Episode 11: Alex Orus [Principalium Capital]

All about the VIX, mean reversion

Alex Orus is a principal at Principalium Capital based in Zurich, Switzerland. Alex is one of the most experienced traders of the volatility index, often called the VIX, having founded Blue Diamond Capital which traded the VIX starting in 2010.

In this conversation, we talk about risk and how many investors measure risk in a way that actually increases their risk. We then dive into the history and the structure of the VIX and its associated products and how investors can trade it to improve the performance of their portfolio.

There were a couple of terms Alex talked about in the interview that I wanted to introduce. Alex mentions a few times an event in February 2018. What happened was that VIX went from 13 to 37, nearly a 300% move in a day which was it’s largest percentage move in history causing large losses or large gains for traders on either side of the market.

We also talk about mean reversion. Mean reversion is the idea that an asset moves back to its long term average. So the VIX’s long-term historical average is around 20 so if the VIX spikes to 40, then moves back towards 20, we call that mean reversion.

I hope you enjoy this conversation with Alex 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 11:

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.

Taylor Pearson:
This podcast is provided for informational purposes only and should not be relied upon as legal business investment or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM alternatives, Mutiny Fund, their affiliates or companies featured. Due to industry regulations participants on this podcast are instructed to not make specific trade recommendations nor reference past or potential profits and listeners are reminded that managed futures, commodity trading, forex trading, and other alternative investments are complex and carry a risk of substantial losses. As such, they’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 and making such a decision on the appropriateness of such investments. Visit www.rcmam.com/disclaimer for more information.

Taylor Pearson:
In today’s episode, we talk with Alex Orus a principal at Principalium Capital, based in Zurich, Switzerland. Alex is one of the most experienced traders of the volatility index, often called the VIX or Fear Index, having founded Blue Diamond Capital, which began trading the VIX in 2007. In this conversation, we talk about risk, how many investors measure risk in a way that actually increases rather than decreases their risk, and we then dive into the history and structure of the VIX and its associated products, and how investors might want to get exposure to the VIX, improve the overall performance of their portfolios.

Taylor Pearson:
There were a couple of times that Alex talked about in the interview that I just wanted to briefly introduce. Alex mentioned a few times in event in February 2018. What happened was that on February 5, 2018 the VIX went from 13 to 37, nearly a 300% move in a day, which was a large percent move in history, causing large losses or large gains for traders on either side of the market. And then we also talked a little bit about mean reversion and mean reversion is just the idea that an asset moves back to its long term average. So the VIX’s longterm historical average is around 20. So if the VIX spikes to 40 and then moves back towards 20, we call that move back towards 20 mean reversion. So with that out of the way, I hope you enjoy this conversation with Alex as much as I did.

Taylor Pearson:
So I want to start off and talk a little bit about risk just broadly or generally and the Financial Times did a piece on you in 2011, where you talked a lot about the financial industry and how the financial industry thinks about risk and has traditionally thought about risk, particularly the Sharpe ratio, which is a measure of historical volatility. You mentioned an alternative measure that you look at a lot more called the Calmar ratio that I’ll let you expand on. I’d love to hear you speak so general, how does the financial industry generally think about risk? And how you critique or comment on that and maybe lead us into the Calmar ratio and why you think that’s perhaps a better measure?

Alex Orus:
Sure. Basically, a lot of the industry has been looking at risk from the perspective of price fluctuation and they call that volatility and they basically think that that is risk. My view on it is that price fluctuation is a measure of risk, short term risk, but much better is to look at price as big risk. So in other words, if I’m looking at buying a house and that house is a million dollars to construct it, so the replacement value of that house is one million, and I buy for two, I’m paying one million more than the replacement cost. So to me fluctuation is risk. It’s the fact that I basically can lose money or drawdown is a better measure of risk.

Jason:
Along those lines Calmar sometimes call them MAR ratio, and it’s just basically your return over time divided by your max drawdown. And as you alluded to an FT interview too, there’s two things that the industry tends to do. We tend to talk about nominal returns and we talk about Sharpe ratio or variants. And it’s really interesting as an individual, you shouldn’t care about either those, those are more academic concepts. What we should really care about absolute return, our returns after inflation, what can I eat at the end of the day? And then my biggest risk is actually my drawdown because I don’t want to lose money.

Jason:
And it’s interesting how the industry has pegged to these nominal returns, and they don’t even count for inflation, and then they use like you’re saying price swings or variants as a metric for risk and not drawdown. I know when you founded Blue Diamond, that’s what you guys were looking at more as like how do we maximize Calmar ratio over time? And as you’re thinking about that, is that still the metric you use for Principalium?

Alex Orus:
Yes, I mean, one of the issues by using the Sharpe ratio which is certainly not a bad measure when you’re talking about a long on the universe basically of equities and bonds or balanced portfolios. The Sharpe ratio basically, is based on a normal distribution of returns. When you start looking at hedge funds or alternative investments, those returns don’t have a normal distribution. So they might be skewed into one direction or the other. So therefore, the use of the Sharpe ratio is certainly not that appropriate. It’s much better to use the Calmar ratio. But when you look at basically the skews of your returns, because you’re analyzing whether or not a manager is good also, not only going long in the market, and equities or whatever, but also shorting the market.

Alex Orus:
So, therefore, the fact that the Sharpe ratio is based on that normal distribution, it misses the point that when you start looking at returns that are not normally distributed it will not catch that. So, therefore, the ratios that are more appropriate for looking at hedge funds are the MAR ratio or the Calmar ratio or the Sortino ratio which is a variation of the Sharpe ratio but it looks at the downside volatility of your return stream.

Alex Orus:
So, yeah my view has not changed that is on how efficient is a portfolio. Secondly, your other question alluded to what I basically mentioned in the FT article a few years ago, which was having benchmarks like [inaudible 00:08:10] and looking at that, and also return to beat that [inaudible 00:08:15] don’t really make sense because at the end of the day, there is no currency associated with that. And as you look at inflation, it’s a much better measure to see what you basically in real terms, what your return is in real terms. So, those two comments I made a few years ago have not really changed.

Jason:
And this might be slightly off topic. The way I think about a lot of times is can we just take a simplified MAR ratio, like I was saying, returns divided by drawdowns. For that to really make sense I would like to see a two decade plus track record and I actually reached out to a lot of people in our network trying to ask around like, has anybody heard of a manager that has more than two decade track record that had a MAR ratio of greater than one or at least equal to one. So let’s just say their return after inflation was 10% and their worst drawdown was 10%.

Jason:
And people really couldn’t come up with anybody besides maybe Ed Thorpe and some people said Renaissance Tech, RenTech. But I think their drawdowns have excluded them. I wonder how you think about that, do you need decades of track record for MAR or Calmar to make sense for you to feel competent? Because you know that our worst drawdowns always ahead of us it seems to be.

Alex Orus:
That’s a good question. I mean, certainly 90, 95% of the times the markets are moving up. So we are just entering probably the 10th year of a bull market. And therefore, a lot of the managers that don’t have a track record that’s more than this period or measuring a Calmar ratio which is looking at the maximum drawdowns is certainly requires that one looks further time, more extended time periods in that sense going back. So, this is the issue that I see in today’s markets. If you look at the the hedge fund industry most of the hedge funds have made money by going long equities or going long beta and they haven’t really been tested on during the drawdowns for have not really excelled during those drawdowns.

Alex Orus:
It’s clear that if you’re running a hedge fund during the last nine years, that the way to make money is by either going long equities, or what we would look at it from volatility trading perspective, we would go short Vol. So the markets and the strategies and the hedge fund managers have predominantly been short Vol. I do understand it because you’re running a business and that’s the way you made money in the last nine years, which is not certainly saying that going forward that can change.

Taylor Pearson:
You mentioned the shortfall, I’m going to dive into volatility a little bit more. You’ve been trading the volatility index using the VIX a lot longer than most people they’re trading it today have been trading it. So can you just talk us through, what exactly is the VIX. I think most people knows it like a measure of volatility, but not exactly sure of how it’s constructed and maybe some of the history there and how it became tradable and how you look at that space.

Alex Orus:
Sure. The VIX is basically an indicator and some people call it the VIX as a fear indicator. And it basically, it’s constructed using a strip of call and put options. So basically, it shows what the option market sees as being the current price of volatility. It was established in 2004. It’s very important to understand that it’s an indicator and it’s non-tradable. It has a series of futures, building a so-called term structure curve each month, reflecting what the market thinks, the implied volatility looking forward will be in one month, two months, three months, four months and five, six, seven, eight months.

Alex Orus:
So, that curve when VIX and the first contract, second contract, is higher than the first contract, third one and so on, it builds a curve that is in contango, is what we call in contango. That means that the market players expect the future implied volatility to be much higher than the realized volatility. So, 2004 this VIX was established in the future as the CBOE, future has exchanged the CFA basically provided the market players with an opportunity to trade the future implied volatility.

Taylor Pearson:
And just maybe clarify a little bit the events like the VIX itself as a number I’m looking at EVIX 17 right now, and then you can’t trade this VIX specifically, but you can buy futures on the VIX. So there’s one month futures at EVIX 18, EVIX 19, EVIX 20 and there’s all different prices associated with the mention. The normal thing is as you go further out into the future, the term structure slopes up because there’s more uncertainty going into the future. More things could happen between now and six months from now than now and one month from now. Is that accurate summary or how would you critique that?

Alex Orus:
That’s absolutely right. That’s the way it gets reflected in the curve, that as you move out there is more and more uncertainty about things. I would say that the market thinks that the future volatility is going to be higher than it is today. So, that’s embedded in that term structure curve is then the risk premia, basically that you can capture an extract from this curve. So it’s kind of like the insurance premia that people pay going forward in the markets.

Jason:
As you alluded to VIX futures are a relatively new product and like we were saying you’ve traded the space almost longer than anybody else. How have you seen that change over time where I’m sure in the beginning, you were one of the few players in the space liquidity is probably pretty minuscule. And then after 2008/2009 we see [inaudible 00:16:00] start to ramp up a little bit, and then you have the VIX, ETFs and ETNs and more players coming into the space. How have you seen just the VIX market evolve since you’ve been involved?

Alex Orus:
Well, certainly, as you alluded to volumes have increased tremendously. Also, they’ve been a lot of ETNs and ETF products based on the VIX futures. So that increased the liquidity markets more market players went into it and therefore, I would say first, second and third, maybe the fourth contract have substantially increased the liquidity. The volumes have increased substantially on those contracts. The rest of the contracts are not as liquid, still today are not as liquid. The way the market has changed obviously that’s great to have more liquidity, more volume for trading in. But basically what has changed are the patterns of how volatility moves. So in other words we started in 2010 trading the VIX, and we were extracting this risk premia was including before and if nothing really happened during the month, there was on average 5% raise premium on the curve.

Alex Orus:
More market players started coming into trading the same, into the space. And that increased competition has made it more difficult to extract that kind of usual 5% from the markets. But what has really changed more recently is after the elections is that prior to that you used to come up with the volatility, you used to come up with the elevator and used to come down the stairs. So, the patterns were not as tech because they are today. After the elections and due to some of the tweets you can have some pretty erratic moves and very short term, mean reversion of the volatility spikes. So the market has become much more technical.

Alex Orus:
In addition to that, obviously, if you look at the other line, you look at the algorithmic trading firms, they’ve basically also made markets more erratic and more technical. By technical, I mean that things move much quicker than they used to. And so they’re scalping whatever alpha there is, or they’re making it certain moving in one or the other direction, much more extended way.

Alex Orus:
So that’s what’s really changed is we went from obviously being some of the first traders and extracting the risk premium to now having more market players, and also having the pattern of the VIX becoming much more shorter term. For instance, we take February of 2018 and there within one day you see VIX jumping to 40. And on February 6th, 2018 you see VIX just dropping down massively, mean reverting. So that kind of pattern wasn’t there before. And so we basically have undertaken some steps, obviously, to trade very differently, much shorter term, I would say.

Jason:
And that actually leads me right into the following question for that. And because I’ve heard you talk about it before, is that, like you’re saying, if it’s changed, whether you used spike and then slowly drift down, and now it’s mean reverting harder than ever, if you’re set up to capture those spikes, you need to make sure you have some sort of monetization if it’s mean reverting just as rapidly. So how do you think about capturing that before it mean reverts on you so quickly, that you can’t even capture any of your profits?

Alex Orus:
That’s exactly the extremely important point right now, which is we have to have a trading systems or ideas that work and that take 15 minutes snapshots. Whereas before we would look at and take three snapshots a day and we will position ourselves. Now you have to have part of your investment process geared towards 15 minute intervals or five minute intervals. So, the intraday trading of these patterns are extremely important, more and more important. Obviously the one thing you have to consider within the VIX or volatility intervals is the costs, the tick size of buying a future trade is $50. So your round trip is going to cost you 100 which means that you have to be extremely effective in the way you trade. I don’t mean commissions, I mean, just the tick size of these contracts are extremely large.

Alex Orus:
There is a flip side to that, which is because they’re large, the short term algorithmic trading programs will have a harder time to enter into the universe and into space. So that’s a piece of good news for us.

Jason:
Good. That’s actually a great way of putting it. The thing about that all time is you have multiple factors on the VIX that I assume would help you out. One is long gone are the days of rebalancing your VIX position at the close, not today. So liquidity is improved in those front month contracts, which means liquidity is improved intraday, which makes it a lot easier for you, like you’ve taken the 15 minute snapshots. But like you said, You got that $100 round turn hurdle and just the tick size, which keeps out the high frequency traders, but also don’t you think the capacity constraints keep out a lot of the hedge funds or the algorithmic traders or trend followers that are in the 10s of billions because the VIX space is a little more capacity constrained, so that provides another maybe alpha source to stay small and nimble or how do you look at that?

Alex Orus:
Absolutely. I think that’s right and that’s our aim is to manage capacity. Obviously, the VIX space has been attractive for some of your trend following CTAs to capture just another market as if they’re an additional market like they have their equity and other commodities. They enter into the VIX market, but as you rightly pointed out, the costs are prohibited to basically do too much of that. On the other hand, you have some of the [inaudible 00:24:14] I basically started doing vol [inaudible 00:24:19] doing relative trades on the curve and extracting the risk premia. That discipline has to be combined with some very strong technical. And this is why I teamed up with my partner who has a 13 year history in the CTA and algorithmic trading combining the vol or fundamental way of looking at the term structure curve.

Alex Orus:
So, that combination means that my partner brings in some of the more shorter term intraday or 15 minute interval ideas, technical factors and filters that will allow us to take very quickly, a long or short position within the market.

Taylor Pearson:
I wanted to zoom out for a second, just sort of talking to an investor that’s vaguely familiar with the VIX, but no experience trading it. Why would an investor want to have some exposure to the VIX and their portfolio? Why would that make sense?

Alex Orus:
Well, there’s been a lot of discussion whether or not volatility is an asset class. I firmly believe that it is an asset class, and it’s a very effective way to reflect in going long the market or short the market or running some sort of carry strategy. So, the way I look at the universe is I can always attach a volatility long or short or neutral position to your traditional markets, for instance, going long equities is going short. And that is extremely effective, is very efficiently reflected in the VIX market, in the volatility market. So, you can capture bear markets for instance, and that you got a long volatility. So, it’s just buying a contract and you’re reflecting that in a very effective and efficient manner with the volatility universe, the VIX volatility universe.

Taylor Pearson:
Yeah, we talk about that a lot. We usually just talk about certain terms very similar to what you said just as diversification. Volatility is an asset class, and just the way you diversify across other asset classes, it makes sense to diversify across volatility is an asset class and most investors portfolios are overwhelmingly short volatility.

Alex Orus:
Absolutely, yeah. You can look at the traditional universe of equities and bonds. You can look at in terms of volatility going short, long volatility, you’re paying in cash. So it’s a very efficient way to trade anything. It’s a very strong diversify, because it is an asset class that has a different return pattern than your traditional asset classes.

Taylor Pearson:
Obviously, this is your business use full time and you’re looking at detail for the retail investor that just interested in the VIX, what are the options for getting exposure and maybe speak to some of how those instruments are constructed and the advantages, disadvantages.

Alex Orus:
Well, the market came out, several providers came out with exchange traded funds. There are several of those, there are those that basically reflect short volatility and rollover continuously. Some other products will go long volatility, some will go this version of short volatility and leverage thought out, some will have a version that will some of ETS will do it on the long side.

Alex Orus:
Obviously, we had a few blow ups, because when you have a short ETF and you leverage that your potential loss is unlimited, you can lose 100% of your investment. For the retailing Master, some of these products… And by the way, certainly going short volatility leverage, short volatility with an ETF has a certain high risk associated with it. Obviously, we spend 90% of the time in initial volatility mode but when the event happens, you will lose a lot a lot of money.

Alex Orus:
Again, I want to reiterate that something similar happens that if you’re long volatility because as I said most of the time markets are going up and your long volatility will have a negative decay, negative role yield. So, will cost you money and cost you money, cost you money, cost you money until that event happens, where your long ETF will will basically provide you with a return. But if you look at now at the last nine years, we have been in a bull market so that is extremely costly. And so what is idea though is to have some sort of combination dynamically moving from one to the other, or having a combination of those two.There are products in in the market, I’m not sure that there are a lot of ETFs in that space but there are some.

Jason:
And then actually, thinking about the ETFs and ETNs in the space, there’s been a consistent theme on this podcast and obviously, through our managers, and I think it shows our biases. But when we talk about short volatility products, it’s really easy to go passive with anything short ball, you could just hit that buy button on almost any short vol trade. But when we talk about long volatility trades, we find it interesting that if you want to manage a long volatility position without bleeding to death, it takes very dynamic active strategies and it seems almost impossible to replicate those passively, like in an ETF or ETN space. I wonder what your thoughts are because you have a lot more experience than we do. Is that just part of being long vol? you’re going to have to have dynamic strategies with people that have been in the markets for hopefully decades, and you’re using algorithms and then their discretionary overlays to have dynamic active strategies.

Alex Orus:
That is a good point. That is a very good point. And when we talked about what has changed in the last few years, I mentioned that the volatility moves are extremely erratic going into my example of February of 2018. The move is close to being intraday. So therefore, if you passively try to or dynamically but in a passive rebalancing mode, you try to capture that kind of event you’re way too late. This is a matter of seconds, that you need to switch from one to the other.

Alex Orus:
And so here is where the expertise and the algorithmic trading know how that for instance, someone like us bring to the table, in that we can very quickly shift that position. So it’s basically the change and the much shorter change in volatility patterns, the more erratic moves, leads to having to choose a strategy that can very quickly reverse its sign.

Taylor Pearson:
And then giving out the theme of, as Jason mentioned, long volatility seems to be a space for short of having active management makes more sense than the short volatility space. What are the short primary active approaches to trading the VIX? I know one is pairs trading it with the S&P where you go long VIX, long S&P or short VIX, short S&P or then calendar spreads where you’re trading the commissions through the front and back month of the term structure is right if you get a few there’s any others or other ways you think about that. But what are the active approaches to trading the VIX and how do you think about the advantages and disadvantages of each of those strategies?

Alex Orus:
Certainly, we could take the example of what we just mentioned. So you can short for instance, the first contract go short volatility, to capture the negative role yield or that risk premia within the term structure curve. And hedge yourself with a short S&P. That is a trade I’ve done in the past and it worked quite well. That trade is now a crowd trade. What I mean with that is that basically, they are sometimes the couplings between your short and the S&P, that correlation breaks down.

Alex Orus:
So what you’ve had more recently in the recent years is that that trade as the S&P has not really hedged your position. And by the way, one important thing to understand about the term structure curve and the futures that are displayed in the universe, is that there’s no natural hedge. There’s no natural hedge of any of those futures. What we’re trying to do is a proxy by shortening the S&P because it has on average a fairly high correlation, but that has been breaking down.

Alex Orus:
So we don’t do that kind of trade anymore. What we do is basically we use techniques that are much more term structure curve and they’ll go short volatility, stop losses, and with some pretty strong risk management, or they may hedge, but they’ll have a very dynamic way of continuously hedge with the underlying market.

Alex Orus:
In addition to that, also, what is important is to diversify that hedge. So not only going short, the S&P but also maybe, not also maybe, but going also long treasuries, because the treasury still when the unexpected event hits, it’s an additional long as an additional hedge to your position.

Alex Orus:
So the traditional way as it’s described now that we were doing, we were putting the trades to extract the risk premium, the curve and hedge changes. We don’t do those anymore in that way, because of the break none and decoupling sometimes of the markets with the derivatives.

Taylor Pearson:
Maybe just to clarify and correct me if I’m wrong, the VIX is, as you mentioned, it’s a derivative of the S&P, it’s calculated using option prices on the S&P 500. And so the idea of going short VIX, short S&P or long VIX, long S&P is you’re trying to find a hedge, you mentioned that there’s no natural hedge that’s used by many people. And you mentioned you historically use that as a way to protect that position in the VIX, is that accurate?

Alex Orus:
Yes, that’s accurate. There’s no perfect hedge, maybe natural is not the right word. There’s no perfect hedge to your short future’s position. What you can do, obviously because they’re related obviously the futures are related to the options market and the options market is related to the underlying S&P 500 futures market, there is a relationship there but that breaks down every once in a while. So therefore, you have to hedge yourself in a much more dynamic way than you used to do in the past.

Taylor Pearson:
Why is it necessary to hedge that trade? Why not just go long VIX, short VIX?

Alex Orus:
Well, because you can think of it let’s give an example. Let’s say VIX is been fairly low in the last few years, but let’s say that VIX is at 13. Okay. And you in the first contract is maybe the first couple of future squeezes maybe at 14 or maybe at 14 and a half. So there’s some risk premium. There’s a difference between your VIX, your spot and your first contract. So the market things are going forward, there is going to be an implied risk premia that is there because people fear.

Alex Orus:
So, let’s say that the VIX goes from 13 to 15, 16, 17. That move is just not a few percentage points. That is a 10, 20, 30, 40, 50% move. So that means if you’re short, the first contract and that happens, and that’s what we call that the spike happens, you will lose 30, 40, 50, 60, 70%. So it’s exponentially, your loss is exponential in that sense. And that means that if you think you’re hedged, and you think you have a linear hedge and that exponential move spice up your hedge is diminished, is eliminated pretty quickly.

Taylor Pearson:
Right.

Alex Orus:
So that’s why you have to have a dynamic hedge or you also have to have all sorts of risk measure if you’re short volatility. Having said that, on average we’re 85, 90% where that trade makes money until it doesn’t and when it doesn’t, your losses is unlimited, because VIX can go anywhere. You can go to 80 as we’ve seen in 2008. So, you can potentially lose a lot of money. The other thing that more and more to is that that’s one tail that is extremely risky within managing volatility.

Alex Orus:
The other is we’re forgetting quite often how in the last few years is that the other tail is also quite risky. That means, going back to my example, if you’re at VIX 14 and you jump to 25 or 30, that’s a huge move. That mean reversion going back to 20 the next day or going back to whatever 18 the next day is also potential loss. It is not the same loss that you incur when you get the spike but you have to consider that you will lose a lot of money if you buy or go long volatility once the spike happen, and volatility means reversion system that has a mean reversion the following day.

Alex Orus:
So in other words, you look at February 5th of last year and the next day, the volatility mean reverts 15%. So you have to look at both what we call the tales of those returns. But obviously, much more dangerous is to go from a low volatility environment to a much higher one in a matter of minutes or days.

Jason:
And then just to reiterate and clarify. So people go, Okay, if I’m short volatility, and I’m capturing that volatility risk premium, and get my face ripped off on the upside so people go,” Okay, I’ll just go long volatility and capture those spikes.” So the problem is those spikes come once or twice every decade. And so in the interim, you’re losing on the, could be at average of 5% a month if you are long volatility. So both sides of the trades have their trade offs. You either bleed to death or you get your face ripped off. So that’s part of the dynamic an active trading positions?

Alex Orus:
That’s right and when it happens and then you go long volatility. Spike happens as you go along volatility as you pointed out that it’s just also quite risky to continue long volatility because of the mean reversion and you can lose a lot on the way down. So, if the curve is in backwardation, meaning that the VIX that the first contract is below the VIX, so the VIX is higher than your first contract that means that the curve is in backwardation that means that the market things that the realized volatility now is higher than the expected volatility in the future.

Alex Orus:
The implied volatility if in a scenario, if you want to go along relativity when things are happening, you’re way too late in this environment, because volatility moves at the speed of light, not only up but also down. So, the point here is the Holy Grail would be to basically prior to a spike or prior to a market downturn, to already have a long volatility position. Finance that somehow so that when it happens when the event happens, you are in with a long volatility position, make the event happens, you make them money, and then you have to very quickly realize the profits or reduce your position because that mean reversion can take place quite soon thereafter.

Alex Orus:
So it’s a very dynamic way of anticipating or being in early. There’s some early signs of trouble. And that is when you see that the risk premia in front of the curve starts getting smaller and smaller and smaller, meaning also that your Fear Indicator VIX moves up. So the normal thing would be for your first position to move down as time passes and set those on the VIX. If you’re in contango and nothing happens you extract that risk premium but come up.

Alex Orus:
If you want to be in early you have to see if that VIX… If your indicator, which is the strip of puts and calls is moving up, that is usually a sign that there’s potentially some trouble coming your way. So you have to be early, you have to look at it, you have to make sure that you don’t bleed to death when you do that kind of positioning.

Taylor Pearson:
You mentioned short term structure and contango and backwardation. Maybe I’ll summarize and you can correct me where I’m mistaken.

Alex Orus:
Sure.

Taylor Pearson:
As you mentioned, in normal market conditions that the term structures in what’s called contango, where as you go further out into the future, say one month contract, two month contract, three month contract, it goes up so to take your example if the VIX is at 13 today, the one month futures contract might be at 14, the two months might be at 15, the three month period at 16, and so on. And so if you’re long that five month, that 14 and nothing happens you lose that belief. You know that difference between the 14 and the 13 at the VIX stays at 13. At the same point if you’re short that fourth month where the short the 14 when the VIX is at 13 and it goes up to 40 as Jason said, you get your face ripped off as a huge percentage.

Taylor Pearson:
Each percentage has changed and so show the way you’re talking about it is what are the indicators or how can you look at one hedging that position and so that you don’t get burned too bad on either side and to flipping back and forth being long it’s important shorted at some points based on different factors or different algorithms indicators, is that a roughly accurate or what would you correct?

Alex Orus:
No, I think that’s accurate. I think the mindset of at least what we do is we do want to very cautiously capture the risk premium within the curve, and not to be too greedy because most of the investors will have as part of their portfolio a long equity portfolio, which is short vol. That equates to short vol, it’s pretty much a synonym of the short vol. So our thinking is, why should we add to the long equity portfolio with being short volatility?

Alex Orus:
More importantly is to be in early with a long volatility position to hatch an event. That should be the objective and is the objective of the program that we do that dynamically without bleeding too much. Because that’s being financed by other parts of the term structure curve. But I think there is a certain discipline and this is why we basically code things and we do things systematically. So we don’t fall into the trap of being discretionary in a moment of panic, making the wrong decisions.

Alex Orus:
So, the the objective is not to be too greedy to extract to pay for the event or not to be too greedy when you extract the short volatility and to be very early in before things happen. When you see the clouds are coming up, you go in long volatility and try to finance that. So I think it’s a combination of those two things.

Jason:
We’ve been talking about throughout this discussion since 2009, and even more recently, volatility has been massively mean reverting, but you’ve been in the markets long enough through multiple business cycles. So if we read our Bedwell Mandelbrot, he would say volatility clusters. So it’s really not that simple. Most of time volatility mean reverts. Now lately it’s mean reverting even faster, but then there’s going to be times when volatility clusters. So I’m wondering how you think about setting up your trading for that time when in the future, we may see volatility clustering again.

Alex Orus:
Yeah, sure. That’s it. That’s an excellent question because you have a lot of hedge fund managers, a lot of managers that what they do is they have some sort of forecasting mechanism. So they forecast the regime and say, well, now there’s clustering now, we’re going to be in this kind of volatility regime. I have spent many years trying to forecast a volatility regime, and I’ve been unsuccessful.

Alex Orus:
So the way I’m approaching it, or we’re approaching it is that the only ways taking the concept of long volatility, or what we call the spy concept of the mean reversion or the extraction of risk premia, those are the three concepts that we trade to have each one of those concepts work in very short term intervals, in medium term intervals and longer term intervals. So, to give you an example, there’s three concepts and there is nine time intervals. Each one of the three concepts, extraction of risk premia, the spike or risk on type of trade, long volatility, or the mean reversion, a risk off type of trade mean reverting.

Alex Orus:
Each one of those has three sub systems or three sub buckets that are looking at different time intervals. So they will face in, if the spy continues and turns into a consecutive spike, we’re going into a sell off mode, into a risk on mode. That concept will be extremely quickly intraday with part of it, it will continue the next day putting on more positions and it will continue the following day or the following month or the following weeks continuing to be a risk on. At the same time, you will have a set of systems that are looking at is this thing is there a reversal, is there a mean reversion and is that mean reversion what I call it a reversal which is a very quick return to normal levels of volatility.

Alex Orus:
So, part of the mean reversion concept will be looking at reversals that are basically five, 10 minutes and looking at strength of signal are we turning example again six of February in the morning 2018, are we turning today? Is their reversal today? So, partially that concept will come in with a certain portion of a certain portion of that concept will come into the market and start turning with a curve for the normalized levels of volatility.

Alex Orus:
So, the only way is to diversify the concepts by time. We see there’s plenty of people out there that can time the markets or can forecast the volatility regimes? I can because especially if you look at what we’ve been talking about that volatility, there’s no way to predict how it’s going to move, I cannot predict what the next tweet is going to be of Trump. So and those do affect. If Trump tweets that he’s going to get together with the Chinese and things are going to be fine as far as resolving a trade war, then that has an immediate effect. That tweet has an immediate effect of volatility and on the market.

Jason:
And not only does it have an effect in that, like you’re saying it most likely a spike, but then it has the effect of the hardcore mean reversion that you’ve seen too because the news gets rapidly out of the market as well.

Alex Orus:
Absolutely. And this is why I basically came together with my partner last year, who has the experience, the technical experience, the algorithmic experience, to really, very quickly reverse that trade. And just making sure that there’s the robustness of signal that this thing is really changing direction. So there’s all sorts of techniques, sophisticated techniques that the algorithmic trading, the CTA trend following type of guys have. And I didn’t have that, if you asked me at the beginning of our conversation, do we have that in 2010? No, we didn’t have it, because this thing didn’t move. There wasn’t a tweet. Right?

Jason:
Right.

Alex Orus:
So now we have these things and that we have these things that the markets move much quicker than they used to.

Jason:
You just made me think about it in a new way like, obviously, Trump is that paradigmatic example with his tweets, but what you’re really saying is like, this is the world we live in now. As the Internet has come of age, and social media has come of age, like you’re saying the markets move so quickly and in a global sense, it’s not just Trump. So it doesn’t matter what your politics are, it’s just admitting that news cascades through the system so rapidly that it we’re in a new paradigm for lack of a better term of how volatility can spike a mean revert due to the internet and social media age, which is very interesting way of thinking about it.

Jason:
But just to recap real quickly, I like the way you were talking about it. You look at these three buckets or three trading styles. Whether you’re extracting that volatility risk premium, you have another strategy to capture the spikes and other strategy capture the mean reversion at the risk of oversimplification, if we had volatility cluster for six, 12, 18, 24 months, most likely the volatility risk premium strategy would do exceedingly well in that environment, don’t you think?

Alex Orus:
Absolutely. Absolutely. I mean, if we go sideways nothing happens and then certainly, yes. Yes. It’s become a much crowded trade. Become a crowded trade because there’s more marketplace extracting the same idea. But it’s still a trade. Yes. And that would certainly be the case. [crosstalk 00:58:11]. Yeah, sorry.

Jason:
I was just going to say when you think you would become. If you have that spike to the volatility cluster, you would actually get rid of a lot of those market participants so become a less crowded trade because they’d be so fearful of that spike and mean reversion. So once validate clusters, the likelihood of most of them still being there is unlikely. What comes up that’s what makes it an uncrowded trader. Am I looking at that?

Alex Orus:
Yeah, I mean, what was very interesting last year about the trade and we were mentioning [inaudible 00:58:44] was that because one has earlier on a convex position, your liquidity provider because your long volatility and the market is struggling because it’s trying to sell its short volatility. So you become a liquidity provider in that sense. Perhaps one of the things that is very important, not only the clustering, but what is extremely difficult to manage at the same time is this back and forth of volatility.

Alex Orus:
So I go back to May of this year, where you go back and forth, but not only do you go back and forth, the market drops by about six percent and your volatility doesn’t really spike. It remains at certain levels. So there’s all sorts of strange, unseen moves of volatility in the past, what is difficult for us as managers is really the back and forth and the whipsaw of the markets and the way we are trying to manage that part is by… You need to have strategies that are in different time intervals, that smoother somehow your return.

Alex Orus:
The other thing that you can do is doing things off the curve where you take costs of what we mentioned before $50 within the take cost of your future is much lower if you trade the S&P back and forth. So, the same behavior mostly as you seen in the underlying market is reflected in the curve. The problem with the curve is or the challenge of the curve is the cost of trading that whiplash and that back and forth. So, you do both you try to mitigate and have some strategies that work on the back and forth of the curve, but you also have some strategies that work on the underlying market which is much cheaper to trade.

Alex Orus:
But that is a challenge, that is a challenge this back and forth having a lot of months where this back and forth it makes sense to me. If I put all my fundamental hat on, we have created the largest bubble in history on the VIX income side. And obviously, the equity markets have had nine years of bull market.

Alex Orus:
So, you have the two major asset classes which are richly priced to say the least. So, I can see that a lot of the macro players, macro managers, hedge fund managers, this is a difficult time for them, because we’re in a fairly directionless type of environment. Are we going to continue to drop interest rates in the US? Or are we going to normalize interest rates in the US? So that’s all reflected in volatility in that you get this back and forth, back and forth. So it’s not only the clustering, but it’s also this back and forth, erratic moves, which happened much shorter term than in the past.

Taylor Pearson:
Well, Alex, it’s been really helpful, great conversation. We appreciate your time. And yeah, we’ll do this again sometime.

Alex Orus:
Wonderful. It’s been a pleasure.

Taylor Pearson:
Thanks for listening. If you’d like more information about Mutny Fund, you can go to mutnyfund.com, or better yet, drop us a message. I am Taylor@mutnyfund.com and Jason is Jason@mutnyfund.com and we’ll get back to you. You can find us on Twitter @MutinyFund and I am @TaylorPearsonMe.