:
Then, think about two aspects of rules, right? So you had two problems, right? Let’s start with a simpler one, is, let’s say I have a seven-year option and three years in nothing’s happened. At what point are you rolling? How much time are you leaving on those options, so roll into new options?
Jerry Haworth:
We only really look at it when it’s got a year left to expiring. We can do a bit of housekeeping and we could trim it up, but, generally, we don’t do anything until it’s got a year left to expire. That’s when the theater, how much bigger you get for how much of the cost benefit of analysis really starts to skew
against you and the last three months even works? So we find if we’ve got a position and we still like it, we can roll. When it’s shared, really, about a year.
Jason Buck:
Then, part of that is then the secondary way I think about it too, is let’s say you go through a period in those first couple of years where you’re able to monetize or you hit your trenching monetizations of your stop loss. But as you know, now you’ve got to re-up your book. You’ve got to get more options back on the book. Now, vega is probably higher, so you’re going to pay a lot. Is this part of your pan asset class approach is that you can still think you can find cheaper vega where vega hasn’t expanded in other markets to relayer that book?
Jerry Haworth:
Yeah, exactly. So at the end ’08, we were 95% in cash, literally because we long balled and there were no opportunities. So we want to be highly invested when the ball is low and the options we think are value and we want to monetize them and be out in cash looking for other asset classes, and this is where multi asset class pays its way in spades. In ’08, things were falling apart and was doing well. But I think well into ’08, Australia and new we’re still raising interest rates, when the rest of the world we’re running down a zero very quickly, so someone was going to be wrong.
Jerry Haworth:
We took the bet that if this crisis deepens, Australia and New Zealand would have to reduce the interest rates massively was effectively what they had to do. So we had monetized some options and we recycled the profits back into swap options on the New Zealand dollar and Australian dollar interest rates. Generally, even in ’09 when implied ball was really in equities, there were opportunities in currency. So we feel that in systemic crisis you do tend to see cross asset volatility correlate to one eventually. Although, in 2020 in the COVID crisis, currencies didn’t participate. But I think given another month or two, they would’ve. The central bank successfully stopped that in its tracks, which well done to them. But I think, all the asset classes, generally, started to participate in volatility.
Jason Buck:
Part of that, let’s say thinking outside the box, like we were saying, what if the listed exchanges went down is I always think about in the modern area, we haven’t seen a second or third down in the modern era. You’re looking for those other asset classes to protect. It’s like if March 2020 we see, let’s say, volatility expand to 80 it comes back to 40 so you’re selling them out and then, after a bounce back also and all of a sudden it shanks off another 50, 60% in S&P, but now a lot of tail risk managers do not have protection on because they’ve gone to cash and they monetize all their positions?
Jerry Haworth:
Yeah. Well, that’s the dilemma. It is a big dilemma. I met a oil trader. I don’t think he was trading oil at the time, but he said, “Oil implied volatility generally topped out at about 40%”, I think it was. So as it approached 40 sold oil volatility, I think it was the first Gulf War hit, he bought it back at 120 implied volatility, went long at 140 and sold out at 200. Implied volatility is just a number, it can go anywhere. It’s very difficult for it to go to zero. It is surprisingly easy to go to any number, 80 on the VIX could be 180. You never know how potentially high it can go. It depends on what people are willing to pay for options at that point in time.
Jason Buck:
Then, part of that, you said in ’09 you were looking at FX or currency ball didn’t really pop. Do you feel the same way now that’s where you’re buying? Well, it’s calmed down since March of 2020, but in mid to-late 2020, were you guys rolling into FX ball or how were you looking at it?
Jerry Haworth:
Yeah, we’ve had FX ball on our books for a while and I think it is multi decades sheep. An annualized implied volatility of five-and-a half percent, you’re basically saying that currency is going to go up and down throughout the year a maximum of 5 1/2%. It can do that in a day. I’ve seen, I think in ’98 or ’99, the yen moved from 150 to 120, I think, in a week. We haven’t seen that for a long time. The Forex markets have been calmed, but we’ve got interest rates at the zero bound with a desire for central banks to keep them there, which means that any geopolitical uncertainty will probably reflect in the currency rates. Now, you’ve got inflation emerging, which means different currencies will start to suffer different effects from inflation or deflation. So I think currency rates will move a lot more in the future than they have in the last, the next five years are going to be totally different to the last five years. So I think that is the major opportunity.
Jason Buck:
What I love about your strategy, though, at the same time is like you can be two Jerrys, right? You can have your view of prognosticating the future of what you think should happen in FX based on what’s going on in the world. But then the jerry portfolio manager of the options book is like, “I’ll just buy cheap options, and if nothing happens, I know my downside, but if there’s compacts upside, I’m going to be there to participate.”
Jerry Haworth:
Yeah.
Jason Buck:
It’s almost like a trade off where you’re two people in one, in a way.
Jerry Haworth:
Yeah. Yeah. Options, it’s a probabilistic outcome. You put a certain amount of money down, there’s a probability that the event will occur. Now, there’s an analogy that if you went to a casino and the coupiers were allowed to give you variable odds, so you suddenly hear on a table down the road, they’re offering 100 to 1 on the number 17; where clearly the real odds are 36 or 37 or 38 to 1, the odds are clearly in your favor. if you manage to find enough of those bets, put them in a portfolio, you would make money over time, that’s an investment.
Jerry Haworth:
If 5 17s then come up on a single table and the croupier is now terrified of 17, and she only offers you 5 to 1, the real odds of it happening at once every 37 spins say, and you’re only going to get paid $5 if it comes up, that’s a terrible bet. That’s exactly the same in the options market. All you have to do is wait until the premium’s low enough that the odds are in your favor. The only wrinkle is you’re dealing with uncertainty as opposed to known risk.
Jason Buck:
No, that’s a great analogy and way to think about it. I would be remiss if I didn’t go back to point out, and I’m not trying to do a marketing pitch for you to yourself, but I always think about the pan asset class idea is that during a risk-on cycle, if you have pan asset options, you might get a pop of volatility and in these asset class, and then you’re monetizing it that helps on that carry during the risk- on cycle. Then, on risk-off correlations tend to go to one, so across your book, you’re just having great returns. Then, like we were just discussing, is after that risk off event, now vega reply volatility is higher, but you can find little pockets where it might be lower in different asset classes, so in the three stages, it’s like you’re covering yourself across those three stages of market environments.
Jerry Haworth:
Yeah. the other nice aspect of being in long-dated options, because it’s got a big, vague component, so asset direction is not as important as vega. So if you’ve got an option that, say, it’s an S&P call and the market goes down to 20%, you’ve got a five-year S&P call. You clearly got the wrong direction, and ball
goes from 20 to 80, there’s a chance your call option will be worth more than it was before. So it also limits your losses by being long volatility as well.
Jason Buck:
No, that’s one of my favorite stories from February 2020 that I tell people is that exact thing, as I know, a bunch of traders that made money off of calls in February 2020. It blows people’s minds that don’t understand if you’re buying cheap enough vega you could be wrong down your Delta and still make money, and it’s always a fascinating way to look at environments.
Jerry Haworth:
The longer dated, the more apparent that effect is. So on a three-month option, maybe you won’t see that, but a three to 10-year option, that’s quite doable.
Jason Buck:
Then, you talked about, so the evolution or a new wrinkle you guys created is thinking about, you have this massive convexity on your book and you’re like, “Well, is there maybe a way to carry that convexity with things we’ve learned over the decades?” So like you were saying, you have this new product with the carry neutral protection, and you were saying your using spreads or neutral deposited carry options, what does that look like? Give me an example, what do you mean by seeking out these positively accruing options?
Jerry Haworth:
Yeah. So they just, basically, call or put spreads that positioned between the forward and the spot. I’ll give you an example now. The ruble now what we’re trading about 71.50 spot today. One-year ruble is the forward is 77, I think, roughly. So you can buy a strike 77 strike ruble call option and sell a strike 72. So you’ve got to spread call option and, obviously, the ruble has to appreciate, it’s going to go down and it’s at 71.50 today. If it stays at 71.50 or anywhere below 72, it’ll realize about 100% in premium, because we outlay, I think it’s 30,000 per million. If nothing happens, it’ll be worth 60,000 simply because the forward has drifted down to the spot from 77 down to 71.50. So here we’ve got an option that actually is accruing if nothing happens. On the same time, we’ve got an option that is losing money if nothing happens. Now, if we can put them together and their correlation is good enough, the one will pay for another under multiple market scenarios.
Jerry Haworth:
I’m not saying that the ruble is a good counterbalance for the S&P put, but the euro also does the same thing. It carries positively and generally, in a market crisis, the dollar strengthens. This is a euro put. So you basically long the dollar and then, you have these highly convex options that also make money if the market goes down. So it’s now you, in the realm of we can get a carry book that is quite robust over every market regime up 10, up 30, up 50, down 10, down 30, down 50, we roughly know where it’s going to be. Now, we roughly know what we’re going to generate from that and now, we can use that money to buy the highly convex options that produce meaningful performance, if the market’s down in that carry neutral funds, if the S&P’s down 30%. It’s a product that appeals to people because it’s carry neutral. There is a behavioral bias against negative carry, which I’ve never really understood, but it’s there.
Jason Buck:
Well, and a part of that added that carry neutral, then obviously, you’re giving up some of the convexity on the negatively correlated part of the book
Jerry Haworth:
Yeah. Yeah.
Jason Buck:
But it’s one thing to hunt for these idiosyncratic positively-accruing spreads, but to put them together in a book the way you guys do, talk to me about that’s a lot of system design. That’s a lot of computational horsepower to figure out the correlations across the book and to add those all in. How long or what was the process of actually building out the system design?
Jerry Haworth:
Yeah. Well, that’s where the interesting work really stopped, because everything’s dandy if you have one correlation matrix and you assume correlations won’t change over any market regime, but that’s clearly doesn’t happen. So you got to get to a position whereas, if the market was down 30, are you comfortable with the correlation matrix that you’ve got today and the answer’s clearly no. So your best guess at what the correlation matrix is going to look like when the market is down 30? Go back as far as you can, and find every time the market was down 30, look at the correlation matrix, and form a new correlation matrix that’s just for that market regime, maybe down 20 to down 30 and that’s your best guess.
Jerry Haworth:
I don’t think you can’t really get better than that. Yes, it might not be that, but a lot of the things will be the same, and when the market’s are 50, the correlation matrix will change again, and so we look at all extreme events. When the market’s up 20, the correlation matrix will be different. So I think that’s where we differ. We’re now plugging in what we call a ‘family of options,’ and we’re plugging in all these different correlation regimes to make sure that it’ll be robust if we get to that environment and that correlation matrix kicks in.
Jason Buck:
How dare you say best guess in world that everybody wants precision, but that’s the problem [crosstalk 00:54:08] distribution, and it’s honesty, right?
Jerry Haworth:
Well, the classic conundrum now is for the last 30 years, you could count on interest rates going down if equity markets went down, so that’s pretty hard-baked into a lot of the correlation matrices. But what happens if rising interest rates cause the equity market to go down? Now clearly this is a scenario, the risk parity blow up scenario, which I think is probably a lot more probable than the market gives it credit for. In that scenario, pretty much every correlation matrices we have for the last 30 years will break down. Notwithstanding, there will be wholesale panic in 60/40 portfolios when both their 60 and their 40 are going down together and so that’s just an example. It’ll always be a little bit of art and a little bit of science. I would love to systemize my portfolio. I don’t think it’ll happen.
Jason Buck:
Well, that’s why we all run shock tests and I love them and hate them, because at best they’re an intuition pump, but really, they’re rear view mirror looking. So they’re going off past correlation and past market regimes and it’s shocking your portfolio if a certain event happened in the past, whether it’s ’87, 2008, 2020, or 2015, all those things. Those are the shock test we use, but it gives you an idea, but it doesn’t give you certainty.
Jason Buck:
I like that you talked about you got shocked to, you said 10 plus market regimes. But to be clear, what you mean by that is if the market moves this much over this amount of time and you trench those out in a 10 and then you figure out the correlations based on that, in those past market regimes. But then, you have the human overlay of the art of saying, “But what happens if interest rates go up and we haven’t seen that in that correlation matrix?” So the 10 market regimes are actually just strength or speed of move up or down? Is that how you trench out the 10 markets?
Jerry Haworth:
Well, It’s like what will the Thai baht do when the markets down 30? What will the Thai baht do when the market’s up 30? Now, I don’t intuitively know what will happen, so if I’ve got a carry option that involves the Thai baht, I need to know that and I don’t intuitively know that. I have to rely on the correlations as they existed for the last 30 years in every different market rating. It may or may not occur, but I think the odds are probably in our favor, it will be similar, but there will be scenarios like interest rates versus equities where it won’t be similar. This time it will be different, and you got to be on the lookout for that as well. It doesn’t take much to buy some optionality to get rid of that risk. In fact, because the correlations have been what they are, you can buy a conditional option very cheaply that are both the equity market and the bond market prices going down together, I think you get about a 70% discount.
Jason Buck:
Well, that’s interesting of adding those dual digitals in, but a part of the overall book where you’re covering a path dependency that your other options are covering instead of just looking to buy dual digitals and waiting for that parlay or that accumulator to take place it’s very different if you’re pairing it with the rest of your book, knowing, “This is where I could potentially get hurt.”
Jerry Haworth:
Yeah. Yeah. Just plugging risk holes. Again, what you’re trying to do is end up with a Dutch book where in every scenario, I will carry neutral. I’ll be around zero and if the S&P’s down 30, I’ll make whatever I make, 40 plus and then, where can that go wrong? Plug every risk call and run it, and if the client likes that [inaudible 00:58:26] they’ll invest.
Jason Buck:
Yeah. We’re, obviously, big fans pairing relative value positive carry with deep out of the money convexity. But I’m curious how you think about there’s a bit of belly risk, or another way to say it is you have ceteris paribus, your positively-accruing options are going to do well if nothing happens as the sell off continues, and then your convexity kicks it. Usually, there’s a relay race to that handoff, and that’s where maybe some negative P&L can kick in between where relative value gets hurt, and then the convexity kicks in. I’m curious about how you guys think about covering that, or leaving it?
Jerry Haworth:
Yeah. You can never cover every potential scenario, so you are right. There can be a scenario where your carry book is losing money and your convex options are losing. They’re just beginning to kick in, but not enough in which case you just leave it. If that situation occurred for you and you go down 10% for the year, just march on to the next year. It’s a very unusual scenario for that to happen and these two standard deviation moves are irritating.
Jerry Haworth:
You want the convexity to kick in, or you want wanted to do nothing, but the next year the chance of doing that half faint and never really following through then, of course, it can always come back. So it can go the two standard deviations, you get a mark to market loss, and then it comes back, and you’re in the same position and you’re three months down the track. So it’s a risk, but I don’t think it’s a huge risk. Again, because we try and diversify our carry book over a lot of market scenarios anyway that even that if that did happen, hopefully, we’ll have some options that will make money in that environment anyway, because of asset direction.
Jason Buck:
I only bring it up [crosstalk 01:00:37] Go ahead, sorry.
Jerry Haworth:
It’s not without risk. You can’t run a Dutch book totally without risk.
Jason Buck:
That’s all I was trying to do is highlight that there always is a commensurate risk, so it’s almost education from our parts. I bring it up without talking specifics from the pain here that we just went through at September 2021, where those kind of scenarios happen, where you almost get pinned to that two standard deviation. So it’s always incumbent on us to remind clients that there’s nothing without risk, and this is where you could potentially get hurt. But over the long run you’re going to be better off running this Dutch book. Sorry, I don’t know if you have anything to comment on that. It was just fresh in my mind, in general.
Jerry Haworth:
Yeah, no, that’s right. In fact, that’s why we focused, because a couple of years ago, the correlations went against us and we got quite a severe P&L hit in another fund, and that’s what forced us to look at these different correlation regimes. So in many respects, it was the best thing that ever happened to us. It wasn’t pleasant at the time and it came back on after that, but it was concerning and the best learning happens through failure.
Jason Buck:
Well, that’s because during the wins, we tend to think we’re geniuses, so it’s hard to learn during those wins. I was right all along. So I want to wrap up with some more like not rapid fire, but just some ways of tying a bow on thinking about options. One of the things that you and I are big fans of that I don’t think gets maybe reiterated enough, is the idea with buying long options, especially, or just buying options in general is it’s non-recourse leverage. Just talk about the value of non-recourse leverage. It’s very few places you could find that in life.
Jerry Haworth:
Yeah. Non-recourse leverage is the holy grail. In fact, just as an aside, I think the way the U.S. property market is structured, it’s non-recourse because it’s very difficult to throw you out of your home in the U.S. It’s also a resettable strike, because if the value of your home goes up, you can remortgage and set the new strike price in which you can’t lose any more money. So in effect, you’re buying a 30-year, non recourse, resettable strike call option on property well, that’s a fantastic option.
Jerry Haworth:
That’s a fantastic option, and in fact, I would argue that that should continue until it breaks the people who the selling that kind of option, which is, it’s a great option. So non-recourse leverage is one of the eighth wonders of the world. If you can put $1 and have the potential to make $10 and if it doesn’t work and it goes down, you only lose the dollar. It’s the same as if you’ve taken a dollar and borrowed 90% of the funds from the bank non-recourse and invested in that asset. If the asset, when pear-shaped, the bank takes all the losses. That kind of optionality is valuable.
Jason Buck:
Yeah. Actually, just this past week my partner and I were discussing that and people don’t realize as Americans that how lucky we are to have non-recourse leverage on single-family homes, because that’s actually not prevalent worldwide.
Jerry Haworth:
Yeah. Yeah. I think you can’t get it, maybe maximum a 10-year loan here. In Europe, you can get 30-year as well, that’s a 30-year option.
Jason Buck:
But also in places, I don’t know how it is, it’s probably country-by- country in Europe, but in Canada, it’s recourse. You can still get like theater doing your mortgage, but it’s a recourse. It’s not a non-recourse.
Jerry Haworth:
No, it’s not a non-recourse.
Jason Buck:
Which is, as you know, a huge difference. But then, what you have then is you have the social construct risk, right? Your recourse is a social construct that you look like a failure to your community if you default on that debt. That’s a
Jerry Haworth:
Yeah. Yeah.
Jason Buck:
That’s a fair way to look at it.
Jerry Haworth:
Yeah.
Jason Buck:
So the other thing I brought up earlier is there’s this interesting, like I said, Hyman Minsky moment in 2007 or 2019 where volatility gets suppressed and gets cheaper and cheaper right before the event. So I want to talk about as options traders, it’s like we’re inventorying liquidity, where it’s risk transfer services or we’re liquidity providers, but I always think about it as inventory on a shelf space, like in a store. Like you were saying is like, when it gets cheaper and cheaper, you’re buying more an inventory, you’re waiting for the event to happen. There’s not maybe a ton of liquidity there, the event happens and everybody rushes to buy your inventory and liquidity is expanding, so it’s this countervailing force of actually, you’re playing with liquidity in and out of the market, but you’re also inventorying liquidity during those cheap and dear times.
Jerry Haworth:
Yeah.
Jason Buck:
Is that a fair analogy or would you extend that metaphor for a little bit?
Jerry Haworth:
I’ll give you an analogy and probably not a very PC one. Imagine you are in the trapping business.
Jason Buck:
Okay.
Jerry Haworth:
You’re in Canada somewhere and you’re trapping and you’re trapping in a valley somewhere and occasionally, you have a migration of a lot of animals come through. But for the last couple of years, you’ve seen nothing. Now, you can go to the general store and you can buy a trap that rusts away in a month, or you can buy a stainless steel trap that lasts 10 years. So some people buy the ones that rust away in a month. Those are the short-dated ones. Some people buy the long-dated ones, but there’s been no animals in the value for five years. There’s been no returns. All the trappers are giving up in
disgust. They’re all sending their traps back to the general store, and the price of the stainless steel traps are really low.
Jerry Haworth:
So you load up, you go and buy all the stainless steel traps. You put them out there, go, “Well, the price is so low is, it’s not really a big deal. I don’t think the price of the traps, per se, are going to go any lower”. Now, after six months now, all of a sudden the animals come through the valley and you’re catching all these animals with these stainless steel traps. You are making a lot of money on that side, now everybody wants to be a trapper. So now, the price of the traps are the general store, which is the rebel of options, goes mad. You uptake all your stainless steel traps, which you got eight years life left in them, and then go and sell them back to the general store 10 times what you paid for them, and you’ve got caught the animals as well. That’s [crosstalk 01:07:46]
Jason Buck:
I’m smiling the whole time, because every time I think I’ve heard all of the analogies in our space, you always surprise me with a new one. It reminds me of almost, in a way, it’s like the old analogy of selling picks and shovels the gold miners, right?
Jerry Haworth:
Yeah.
Jason Buck:
That’s what we’re doing. We’re just waiting for that gold rush to happen, basically.
Jerry Haworth:
Yeah.
Jason Buck:
That’s a great way of, I think, looking at it. So when I was thinking about I knew you and I were going to talk today and yesterday, I was thinking about in general. I was thinking about back in the day, I used to be a soccer player of European football. I had the great fortune when I was 17-years-old to play against one of my heroes at the time, Carlos Valderrama from Columbia, central midfielder. I was a central
midfielder.
Jerry Haworth:
Yeah. Yeah.
Jason Buck:
I’m going against him and I realize very quickly that what happens with Carlos Valderrama, he looks like he’s effortless. He’s just floating around the field, doesn’t look like he’s working hard at all. If you try to mark him too tightly, he’ll beat you on the dribble so quickly that then you’re like, “Okay, I don’t want to be embarrassed,” so I step back. As soon as you step back, he makes a killer pass to the forward and they score a goal. So he is impossible to mark in a way, but it looks totally effortless. What I think happens is over decades of experience, or time goes on, we get these really cagey veterans that they know more and importantly not what to do, but what not to do.
Jason Buck:
So what I was thinking about you is over all these decades of experience from nascent markets in South Africa to now, and evolving into the carry neutral space, it’s like you more know what not to do. I always talk to all the young gun options traders, and they all have these great ideas and everything, but to me,
it’s like, you’re sitting back and go, “Look, if I buy long-dated vega and I buy fistfuls of it in all the asset classes of the world, I’m going to be just fine.” So it’s really just reducing the core competency into the basics, and I say that in the best possible light. Is that fair?
Jerry Haworth:
Yeah, and that’s fine. What do they say about experience? Experience is what you get just after you need it.
Jason Buck:
Unfortunately, our recording cuts out right here. Jerry and I go on for another several minutes, but unfortunately, it didn’t record audio or video. Obviously, I could listen to Jerry talk for hours. I always enjoy a conversation with him and I hope you got as much out of this episode as I did, and we apologize, again, for the technical difficulties, but we appreciate you listening. Thank you very much.
Taylor Pearson:
Thanks for listening. If you enjoyed today’s show, we’d appreciate if you would share this show with friends and leave us your 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 this 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.
