In this episode I am joined by Mutiny Fund CIO Jason Buck and our close partner at RCM Alternatives, Jeff Malec.
In this quarterly review, we discuss what we saw in volatility markets and how various volatility strategies performed in Q4 of 2020 and what we might expect to see in 2021. We go into the VIX term structure around the election, the impact of retail call buying, and the dislocation of the normal relationship between volatility and equities.
In addition to our conversation, Jason also sat down with Bastian Bolesta from Deepfield Capital which employs volatility arbitrage and short term trend following models and Wayne Himelsein from Logica Funds which focused on long options strategies for their takes on the market in Q4.
To give a bit of context, Q4 2020 saw The S&P up about 10.9%, and the VIX down about -14% though it was mostly range bound between 20 and 25 with one spike at the end of October.
I hope you enjoy these conversations.
We wanted to release this publicly so we don’t go into specific performance here and will instead focus on volatility markets broadly. Accredited investors interested in learning more can contact us at info@mutinyfund.com for more information or submit an inquiry on our site.
Resources on Gamma Dealer Hedging
Listening options:
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.
MONTHLY UPDATES – LONG VOLATILITY & TAIL RISK EVENTS
ENTER YOUR EMAIL TO STAY UP TO DATE:
Transcription
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 our RCM Alternatives, Mutiny Fund, their affiliates, or companies featured.
Taylor Pearson:
Due to industry regulations participants on this podcast are instructed to not make specific trade recommendations, nor reference past or potential profits. And listeners are reminded that managed futures, commodity trading, Forex trading, and other alternative investments are complex and carry a risk of substantial losses. As such they’re not suitable for all investors, and you should not rely on any of the information as a substitute for the exercise of your own skill and judgment in making such a decision on the appropriateness of such investments. Visit www.rcmam.com/disclaimer for more information.
Taylor Pearson:
In this episode, I’m joined by Mutiny Fund CIO, Jason Buck, and a close partner at RCM Alternatives, Jeff Malec. In this quarterly review, we discuss what we saw in volatility markets in Q4-2020, and how various volatility strategies performed, and what we might expect to see looking into 2021. We go into some stuff around the VIX term structure, particularly around the election, the impact of retail call buying and the general dislocation of the normal relationship between volatility and equities.
Taylor Pearson:
In addition to our conversation, Jason also sat down with Bastian Bolesta, from Deep Field Capital, which employs volatility arbitrage and short-term trend following models, as well as Wayne Himelsein from Logic of Funds, which focuses on long option strategies for their takes on the market in Q4.
Taylor Pearson:
To give a bit of context, Q4 saw the S&P up about 10.9%, and the VIX down about -14%, though it was mostly range bound between 20 and 25 with one spike at the end of October. So without any further ado, I hope you enjoy these conversations.
Taylor Pearson:
So, let’s start with October. What was wrong in October in volatility markets and how did that sort of play out?
Jason Buck:
Well, I guess I’ll start with kind of just a general overview of October, and what you had at the beginning of October going through October 12th is you had volatility just got crushed back down. As the S&P rose about 5%, volatility got absolutely hammered by mid month. And so that was obviously a difficult environment for a long volatility fund in general, or a lot of long volatility strategies.
Jason Buck:
As we got towards the very end of October, those last few days in October, that last week, you saw a massive volatility spike as S&P crushed back down a little bit. And most of our managers we were able to capture that volatility spike, except for the last few days in October, it got chopped back down. So it was kind of a three-part tale, volatility crushed through mid month, the last week of the month volatility spiked, we captured it. And then you had a big pullback in the last few days and it chopped around where you were able to lose a bit.
Jason Buck:
So in essence, long volatility strategies in general were down mid month, up towards the end of the month, and then back down a little bit. And that’s kind of the general story of October.
Jeff Malec:
So yeah, what was weird to me in October was you saw this big disconnection between the print in the VIX, which everyone uses as an easy proxy for volatility, and the actual volatility itself inside the market. Be it fixed strike balls, or front month versus back month fix curve. Those levels were up either next to nothing, or small single digits, while you saw the VIX print up 40-some percent. So that was a big disconnect in the … Of course the things, the strategies that we employ can actually trade or the actual futures and the actual options, not the VIX itself, it’s not tradable. So that was a little bit of an odd disconnect there in October.
Taylor Pearson:
Yeah. And maybe to put some numbers on that, the VIX itself was at 39% in October, the VIX S&P 500 fixed front run futures index, which is an index of the actual tradable instruments was up about seven and a half percent. So just a big difference between the nominal number and what the tradable instruments did.
Jason Buck:
And that’s maybe a good … I’ll piggyback on that, but it’s maybe something to highlight. I think in risk on times or normal times, if we discount 2020, a lot of times, if you’re just looking at the VIX index number, especially in points versus percentage, it gives you a good idea of where volatility is trading or if volatility spikes or declines. The issue is when we have 2020, and you had a sell off in March and you have that echo of volatility in the markets. And then we have … The term structure matters a lot more in the actual tradable VIX market.
Jason Buck:
So the VIX index is no- tradable, you have to trade the futures or options on futures to actually trade the VIX. And that’s where term structure then matters, where you can have a spike in the actual non tradable VIX number, but that doesn’t subsequently realize actual VIX futures. And especially in this scenario in October, it’s because we had the November 3rd election. And so there was an interesting kink in the term structure around October, November, December contracts about unknown election volatility that was giving you both high contango and backwardation right around the election cycle.
Taylor Pearson:
Just to define that quickly, we do have an article on the site for what is VIX and contango and backwardation, but to expand on what Jason was saying, typically in quote unquote, normal times you have the front month is lower volatility, and then you have sort of increasing as you go out further months, the sort of the VIX futures goes up, and there was a weird kink in the curve where it went up a lot, right around the 2020 election in the US and then sort of dropped back down. So it wasn’t … The shape of the futures curve was very different from what it typically would be.
Jason Buck:
And to Taylor’s point is then, if you’re putting on a trade, let’s say a pairs trade on the calendar of the VIX, you’re going long in that front month, because you need to be long volatility, but then you’re fighting against that contango curve. So you’re losing on that position.
Jason Buck:
And then you’re hedging it out with the back month, you’re going short that volatility, and now it’s in backwardation, so you’re fighting that as well. So you’re getting hit on both sides while you’re trying to create a paired trade to be market neutral or long volatility. You’re getting beat up on both sides when you have a kink like that in the curve.
Jeff Malec:
Yeah. And another was just about to say similar thing of, just assume you’re going to try and capture that fall spike, but you’re worried about the high level of VIX. Now you might go long in the back months and either have neutral on the front months or short in the front months. And in this case, it’s spike somewhat in the front month, but the back months barely moved or didn’t move at all, because they were pinned to that election, as Jason said.
Jeff Malec:
And then I’ll just … Another point there with October was, as we noted was super [inaudible 00:07:48] not just for the VIX, but for the market itself. It was on either side of even. A couple days it seemed, okay, the election is going to be a big problem. People forecasting what turned out didn’t happen until just recently here in January, but that caused a lot of days where you’d come in, US traders would come in, the markets down, by the end of the day, it closes at even or break even, and vice versa. So for our short term, future strategies that are trying to capture those small moves, if they’re getting in on the beginning of the day when it’s down, and it retraces higher by midday or the end of the day, it’s problematic for those. They’re going to lose a little bit.
Taylor Pearson:
And then what about November? What was happening in the market in November and how did sort of long volatility strategies perform?
Jeff Malec:
And to me November, was weird as October was, vol was high and it was just a weird month. I think November was a return to normal in terms of the correlations between the equity markets and volatility. That was a bad thing to be long vol because, that equity market screamed higher, but as a normal, “Hey, we’re buying vol and all of its different forms,” and the market screamed higher and volatility got crushed. Everyone was expecting big fireworks out of the election and it turned out to be sort of a non-event, and volatility reacted as such.
Jason Buck:
Yeah. And it’s Jeff saying as that volatility, drifts or crushes back down after the non-event with the election, that makes any sort of long volatility strategy struggle, whether that’s playing VIX or your long options, or in the futures contract as well, not a lot going on there that you can really take advantage of. The interesting thing towards the end of November and going into December that’s when we started to see implied volatility staying up in that low 20-ish range and just kind of drifting around back and forth in the low 20s, but then going into end of November into December, we started to see realized volatility crushing back down into the single digits.
Jason Buck:
And so you had kind of have this dispersion between implied volatility staying pinned, and realized volatility crushing back down. And most of our managers, or our long volatility managers, are taking advantage of when realized volatility spikes. So if it’s crushing back down versus implied, it’s a little bit more of a headwind, but also as Jeff was alluding to, we started to see at least the correlations coming back into line, which are present in normal market environments.
Jeff Malec:
And I’ll, I’ll throw some … Little bit of mini shade on some of our managers, we would have hoped to have done better in November, and the single name volatilities were increasing, right? You saw some huge moves in single name equities. And the structure is such that you can capture both sides of volatility in a ’99 melt up type event and in a 2008 type crash. So one month doesn’t make a ’99 melt up, but just was a little disappointing, or I wish we’d seen a little bit or performance there. Part of their reasoning was it was not in the names it was expected to be, there was a bit of a shift to value stocks in November from momentum stocks, a once in a lifetime shift. I think one of the days had people get mad at thrown around standard deviations like this, by a 20 standard deviation move or so.
Jason Buck:
Yeah, we haven’t seen to … Jeff’s alluding to the vaccine day, right? The vaccine announcement spike. And we haven’t seen a rotation that violently from momentum to value since 1983, I believe. So it gives you an idea, if our right tail, or an option, or long [inaudible 00:11:43] manager is looking at the right tail of the S&P or other indices spiking, and they were on the indices side, you didn’t see that subsequent spike on indices side, you saw more spiking on individual stock names, like in value names, as Jeff was alluding to. The other story that he was also alluding to is the Robin Hood trader, the WallStreetBets in massive call buying from retail traders.
Jason Buck:
And it’s a great story, a very interesting story, and how those retail traders were able to kind of catch the market makers and the dealers off sides. And by them having to hedge their position, it forced the markets higher and moved towards those deltas and those strikes that those Robin Hood and WallStreetBets retails buyers were buying. And so that was an interesting kind of move to the upside as well in single names, especially tech names, especially Tesla, for example. And what’s interesting about that is that you can catch those dealers offside and do really well as a retail trader in those environments. But the next time that happens, the dealers are going to bid up those implied volatilities and it’s going to be prohibitively difficult for retail to pull that off on a second or third time.
Jeff Malec:
Yeah. I was just going to say, you don’t read too many articles about hugely successful hedge fund managers who followed retail, right, into a trade. So yes, those trades have worked out. But A, they’re making the calls more expensive to buy, which makes it more difficult to position to capture that upside volatility, that right tail. But B, yeah, it’s just not an over … A long-term winning strategy. You’d be buying huge, two weeks out of the money calls, hoping Tesla goes up 50% in two weeks.
Taylor Pearson:
We don’t need to go into the details, but maybe to touch on just the general mechanics there, if that’s not intuitive, right? When the retail people on Robin Hood or wherever coming in and buying short day to call options that are 10 or 20% of the money or whatever it is, it’s forcing the option dealers to go long the stock, because since they just sold that option, should have to hedge it out, so when they got long the stock, it forces the stock price up where you can get this kind of somewhat reflexive feedback loop. And that was probably a part of the market dynamic that we saw in November, and just in general last year.
Jason Buck:
I’d sum it up of there’s not a perfect supply of retail option sellers to retail option buyers, it’s ten to one on the buying side. So firms like Citadel and big, huge market-maker firms, [inaudible 00:14:04], they step in and say, “We’ll sell you these options.” They’re super smart, so they’ll sell you the option, but they don’t want risks that Tesla increases 50%. So they’ll buy what the called delta hedging, they’ll buy some of these stock to hedge that. When they first sell you the option, they only have to buy, say, 20% of the exposure. As the stock gets closer and closer to your strike price, they have to keep buying more and more to get perfectly edged. So that causes this gamma squeeze, where the closer you get to the strike, the more stock those market makers have to purchase in order to be perfectly hedged and just take your money on the spread they gave you on the option instead of … They don’t want to take any directional risk. They just want to lock in the spread they offer you on the option.
Jeff Malec:
And then on the other side of that, as you reach the expiration of that option, that gamma rolls off, they’re going to roll those off their books and you can have a violent turn the other direction as well. It just depends on where the positioning is.
Jason Buck:
Yeah. And I mean, this is going to be a continuing theme in these markets, probably throughout 2021. We could spend three hours on here talking through it, but I’d say we’ll put some links to some good resources on learning about that.
Taylor Pearson:
Great. And then let’s talk about December for the same question, what was happening in the market in December, and how does sort of long volatility strategies react to it?
Jeff Malec:
I’ll just say December was, again, a return to normal. You didn’t have the huge equity rally. You didn’t have a huge sell off in vol. The main story was vol continuing to be pinned, and implied vol staying well above realized vols. I think we wrote a post or it’s coming of the implied vol is kind of what you want to pay. And the realized vol is what you’re going to get. And for several months now that implied has been well above what you’re getting out of the market.
Jason Buck:
Yeah. I think Jeff beat me to it. I was going to say a return to Normalistan, So in return to normality in markets. I mean, you still had the S&P grinding higher in general through the end of the year. But I think what’s more interesting, maybe anecdotally, is we’re seeing a lot of players starting to regrow their books. And so what we talked about a lot in March was this ed-grossing or de-leveraging of books. When everybody’s got to … If they have a vol targeted fund and they have to … Volatility spikes, they have to reduce their leverage. And that creates a cascade of selling effects that we saw in March. We’re seeing kind of the opposite now, we’re getting into December because maybe those look backs are shorter for a lot of managers. So as volatility is coming back down, especially realized volatility, they’re starting to re-gross and re-lever up up a lot of their positions, and we’re starting to see that from some big players anecdotally in the market and December and moving into to the beginning of the year.
Jeff Malec:
Another interesting thing in December, is you saw gold rally, pretty big. So I think that was a return to normal correlations as well. You had gold down pretty big September through November. And some of these managers that we employ use gold as a proxy, whether they’re buying options on gold, or long positions in gold, that can be a cheaper proxy than buying puts on the S&P, or even the VIX term structure when it’s pinned artificially high like we’ve seen. Some of the managers can go into some proxy markets and those proxies weren’t behaving as they’d be expected to behave September through November.
Jason Buck:
If we think about not really month to month, but if we think about Q4 in general, and we saw towards the end of Q3 at that Jeff was alluding to as well. In September, October, you had basically kind of all strategies struggle. So I’m just thinking about things in time sequences or temporality. So if you think about a permanent portfolio where you have all the world’s assets or risk parity, et cetera, everything was kind of down in September, October. Of course, except for Bitcoin, and I don’t want to … Let’s set aside Bitcoin for a second. But you had basically almost all strategies, all markets, all asset classes are down in September, October.
Jason Buck:
And so if you take anything in isolation over a few months or a quarter, you’re going to have down months, that’s an inevitability of the investments. So it’s more about looking at the long run of history, how things perform. And, and once again, we always think about long volatility, tail risk options as a hedge or a ballast to a [T-way long 00:00:18:26] S&P portfolio. But you can have times where the S&P is slightly down, and long volatility and tail risk are slightly down as well. And that’s just part off having things that are negatively correlated yet, not perfectly negatively correlated right from that at the money starting point.
Taylor Pearson:
And I think just zooming out a little bit from just Q4, but sort of the … At least in the volatility landscape, part of the macro backdrop was the drop from … The VIX drop from 80s and late March to … And it dipped below 20 briefly in November. So that’s the fastest vol crush of that level since the VIX started in 1990. So it’s not … An unusual or an atypical year in that sense.
Jason Buck:
And you’ve seen an S&P rally of over 70% from the bottom. I mean, that’s just phenomenal.
Jeff Malec:
And as we’ve touched on before, the last time we were at all time highest, VIX was at 14 or something. Now it’s seemingly pinned at 20 to 25.
Jason Buck:
Excellent point. Every time on, average we’ve seen S&P highs, VIX has been at 14, as Jeff said. The last time we’ve seen both S&P at highs and VIX up was 1999. We’re not saying we’re exactly in that environment, but it’s always a rare occurrence, and unusual, to have the S&P making all time highs at a higher VIX point.
Jeff Malec:
Yeah. And if you took the whole year, right? The perfect trade would have been, I’m going to sell volatility and have some super cheap way out of the money calls on the VIX, or our puts on the S&P right? So I’m going to collect all that premium, sell all that volatility, and then I’m going to protect myself against that huge spike. So this was the poster child for that type of strategy. But long-term, that’s not necessarily a winning strategy because there’s tons of miniature spikes, right, that are not going to get those way far out of the money puts or VIX calls that you’ve purchased that can just grind you down.
Jason Buck:
You’re saying you don’t have a time machine and a hindsight look back machine for us to be able to trade in reverse?
Jeff Malec:
I’ve long decided … Would I do that trade, or just buy tons of Tesla calls? Probably in the latter.
Taylor Pearson:
It was sort of a big picture, any thought about Q4 as a whole, or 2020 as a whole?
Jeff Malec:
I think Q4, we were able to learn a lot about all the long volatility and option strategies. I thought it taught us a lot about where they could potentially break down, when correlations break a little bit, when you have this echo of volatility combined with an unusual election event, when you kind of … And then COVID uncertainty, a vaccine announcement. We got to see a lot, as your Tolstoy quote about a lot of things, “There’s decades where nothing happens-” … And I’m going to get that one wrong. So Taylor, you can-
Taylor Pearson:
Yeah, it’s actually Vladimir Lenin, which is kind of weird to quote a Russian dictator. But, “Decades in which, nothing happens, and weeks in which decades happen.” So 2020 seemed like one of those years where there were a lot of weeks in which decades seem to happen.
Jeff Malec:
Yeah. And I think that at the end of the day, all of us hate draw downs, no matter who we are. But draw downs are part of any investment portfolio or any investment strategy. And learning a lot is underrated and overrated. And so we constantly get feedback, and we get to constantly iterate. And that’s part of the red queen principle of staying in long volatility markets, is we always have to run faster and faster to hopefully stay in the same place.
Jason Buck:
I think the big thing to me was the … How do you want to position your protection, right? So a naive protection might just protect against that initial spike down, grab the money, call it a day. Mutiny’s designed to capture multiple legs of a down move. So if the second, if the third, if the fourth leg never happens, that’s going to cost money, because you’re setting up the protection in order to protect against that. And in retrospect, right, there was no huge blow up during the election. There was, against all odds in this raging pandemic and the economy is shut down, the market is at all time highs.
Jason Buck:
Those could have just as easily been, I think we can all imagine a universe where … An alternate reality where we took another leg down, we were down 60, 70, 80% in stock indices with this pandemic and with a contested election. So the job is to protect all the legs down. And when you sit here in Monday morning quarterback, you can say, “Ah, if we’d taken off those second, third, fourth leg protections, we would’ve made a lot more money.” But we don’t have the time machine.
Taylor Pearson:
And that’s that sort of underscores, just as we talked about all the time, the importance of ensembles and diversification, right? Without having a time machine for what the future looks like, a diversified portfolio of long volatility assets combined with the diversified portfolio of short volatility assets in 2020, still did well. So you have to look at it in that sort of holistic way.
Jeff Malec:
Yeah. And I think the point is too, that the long volatility mandate is to remain long vol and have that protection, no matter how fierce the headwinds are. And that’s what it’s there for. And no matter how fierce their headwinds are, we still have to maintain that exposure in case there is that second or third leg down. And I think we’re … I don’t know if I want to hint at this, but moving from-
PART 1 OF 4 ENDS [00:24:04]
Jason Buck:
And I think we’re… I don’t know if I want to hint at this. But, moving from Q4 into 2021, I mean, if you would’ve told me a couple of years ago that you could be running a long volatility book and people would storm the Capitol and volatility would stay flat. I mean, this is just part of the crazy markets that we all get to experience.
Jeff Malec:
Yeah, no comment there. Right. That’s unbelievable. You could have made a lot of money selling. People like, “I’ll bet you vol doesn’t move. I’ll bet you 50 to one, vol doesn’t move when there’s a storming of the Cap.”
Jeff Malec:
So, looking ahead to 2021, what are the thoughts? What do things look like for 2021?
Jeff Malec:
I mean, to me, with these markets back at all-time highs, you’re right back where you were Jan of ’20 and Jan of 2018. And there’s tons of potential for dislocation and a lot of action in the volatility space. Personally, I think we’ve come through a lot of the pain of that dislocation in vol markets.
Jeff Malec:
There’s got to be a coming to Jesus moment of implied versus realized. One of those two is going to move and meet the other. Yeah and that’s it. But I think we’ve seen that return to a more normal correlation between the two that can only help most strategies that we’re looking at. So I’m excited.
Jason Buck:
And as Jeff that, those correlations coming back into line. But also, not quite the same, maybe as January 2020, where we had vol down into the teens, implied vol in the teens and now we’re in the low 20s`. So not quite that huge convexity that we’re sitting on, but still, we like to see it back down here. So that way our managers are able to reload and [inaudible 00:25:50] risk is in a good position moving forward. And as always, we don’t know when the next crash is going to come, but we always want to be positioned for it. And so we’re looking at a great set of positions moving into the subsequent year.
Jeff Malec:
Yeah. And I would just add, I’m not saying there’s going to be a crash. I don’t think we need a crash. I think the more normal environment’s going to result in some more normal abilities to do well, whether there’s vol spikes or not.
Jason Buck:
I’m Jason Buck from Mutiny Fund and I’m sitting here with Wayne Himelsein of Logica. We’re going to do a Q4 2020 review here to talk a little bit about long volatility and options. I think we should start it at a high level and talk about Q4 2020, what are the headwinds when you’re running a long volatility book? And how do you manage environments where you have a very strong headwind slamming you in the face every day?
Wayne Himelsein:
Yeah. So that’s the downside of optionality is that it costs to own. And so you talk about a headwind, it almost be thought of as a hurdle rate. Right? And so, obviously, we all have the very well known hurdle rate, the risk-free rate, right? And so if government bonds or treasuries were yielding 10%, or paying 10%, there’d be no reason to buy equities because you make all your money risk-free. Now they’re paying down to zero or quarter or whatever they are, so now everybody wants to buy equity. So the hurdle for risk is of course, much lower for taking risk. Now take that analog and map it over onto optionality, is the higher vol is, literally the more expensive and option is. So the price of an option is you can bifurcate into two pieces. The intrinsic and extrinsic, the intrinsic value of the option is directly related to the underlying, the price of the underlying, where the extrinsic value is all premium.
Wayne Himelsein:
And that premium is priced by the way options are priced. Black shows, as the famous model, are priced by volatility. So the higher the volatility, the more expensive that premium, it’s that simple, right? And you can think about this in terms of insurance, right? If you’re someone who is less healthy and you tend to go to the hospital more often, then your premiums are higher. It’s that’s simple, the more prone you are to accidents, the higher your premiums. So if we think about it in that context, the February/March event, it was a major accident, right? In terms of insurance like this major event happened. And so now all insurance premiums are expensive. Vol is so much higher than any option you buy. You’re starting with a higher premium. And that extrinsic is so inflated that you now have to make potentially not 10, but perhaps 15% a year, just to cover that cost of the premium.
Wayne Himelsein:
Right. And so can you say, well, let’s not buy insurance? In our opinion, no, you can’t, because we still don’t know when the next event is coming. If you think back to February/March, the pandemic started. And a lot of the chatter around perhaps June/July was the “second leg down” right. It’s coming and lots of big hedge fund managers and economist SMP people everywhere. That was the social media discussion, was the second leg down. So how could you not continue owning, put optionality? You can’t, right. So, especially as doing what we do, we’re in the business of long volatility for that reason, as you never know, when that next thing is coming, whether it was the second leg as a result of the pandemic or whether it was something totally new. I mean, for all we know there was a complete unrelated event that happened that would have taken place in August, right?
Wayne Himelsein:
That’s the problem with life is you never know. Same way everybody was blown out of the water in February when suddenly there was a pandemic, January of 2020, everything was fantastic. So with this thinking in mind, i.e. That you have to own insurance, but now your hurdle to own it, the pricing of these premiums are so high, now you have to make so much more money just to cover that hurdle. So as long vol owners, we say, okay historically when vol is lower, when the premiums were cheaper, we could trade and do all the things we do to generate profits that would make money above a low hurdle. Let’s say our hurdle was 5%. So if we made 15%, well we covered the five and we were profitable by 10% fantastic.
Wayne Himelsein:
But now, if your hurdle is 15, if we’re generating 15, we’re barely scraping the surface. That all the money we’re making, every little drip of profit is literally just trying to keep us above water, in fact, right below water. Right. So just so that we don’t sink with a cost of what we’re buying. And again, why do we do it? Because we don’t know the next time it’ll be needed, might be “Tomorrow”. And so we’re in the business of protection. We got to keep on buying, but for us, you manage that headwind, you get through it because vol always tends to decay back to normal levels. It already has, as of recent, it’s back to close enough to historical norms. So it’s just this period you kind of have to go through when you’re in the business of insuring and therefore we did it, but that’s it. I hope that answers your question and ask you if you have any follow ups on that.
Jason Buck:
No, I think that’s great. It’s if we have this mandate of long volatility and tail risk, you’re going to fight that headwind. And you’re just trying to limit that bleed as much as you can and stay in those positions, as long as you can waiting for the next event to happen, never knowing when it’s going to happen. And it’s just part of life that we have to deal with, right? And we’re always trying to have that protection on because nobody ever knows that there’s a second or third leg down. If we knew that in hindsight, right, you would need that protection, but that’s not the point to what we do.
Jeff Malec:
Well, what’s even funny about that is if you in real life or not in real life in non-market life, right. People would never say that in terms of their other insurance. If I said, “Hey drop your car insurance for a month”. No, are you kidding? Because like next Tuesday might be that accident, or, “Hey, don’t worry about your health insurance this month. Don’t, don’t pay the premiums. You’re fine to go without health insurance”. Are you kidding me? No, that’s going to be the weekend. You fall down the stairs, right? So why is it unacceptable to all of us in health insurance, car insurance, homeowners insurance, but in the markets, we’re fine to go a few months without insurance, it doesn’t make sense to me. And I mean, that’s why I’m in this business, that we’re also totally uncomfortable, not insuring things around us that we live our lives with, but people tend to do it much more often and frequently in the capital markets.
Jason Buck:
And then if we tab into the different months during Q4, if we look at October going in from the beginning October through October 12th. The SMP was rising, and I believe it was up a little bit over 5% by then. Volatility was getting crushed back down, which is part of that headwind that you referred to. But then towards the end of October, we had the markets come down and volatility spike back up. But we also have this other headwind of the election campaign and a rise in volatility in general before the election. So we did see a bit of a spike towards the end of October in volatility, but it came on the backs of volatility crush. And then in, just before those last few days, at the end of October, volatility got crushed back down after the spike and chopped around a little bit. I’m just curious about how you guys saw October and in how your models were reacting to that different environment of vol crush, vol spike, vol crush, chop, et cetera. It was a pretty exciting time in October.
Wayne Himelsein:
Yeah. October was like one month that felt like one year, right? We went through three major receipt regimes in 21 days, right. 21 market days, a market month. So yeah, that was exactly it. It was, if I had to describe the feeling, it was just being whipsawed. Right. And vol was crushing. And so we’re trying to turn profits, and we are profiting to pay for that headwind and then comes the spike and we make a little bit of money, but then it gives it all back in the next seven days or whatever. I don’t remember exactly. But it’s shortly thereafter, that spike has totally gone and it’s back down, crushing it again. And so you give back what you just made. Now, in normal environments, we are able to trade that. What I call that is [volavol 00:34:06] and what volavol is, is the volatility of volatility.
Wayne Himelsein:
Of course, as it sounds, but the way to think about it in simpler terms, a lot of people track the VIX index as an index of volatility, right? It’s the near term at the volatility of the SMP. So if you think about the VIX and the way it moves, VIX doesn’t just sit everyday at one level, it moves up and down. So the variants of VIX would be “Volavol”, as a proxy of that. So in in October, that was an incredibly high volavol month. And so if you asked us typically, are you guys good at volavol? We would say, yes, we are. The difference is, it’s not often squeezed into a single month, where there’s such extremes over a 21 day period, a peak and a trough of those magnitudes. So we like volavol.
Wayne Himelsein:
We like the variance of volatility because we’re trading volatility. If I can buy volatility low and sell it higher, and then it traces back down and I can buy some back and then sell it higher again, I’m swing trading the variants of volatility, right? So I like that, because I want it to move so we can trade it. But if it does it also rapidly, it tends to throw your neck back and forth. Where you get “whipsawed”. And it’s just, I guess the summary is it was too quick for us to handle.
Wayne Himelsein:
Not that there shouldn’t be such a thing. Like if you can trade, you can trade, but it isn’t always that simple. And if you said to me, “Well, are you going to update your models to handle that quicker whipsawing or that more tight-windowed volavol?” My answer would be, I don’t know if that’s going to be the way things are. I would say that that might’ve been a result of a upcoming election. So for something that happens once every four years, should we adjust all the models? Probably not. But yeah, it’s something we look into, but I would rather exchange being good at the normal volatility of volatility, rather than fitting our models to what happened just once and what seems like a more rare occurrence that you’d see such extremes within a single month.
Jason Buck:
And then moving into November and that first week. We almost wanted to say the election event was event-less, even though it didn’t settle right away, but I guess it wasn’t as volatile as people expected. So we started to see that roll off in volatility. So everybody’s excited to just put that in the rear view mirror and get back to trading markets. But then we have this vaccine announcement by Pfizer, which creates this violent rotation for a momentum devalue. And we haven’t seen that big of a move from momentum to value since like the early 1980s.
Jason Buck:
And what’s even more particular to talk to you a little bit about this is you guys trade both, you know, puts in calls. You have that straddle on the SMP, but you may diversify some of your SMP calls to single names and maybe get the most bang for your buck in a more momentum strategy on those single names. So you would hope that you and the market spikes on a vaccine announcement from Pfizer, you’re going to make a lot of money on that call side, but if you’re long calls and momentum, and it’s actually a momentum devalue rotation spike, you can get caught on the other side, in that unique scenario.
Wayne Himelsein:
Yeah. And that’s a, it’s a nice summary of that, of what happened. And you used… Your first word there was the violent rotation. I think violent is an understatement, right? That was total and utter destruction on that day. And to put that in mathematical terms, it was the most extreme outlier we’ve seen in decades. And not just that since my time in the markets in 25 years, I’ve been in the markets. But even before that. Looking at historical data, this is just so extreme to give you the numbers. Like Value had a upside of about 8% and momentum had a correction of about 15, I mean, between the two that extent of an outlier where one value could be up so much and momentum down so much on the same day was some popular magazines or financial publications called it, I think a 25 Sigma event.
Wayne Himelsein:
I mean, that’s, that’s a ridiculous way to think about it. Not ridiculous. It’s a way to think about it. It’s that 25 standard deviations assumes a normal distribution. We all know that the markets are not normally distributed. So it’s certainly a fat tail event. The point of all that, is that it was so extreme. It’s never happened before, and of course, in markets, people always saying, “Well, that’s never happened before”. Yeah, that’s true. And we expect things that haven’t happened before, but it still happens. Meaning what hasn’t happened before will happen. And it happened to happen on November 11th. And we were there. So therefore, what did that mean? Back to your second part of your question, which is how it affected our portfolio? Yes. We’re in the SMP we’re in a straddle. So we own both upside convexity and downside convexity on the SMP.
Wayne Himelsein:
And we trade it back and forth every day to create some trading, or we call it scalping, to make profits, to pay for this optionality. The other thing we do, we have various models in our portfolio. One of them has a long biased momentum where we pick momentum-ish stocks that have this tendency where the characteristics of momentum fit very well, are very synergistic to optionality, right? And momentum has a tendency to take off, to skyrocket, to be what I’ll say is convex at times, and an option, a call option is convects, it can accelerate very quickly. That’s the beauty of a call option. So putting a call option on a momentum name, let’s say like Netflix or Tesla, it’s like putting a, an option on an option, right? You’re, getting a double whammy if you’re right in the direction and over a time window.
Wayne Himelsein:
If you knew that Tesla was going to be up 20% next month, you buy call options. You don’t buy the stock. And you’ll make much more than that 20. So we understand this characteristic and we understand not just, is there more money to be made in optionality and momentum, but there’s also better downside protection. You’ve mitigated the downside because at the end of the day, you’ve just spent a premium, you’ve just bought an option for a dollar. So the most you can lose is that dollar. And that dollar is a fixed part of your portfolio. Let’s say 1% of your portfolio. So these are the nice characteristics of momentum investing that fit toward call optionality. So with that in mind, we have a portion of our book, of our portfolio, that buys call options on specific names that we select using one of our models that has a very momentum-ish tilt. Therefore on coming into that day and not just coming to that day, but for years on out, that’s what we’ve done.
Wayne Himelsein:
That’s what we always do. That’s what we believe. That’s part of our core thesis, is this momentum tilt or momentum bias. So we had those on that day, momentum cracks. So all of those names or that basket is down and that’s a lot of our call upside. And then on the long put side, where we’re short, the SMP, that SMP is skyrocketing, because all the value side of it is skyrocketing. So our short sided is against us and our long side is against us. And so we completely lose in both directions, right? It is literally the worst of worst events that could have happened to us was on the announcement of the vaccine. And what’s funny is we thought the big event was going to be the election. And we are very well hedged coming into the election, very straddled.
Wayne Himelsein:
And we’re like, okay, we don’t know what’s going to happen here. Let’s just keep it very tight. And then the election comes and goes, and it was almost a non event. I’m like, okay, we’re good. We’re out of it. And then the next day, Pfizer, boom, like we’re going to… The vaccine is going to save the world. Fantastic. But now of course, the airlines and the oil stocks and everything that’s been completely decimated over months, is now up huge. And of course all the Netflix’s and momentum names of the world are cracking. Or kind of the end of the pandemic run that had. So yes, that was a horrible day for us. And when I say horrible, it hit us for just under 2%, about 1.7% somewhere around there on the day.
Wayne Himelsein:
And that was one of the worst days we’ve ever had in the history of what we do. And on the one hand, it was incredibly painful. But on the other hand, I looked at it and said, “You know what? That was literally the worst possible chain of current things that I…” Like every coin I flipped, landed on tails. And I called the heads for all of them. And so it was the biggest chain of wrong things. And yet we are down less than 2%. And so we ended the month about down two, but for me, it was kind of comforting to know that if everything went wrong in the most extreme way, this is still where we’d end up.
Wayne Himelsein:
It was happy to know that we can mitigate our drawdown when the regime for us is so out of favor, when our momentum lungs are getting decimated and our shorts are spiking the other way, this is the extreme of what we’d expect. And so, yeah, I mean, it’s good and bad. I never like to lose money, of course, that’s not what any of us want to do. But given the context and given the circumstances, it was a healthy… For us we felt that our portfolio absorbed it well. And so we were happy to go forward and now hopefully come into a better regime.
Jason Buck:
Yeah. Not to extend our metaphor too much when we’re talking about this, the headwinds of being a long volatility manager in general, but I guess when you’re peeing into the wind, you’re extremely careful.
Jason Buck:
That careful hasn’t mitigated in these downside loss, but it’s also painful because in a spike like that, you would have hoped to capture some of that spike. So it’s not only in mitigating the loss, it’s missing that spike. So it’s painful all around, but at the end of the day, it’s survivable. And at the end of the day, that’s what matters most is survivorship. And so this is a very unique and definitely learning experience event for you guys in November. As we traveled into December, I almost want to say is it’s kind of a return to normality in a way for all of us to catch our breaths a little bit, and start to see vol drift back down, correlations start to come back in. Is that what you guys saw or did you see something differently?
Wayne Himelsein:
Yeah, that’s what we saw. In fact, I mean, December, we were up a little bit in December and it was nice for us to be up a little bit because it was just, “Hey, the pain is done”. We’re out of the worst of all possible times. And it was actually even more so nice because vol was still down and we were up. So we were still fighting some of that headwind, but the headwind was so much less than it had been over the prior months, that at that point, a lot of our profit generating models were able to not just cover the hurdle, but get above it. So now we’re not just skimming the water our heads are above water and we’re like, “Okay, good.” And that is the first sign of the turnaround, not just in quantitative speaking, but just looking at a broad
Wayne Himelsein:
The meltdown happened in February/March. Vol was peaked at 80, 90, 100 during that period, during the pandemic sell off. And then it spent the rest of the year, the summer, decaying back down. And now we look at it, it’s back down to close enough within one standard deviation, if you will, of the historical SMP volatility at 16% a year. It’s in the low twenties now. So that’s it, we’re back. Sure it can trickle down to 16 or 15, whatever that’s fine, but that’s no longer the crush from 60 to 40 or 40 to 30. And although those are just big moves happening at that point, 10 points, rather than now, we’re in one or two points at a time. So the bare market in volatilities over. December was the first sign of a low enough headwind that now all of our profit centers can get us above water.
Wayne Himelsein:
And that’s great. And again, we’re experiencing it in January, we’re up nicely this month again. Vol’s been crushing a bit more, but again, at a lower magnitude, it’s coming down in single points rather than giant chunks. And so our profit centers, once again, are able to turn up any we’re up at least nicer than we were in December, the months not over, but it’s at least, as of today. So it looks like things are “Back to normal”. And that’s really exciting because we just went through the toughest thing that our portfolio, our tendency to long Vol can go through, which is a bare market in the thing we’re long. So, yeah, it’s a nice relief and nice getting back to normal.
Jason Buck:
You know, you referenced about like vol crushing back down to within a standard deviation of historical norms. I wonder how you think about the perversity of we almost hope for vol to get crushed back down so we can reload on our long vol positions, but as all crushes back down. So how do you feel about that?
Wayne Himelsein:
Yeah. It’s funny where, yeah. Can it get lower so we can wait for the next pandemic or which the next time won’t be a pandemic, it’ll be the new event. Whatever that is in the world, there’s always an event. Yeah. And the thing is obviously February/March was extreme. SMP cracked 30% or so, but just in the years prior, I mean, it was only a year change before December of ’18 SMP fell 14%. In January of ’16, it fell 12%. In August of ’15, it fell 11%. These falls happen. That’s the market. It doesn’t take a pandemic. It, sometimes it just takes, “Hey, it’s overvalued, it’s getting frothy up here”. Let’s correct 10 to 15. so we always know that something’s about to come. Either it’s just the natural market shaking itself out, profit taking, or it’s some new event.
Wayne Himelsein:
I don’t know, there’s something happens in the world that none of us saw coming just like we didn’t, of course, in February. And then it could be completely unrelated. So yeah, we get excited because we can start not only making more money, but loading up on that inventory. Waiting for that right skew event to pay off. Waiting for that event that’s going to need our insurance, all that insurance we own to pay handsomely. And so it’s double exciting and it’s almost weird because it’s like, “Oh, things are great now, we can start to expect the crash.” But that’s what we do. That’s the world we live in.
Jeff Malec:
And kind of tying it all together, of many things you’ve said is like you’ve been in the market for over 25 years and
PART 2 OF 4 ENDS [00:48:04]
Jason Buck:
… many things you’ve said is like, you’ve been in the market for over 25 years and if anything, the market continually surprises you. Right? And everybody talks about 2020 is a very unique environment. We saw these things we’ve never seen before and then in November you saw this rotation for momentum value, we never seen before. And it’s always something we’ve never seen before. But that’s the point where you and I have meetings of our mind and meeting of the minds is that, the point of long volatility and buying straddles on the S&P is, you’re set up for unusual events to happen that you couldn’t predict.
Jason Buck:
And that’s the whole point, is you’re prepared for it, no matter what happens and you’re not trying to predict what’s going to happen in the markets. Like for example, if I had told you, years ago you’d be running along ball book and there’d be storming of the capital involved at a state flat, you wouldn’t believe me either. So the good news on that, is it sounds like you’re saying, is that, what we’re seeing too is that, this return to normality allows us to get strong positions and good inventory on the books for whatever’s going to happen in the markets. And maintaining that long ball mandate even when thankfully the headwinds have slowed down a bit.
Wayne Himelsein:
Yeah, absolutely. I mean, yeah. I still don’t believe that there was a storming of the capital. Although I see it all over the media. It’s… I’m still absorbing that fact in our United States. But no… Yes, we… None of us… I mean, the extremes, that’s the nature of the word outlier, right? It lies out of our frame of reference. It’s an outlier because there’s… Within our, the width of what the eyes can see that they’re over in the far left, they’re in our blind spot or the far right. Right? And so, yes, you and I share this deeply on the philosophical side, is that we don’t know. Everything’s always what we haven’t seen before and there’s going to be something next year that we haven’t seen before. And it’s not just in the markets it’s in life. Like I… My son just did something the other day that I’d never thought he would do, on the positive side. Right? He achieved something I’m like, “wow, that’s great, good job kid.” So it’s… Life is just shockingly shocking. Right? It surprises us on the downside surprises on the upside.
Wayne Himelsein:
And what we’ve learned is that we just can’t know. Right? And so, instead of trying to find the certainty, it’s rather to manage the uncertainty. And there is no better way to do that than long volatility. Why? Because a shock is always coming, in some way or another, right? It’s always going to be, Oh my God, we’ve never seen this before. That’s by definition around the corner. And so yes, we manage long vol books. We build it up. And in our minds at Logica, the way to do it of course, is with a straddle, because not only do we not know what’s coming, we don’t know which direction it’s coming. Will it be a fantastic event on the upside or a horrific event on the downside or somewhere in between. And so you have to be on both sides like that.
Wayne Himelsein:
How else do you best manage the uncertainty? You can’t just say, “well, I’m certainty is definitely going to be in that direction. It’s definitely going to be bad.” Well, maybe it’s incredibly good, maybe the market gaps up 10% tomorrow on something that we, none of us ever expected that Biden would do. Right? One of the funny things is… Yeah I mean, there’s so many different stories I could tell and I can go on for too long and so I don’t want to, but it’s the summary statement is that life is so surprising and so how better but to position yourself in the markets, to be wanting of surprise. Right? And to be sitting, waiting around, “when’s it coming? When’s it coming?” Right? And to just make money along the way while you’re waiting, but then have that built-in system to really profit on that surprise.
Wayne Himelsein:
I mean, when people call it anti-fragility and there’s different words that are used out there for that positioning. But it’s just philosophically a beautiful way to approach the world is, “no, I have no idea what’s going to happen tomorrow. I don’t listen to the news. I don’t listen to economists because I find on average that they don’t know and they don’t predict well.” I mean, I listen to the news don’t get me wrong, I want to know what’s going on in the world. But for the most part, I discount people’s opinions on the future because they tend to, on average, have nothing better than 50/50 foresight, so… Or forecast. So, that’s it. Yeah, we share that.
Jason Buck:
I guess we optimistically or opportunistically look at the proverb. May you live in interesting times [crosstalk 00:52:16] that’s the way we do it.
Wayne Himelsein:
Exactly.
Jason Buck:
I want to thank you for doing a little bit of a Q4 2020 review. We appreciate it. And just look forward to always continuing this conversation in the future.
Wayne Himelsein:
Yeah, likewise. Thank you very much Jason.
Jason Buck:
This is Jason Buck from Unifund and I’m sitting down with Bastian Bolesta of Deep Field Capital. We’re going to do a Q4 2020 review, to see how their volatility arbitrage models did throughout the quarter. And then also specifically their ICA model, which is their intra day trading on the market indices around the globe. Bastian is joining us from Switzerland. How are you doing today, Bastian?
Bastian Bolesta:
Hi, Jason. Thank you very much for having us today. Am good. It’s a cold and a little bit snowy day in Switzerland.
Jason Buck:
And previously we were talking about the different strains of COVID and how the different countries are responding. So we’ll leave that for another discussion. But let’s go back to October, November, December of this last year of 2020. And would you like to start maybe with the volatility arbitrage models, or the ICA model, or potentially just how your firm was reacting and responding during Q4 2020?
Bastian Bolesta:
Sure. Yeah. Probably start with an overview across entire range of models and then we can dive a bit deeper on the one of other. Q4 has been quite the opposite to what we have seen in the previous quarter specifically. You can even divide the year in the first half of, in the second half of the year. The Q4 environment of was centered around the election in November.
Bastian Bolesta:
And the volatility space was rather difficult and challenging to navigate in comparison to, in very obvious case we had in Q1 and in Q2, where we have the massive sell off in markets and volatility was rising substantially. And obviously all we do is, we have various strategies which are all long ball and strive in the high of all environments and they have different past dependencies, they device markets differently. But they like the expansion of volatility and have done really well in this sell off where markets dropped substantially. But the subsequent rarely more than 70% in the S&P over nine months, was something special and it went to a completely different degree in Q4. One can probably summarize that, what started was COVID in March, February, March and subsequently the monetary and fiscal reactions to it resulted in market moves specifically in the equity side, which have you haven’t seen in history before.
Bastian Bolesta:
So history was written throughout the entire year, continues to be at the moment. And Q4 with an extension of that equity market rally is a reflection of that. Where the S&P added another 11%, but at the same time got shaken around quite a bit first in October and then have this massive rally after the election. If we look at the different programs, the Intraday Crisis Alpha program, which is also a central part of the Wallop program as a sub strategy. It focuses on intraday momentum moves in global equity indices. So it trades the Asian intraday session. It trades a European intraday session and the U. S. The U S Intraday session, which is very often the center of focus because everybody looks into the boat of finance through the lens of U.S. equity markets, has been dominated by some very specific pattern, which was very dominant in 2020. And it’s not really reflective of what could… One could observe historically.
Bastian Bolesta:
And that was that, the majority of action in U.S. equity markets actually took place overnight. This goes for the sell-off in Q1 where the equity markets had the entire sell off basically overnight. The S&P was actually positive in March and it also goes if you’d chart that. If you differentiate between the day session and the night session, you see that the massive rally, the 71% up in the following nine months after the sell-off, were driven by the overnight. And took and complete, entered an eight and higher level in terms of degree in magnitude in November. As such, that was rather challenging for us with the intraday momentum trading in the U. S., because if the action takes place overnight, the environment presented in the U. S. is difficult. The good thing is that this program has evolved into a global program and we had a lot of success in trading the European intraday session throughout this entire period.
Bastian Bolesta:
If one looks at the data, not just in Q4, but over the entire 2020, the U. S. intraday session was actually the weakest out of 20 years of data. This goes for simulated research, as well as our live trading. But on the other side of the spectrum, the European intraday session was actually the best trading result, out of the same period of data. So it shows that markets from time to time move in cycles. And that in 2020, there was a dominant feature that the U. S. didn’t really move substantially in a momentum, in mentum characteristics intraday, but had a more mean reverting and choppy pattern intraday. And on the other side in Europe, stronger momentum moves for occurrent. And we benefited from that quite substantially in Q1, two and three. In Q4, in October, we got hurt a bit more than usually on the S&P, in the U. S. intraday session, on the long side of things.
Bastian Bolesta:
So, why all we do is basically uncorrelated. So our focus is to provide uncorrelated positively skewed returns across all these different programs. We were very uncorrelated in the first half of the year, providing positive returns in times of crisis, not only during the sell-off, but also in the subsequent contraction of volatility in Q2 and Q3. But in Q4, when the equity markets were even rallying further, we started a drawdown on the U.S. intraday side. And that was also uncorrelated. So a lot of our investors basically have equity beta on the core, and then have various of these programs as an overlay, or as you use us in your portfolio, we have a specific function to deliver certain returns and so in certain circumstances. And we are a bit relieved from that role when the overall market is going upward, but ultimately we are also absolute return.
Bastian Bolesta:
So we would also like to strive in such an environment, but it was quite clear that we had difficulties in October, specifically on the long side. If you dive a bit deeper in October, the equity market actually went up in October initially, until late last trading week. And in the last trading week, it had a larger sell off. And that’s when we actually captured the moves as well. So we delivered in line with this profile, we lost initially when the market was moving upwards, on the long side, but had very attractive positive return capture when the market was selling off towards the end of months. But ultimately it was still a very difficult environment. And that has been the narrative for Q4 for us, that the intraday program trading U.S. equities, has been the driver of a drawdown which started in October on the long side and being softened by sizable returns on the short side toward at the end of the month when the market sold off. But it continued into November where we had another down day basically, on the intraday momentum side, and a little bit also in December.
Bastian Bolesta:
And that has been the key driver of the difficulties as a result of what we experienced in the U. S. intraday session. And the intraday sessions in Asia, Europe and the U. S. are usually uncorrelated. So if you look at the correlation between equity markets from a close to close basis, they have rising correlations… Have seen rising correlations over the last 20 years because of globalization interdependencies. But the open to close session, the intraday sessions, are actually not correlated and a program like the Intraday Crisis Alpha program benefits from that because you access and call it return streams. But sometimes these anticorrelation, the desirable anticorrelation or uncorrelated return streams, breakdown for a short period of time. That means that you can have joint classes in the U. S. session and maybe also in Asia, or the positive contribution, which you may have had from the European in today’s session, may not follow through, in a period where you have no difficulties in U.S. intraday session. And that was the case in that period.
Bastian Bolesta:
So the European intraday session was very strong throughout the year. It had positive returns in 11 out of 12 months, but it had a down month in November, for example. And as such, the drawdown which started on the U. S. side in October, then continued with another down day basically in November, now driven by European intraday session. And this things can happen. So you have periods of joint strengths such as in June, where we had our largest trading day, where we captured sizable returns in a global relay race in Asia and then later on in Europe, and then in the U. S. on one day. This is a perfect scenario where you can benefit from these uncorrelated returns. And at the same time it can happen that these things break down, or you don’t get support from any specific strategy, counterbalancing difficulties of another. And that has been the dominant feature for the Intraday Crisis Alpha program. And as such had an impact on the systematic volatility arbitrage as well. So the drawdown we observed during that period was predominantly coming in from the U.S. intraday session, in the Intraday Crisis Alpha program.
Jason Buck:
And so part of that, I just want to highlight a few things that you said. One is, if those down moves we’ve seen this year coming in the overnight session in the U. S. You don’t quite have the liquidity to trade there with the algorithms you use, for most people it’s not a very liquid market overnight. So therefore you use Europe and Asia as a proxy. But as you alluded to it, they can be uncorrelated, so it’s not a perfect proxy. Is that how you view trading if the down moves are happening overnight in the U. S.?
Bastian Bolesta:
It’s… Yep. That’s a very fair point. It is like a proxy and at the same time the liquidity is substantially higher in the specific geography, usually. It can be in times of crisis, in times of larger move, liquidity can rise also in the U. S. overnight session. But ultimately, trading market moves in Asia during U.S. and early night hours, or in Europe during U.S. late night hours, has been substantially more stable this higher liquidity and usually capture these moves. But it can be that most in the U. S. are more insulated that they are U.S. specific, and they do not necessarily play out as dominantly in the other geographies. So it is historically and over longer time, research suggests it is more stable and beneficial to trade the individual geographies and rather abstain from the overnight sessions, the Globex session in the S&P for example. However, that does not mean that such an environment doesn’t provide opportunities. Because there was still action taking place intraday, even when the majority of the move was coming from the overnight, we still had moves intraday.
Bastian Bolesta:
And the last year, the entire last year about Q4 as well, very specifically provided us a lot of new and interesting data to learn and further develop the programs. Not only the ones trading at the moment, but also to support research initiatives. One of the most important ones was that after the selloff in March, where overall the programs did really well, we provided high uncorrelated returns and delivered in line with the objective, what our investors expected from us to protect the portfolio in times of crisis, considering that all the other asset classes sold off. So everything went down, even safe haven assets like gold and treasuries. And that’s quite valuable when at that point of time you can actually live a positive uncorrelated returns. But at the same time, looking a bit deeper, we saw the huge driver of these returns were the relative value strategies, so the calender spread and the intermarket spread. And at the same time in the intraday sessions, it was the Asian and the European intraday session. Predominantly, as said earlier, the European intraday session presented by the ducks, the strongest instrument last year.
Bastian Bolesta:
And the U. S. was still moving a lot. So if you travel back in time and think about what happened really much was, standing in front of the screen say, were a lot of large moves basically intraday. But our way of trading momentum intraday was not suited for that specific setting. The moves were not the ones we would like to capture with the Intraday Crisis Alpha program. But it triggered interest, how can you trade and benefit from such things? And there were a couple of other data points later on also in Q4, where you had for example, a larger gap overnight. The market was gaping up substantially as in October, on the 1st of October, 16th or 21st of October. Sizable gaps, the market travels a bit farther and then falls back in. Maybe traveled the entire gap down again.
Bastian Bolesta:
And that’s a quite a sizeable move, but it’s not a classical momentum move in terms of, this is a long signal. And if you change your perspective on such scenarios, you may find additional value. And that fueled a research initiative which started in March, to basically look for what we call the sibling of ICA, the Active Internet Momentum program. It’s AIM program which is shorter term, it can react quicker. The idea is that it is quicker in the market, writes of all moves, short of all moves quicker and does not necessarily need large magnitude moves on an intraday side. And we would not have developed that without the observations first in Q1, but then further pushed also on the live observation, because we started live testing this variation in Q4. And so why I agree that the set up presented, that the U. S. markets were dominated by overnight moves, which historically has not been the case.
Bastian Bolesta:
If one looks at the largest sell-offs in the S&P since the birth of the dot com bubble, they usually take place intraday. So the selloff is intraday and yes, a part of the recovery afterwards takes place overnight as well, but there’s also substantial intraday momentum component to it. And that was not the case here in 2020. And that’s why it’s so important to have many past dependencies as you do in the mutiny fund. That you do not only have for example, this specific intraday approach trading U.S., as we do it in the program itself, that we trade Europe, Asia and the U. S. and the European intraday session has compensated the weakness of the U. S. intraday session throughout that period in 2020. This also goes on a higher level of course, on a portfolio construction level for the systematic wallop, but also for the mutiny fund. Where you have these different past dependencies and you put another manager at the sideline who… Not at the sideline, at the side of… In U. S. ICA program for example, who may benefit from exactly the specific patterns.
Bastian Bolesta:
And may run into difficulties when it’s ICA’s U. S. intraday session time to shine again. And that’s the overwhelming story of 2020, that we received a lot of data sets with a lot of positive news, how these programs navigated this historical environment with moves we haven’t seen before. Not just we as Deep Field Capital but all of us. And at the same time use this data and the learnings and these humble experience of these huge moves, to drive research further, to identify new opportunities. How to strengthen your existing programs, or how to develop additional ones which can trade side by side with the existing ones. To be even better prepared next time around.
Bastian Bolesta:
So from that perspective, we are quite grateful what we have learned. And the AIM program, the Active Intraday Momentum, has an even stronger long ball profile, as the way we have developed it. So it’s even further down the overall objective we have, to have this pronounced long ball profile, to deliver positively skilled uncorrelated returns in times of crisis. But at the same time, broadening the definition of what a crisis is. Yeah. Be more flexible on that side of things. And we can see that for example in October, which is the key reason of the draw down for ICA. With these three down days on the long side, and being compensated by a positive capture, where we then kicked in and captured the downwards move towards the end of the month. But AIM does deliver a different path here. And AIM and ICA together have a stronger foothold even in such a setting. And as such, as humbling as it is in a draw down and as annoying…
PART 3 OF 4 ENDS [01:12:04]
Bastian Bolesta:
As humbling as it is in a drawdown and it’s annoying it can be, we are grateful that, generally speaking, the majority of investors, they have striven or their portfolio has grown substantially based on their equity exposures. If you put together the Mutiny Fund and Equity, as you have done in one of your share classes. They have the opportunity to benefit from the equity side of things. And at the same time, be protected in a scenario as in Q1. Though, not having a sell-off as deep and a drawdown as deep, because you have long vol strategies which kick in and maybe even substantially, if there’s real deep crisis. And at the same time, then you have a market recovery afterwards. You will always end up on a much better situation than just having the equities or just having long vol. So combining it is always very helpful and you can do that, there’s different long vol strategies, but also of course, classically with traditional asset classes and long vol on top of it.
Bastian Bolesta:
And as such, it has been a very mixed bag of stories in 2020. And we have been terribly busy, as busy as never before, probably. Because a lot of very interesting data and very valuable data. The same goes for our trading on the equity side, which has been not our key focus. We have an equity trading program, as you may remember. And an interesting data point is there, Liquid Equity Alpha Program, that it has a 10-year track record and it had its best year of trading last year. Which also gives you an indication that something was different and special in this market environment. It’s ultimate intraday program. It’s a mean reverting program. So it kept us something different. It has always been a decent program, but it had its best year, last year.
Bastian Bolesta:
And at the same time ICA had its most challenging in the US in today’s session. And the European in today’s session was most profitable in 20 years. So there are a lot of historical terms how special this year has been. We will probably even argue you’re not out of the woods there. So it’s a con… The year goes on. It is probably one of the best years. That’s always the running joke here in the team. It’s such a long year and we know that it’s 2021 now, but it doesn’t feel like it, it feels like a continuation of 2020. And as such they’d be really grateful that we have navigated it the way we have so far.
Jason Buck:
So it actually begged them a much more philosophical question in that in two ways. One, when we’re talking about Q4, but it’s hard to talk about any sort of a temporal timeframe in isolation. As you were alluding to, if we look at 2020 in general, ICA has done fantastic. But then if you look at it, it’s getting into drawdowns into Q4, but no program is perfect and they’re all going to experience drawdowns. So I’m just wondering at a philosophical level, if you think about any sort of systematic momentum strategy, you’re going to have to take those trades. And sometimes you’re going to get stopped out and you’re going to have losing trades. So you’re going to go through drawdowns from time to time. So how do you assess… Is just one of those random processes where you’re in a drawdown in Q4 of 2020, or how do you then go… Is this a natural drawdown of a systematic process or are the markets different? Are the models broken? You know, that’s a problem that’s quite frankly insoluble, but I’m curious at how you guys think about solving that problem.
Bastian Bolesta:
Sure. Yeah. It’s obviously always a concern of investors that something could be broken. And obviously one of the most important task of every systematic manager is to make sure to stay on top of things, to understand where returns are coming from, that that goes for the losses, but also for the positive returns. And you need to do in analysis, of course, what kind of environment am I in? Is that an environment where a program should normally strive, that would be really concerning. So if you have very clear and obvious opportunities, which have historically led to positive returns, and now you don’t deliver or the other way around, now you have losses where you normally made money. And that can be any indications that something has changed maybe in the market environment or that the model has weaknesses which need to be addressed.
Bastian Bolesta:
This analysis needs to take place on an ongoing basis. And most managers in this space to do a daily tree treachery conservation, to really understand every single trait and to reconcile what has happened here. And what kind of expectation did I have prior to that trait for such a setting based on the simulations. And that is one of the most important parts. There have been certain things which were… I wouldn’t say departures, but temporary departures from historical norms, whatever norm is. For example, we have this very pronounced negative correlation between the VIX and the S&P. And a lot of modeling not specific to our models, but in general, in the entire space is built on that. And all of us know that temporarily, it can be different for shorter periods of time. It can be different. And there were some very pronounced departures, temporary departures from that relationship in Q4, even starting in Q3 already.
Bastian Bolesta:
And a lot of narratives that are then built around that. One of the narratives was that we have new investors moving into this space, Robinhood loss now very aggressively being on the long side of things and implementing that traits via buying call options. And that had an impact that you have situations that the market was moving up and at the same time, volatility was moving up because you had no pressure upside volatility because of this massive call option buying. A friend of us at Logica, Wayne, I think you will be on a podcast as well. If I’m not mistaken, he has done a lot of research on that side of things and also referenced liquidity concerns that the liquidity in the market has changed. And that narrative such as a call option Robin Horton things like that are certainly valid points, but they hide or divide our attention from even more concerning aspects in terms of how liquidity markets has changed.
Bastian Bolesta:
And these things can have impacts on how programs can navigate market environments and certainly an aspect which need to be taken into consideration for research. But ultimately, when we look at how the various programs of us have evolved or managed the environment of 2020, we haven’t seen any indication that there’s something broken. These are every single trait was a trait where we said, “This is a trait we wanted to take.” It can be that sometimes you say, well, the exposure was too small or the exposure was too large. I would have loved to see that in a different fashion. And you can do an analysis, how adaptive the exposure management takes place. If you can improve that, if there are new indications, if there are new data available, how to trade better. For example, the aim research project has built on ICA proprietary qualifiers, but has an increased dataset.
Bastian Bolesta:
So as part of that research process, we got additional data. We got an additional set of indicators. So the proprietary qualifiers pool has grown, which gives us a different picture on the market and on the quality of the momentum of taking place. End users utilizes this set differently than ICA does, but still it can be that these research projects and changes the market environment result in some very positive outcomes because you broaden your perspective and you enrich your models by new datasets now available to make them even more robust. But ultimately Q4 has been challenging on all kinds of different levels. But what has happened has also already happened in the past. So a departure from the negative correlation between the S&P and the VIX has taken place prior to that. So there have target data points that this may occur.
Bastian Bolesta:
And very often we have the narrative comparing the Robinhood loss and this call option and buying to what we had at the .com area. And a lot of pallets, but a lot of things are different as well. And so I would always be careful to make the direct causal lines here or links basically and derive action items from that. But it’s still important to review that momentum and into the momentum it’s here to stay. It may disappear in the US today’s session for a couple of weeks, for a couple of months, the music may play somewhere else. It has played very loudly in Europe and in the US overnight session. And it is rather likely that this will change. Maybe Asia will be more stronger going forward or the US will be the next one where you have the action.
Bastian Bolesta:
Momentum is driven by something very deeply rooted in us as human beings. It is based on fear and panic on the short side. And it’s based on euphoria maybe and excitement, maybe greed, if you want to say it on the long side as well. And these are very strong behavioral patterns in us human beings, which are embedded in active trading, they are embedded in our investment behavior, they embedded the way we not just at deep fear, but all of us, we also caught our algorithms. And these things may be more pronounced in certain periods and are less pronounced or one side of the things. Maybe the upside is more pronounced, but this only builds up the pressure for the other side going forward. So from that perspective, I’m quite positive that long vol, even when equity markets have been rising like hell since March, it’s a very valuable proposition.
Bastian Bolesta:
People may be reminded not to distant future, that it’s very valuable to have uncorrelated strategies in your portfolio. An equity rally of more than 70% in nine months may make you forget that there can be difficult times. And the good thing is that the way Mutiny does manage the portfolio is that these long vol characteristics are not bought into the portfolio with high bleeds, but actually the ideas even to make money in most market environments and manage the costs for having such a portfolio, such a profile of the portfolio. And we do that as well with our strategies and as such… While it may have been more difficult in Q4 at the same time, this is a very short data set. It has coincided with most investors portfolios doing phenomenally well. And as such, I wouldn’t be too concerned here, Jason.
Jason Buck:
There’s a couple of things I want to touch on that you said there. One is, everybody breaks down this dichotomy. If you’re in greed, I’ve actually argued it’s fear, right? It’s fear on both sides. It’s fear of missing out on the other side. It’s fear of our neighbor making more money than ours. So I think greed is another form of fear too, on both sides of that. So that’s the predominant human emotion, unfortunately. Thinking about that’s the interesting piece is that if you are… If you look at correlations between the Valar models, you have to worry about correlations on that front. When you have, you said surprises like the rise of Robinhood call option buyers, which puts the market makers on the opposite side, which can accelerate prices. And there’s always going to be something new in the market that surprises us, that we haven’t seen before.
Jason Buck:
And that is a point of having an intraday momentum price action model. Is you don’t need to… You’re agnostic to what’s coming in the future. You’re not trying to predict that, that will reflect an intraday momentum and you’ll try to capture those moves no matter what is new and what we haven’t seen in the past. So you’re not needed to adjust your models to do any sort of fundamental past behavior. You’re not fighting the last battle. You’re going off today’s price action and momentum on whatever’s happening in the markets on that intraday session. So that’s a very interesting piece, I think to ICA that needs to be highlighted. And then thinking about the volatility arbitrage models, whether it’s the intermarket spread between S&P in VIX or the VIX calendar spread, we had… You could talk to them about the uniqueness of 2020.
Jason Buck:
We had a very unique Q4 in that we had this echo of volatility from the March sell-off.
Bastian Bolesta:
Mm-hmm (affirmative).
Jason Buck:
You had this very contentious presidential election, but that was also coming on the back of a surprise election of Donald Trump in the previous election. And so you had this huge bid up in volatility going into the election, which then created this hump or kink or bump in the volatility curve as is VIX is a 30 day forward looking volatility that made a sharp contango and then sharp backwardation around this election event. Which made it incredibly difficult and there was no easy trades, right? For any sort of volatility arbitrage.
Bastian Bolesta:
Yeah.
Jason Buck:
And then subsequently after the election, in going into November, December, we’ve seen this implied volatility has been pinned in this low twenties kind of working around between 20 and 22.
Jason Buck:
Meanwhile, I realized volatility is crushed into the single digits again. And so that makes it extremely difficult environment for a lot of volatility arbitrage models. But across our managers, we’ve kind of been seeing as we’ve gotten in the last few weeks of December of 2020 and now we’re moving into January 21. Are you seeing those correlations start to come back a little? Or how do you guys view what happened? The unusual election event followed by the crush and realized volatility into what we’re starting to see maybe a little bit of normalization again or do you see it differently?
Bastian Bolesta:
Yeah, exactly. I would say this oddly shaped term structure, this is bump around the election was certainly something we didn’t scratch our hats and know that our peers and friends in the space, we have seen things like that before, but it’s difficult to navigate that does not mean that it needs to result to losses. It is more that the opportunity set is rather weak. And it’s more question of how you navigate that. We have also seen that on the relative value side. So if I look at Q4 on the relative value side, the relative eyesight for slightly positive throughout the majority of the period and we basically had one down day on the 21st of December. Where there was a sudden change in the market environment and the intraday momentum programs kicked in initially as they are designed to protect basically you getting caught on the wrong foot on the RV side, but the market reversed substantially intraday.
Bastian Bolesta:
So there was initially a downwards move, a very large downwards move in Europe and then also in the US but it reversed. So and that results very often on the RV side, that volatility may jump on a day because the markets sold off or started to sell off. And when the market then comes back within the session, volatility is a bit more sticky. It doesn’t come down as quickly. So you can lose on the vault rate side, whereas you had just may be calendar months further out, which may not be as sensitive to the move, or you hedge which may be the S&P even the biggest weeks. Whereas S&P though you hedge was very… Had high open trade profit, but now the market is coming back again, being reflective of the choppiness of what we saw on the intraday sessions in the US and as such, you lost on the vault side and you hedge basically weakened throughout the day and you may end up with a loss.
Bastian Bolesta:
And that basically happened on the 21st. What we also saw in Q4 is that you didn’t have follow through. So there was a single event, a movement and you didn’t really have a follow for two, three, four days. So if you’re positioned accordingly is that you could benefit. So the models not just are specifically, but I think around the space had a challenging time to navigate, but that did not directly result in losses. In majority of cases, it was more like that. You had not as much juicy opportunities. And we have seen that changing at moment. A lot of the uncertainty was obviously around the election and of course it is the on and off discussion about another stimulus package. And it was further fueled of course, around the uncertainty. If president elect Biden back at the time will actually be the ex president because he had challenges across the board.
Bastian Bolesta:
And that certainly provided some kind of uncertainty that people could move on from that point. But ultimately in the equity market as was still driven by an equity rally, it was more than 10% in the last two months. So, that side of things at least moved on the perception of new stimulus. And we have seen a normalization in the term structure since then. And we believe that the opportunity set on the relative value side has certainly improved and will further going forward.
Bastian Bolesta:
But at the same time, momentum, we’ll probably be stronger again, because the messages will become more clear, either good or negative going forward, because you have a new administration in the US there was a lot of hesitation if things happened before the inauguration or it took place yesterday now going forward and probably a lot of the noise associated with this period in Q4 and maybe if you zoom out also noise around the previous administration where messaging was not always clear will fade away and something new will happen. I’m not saying it will all be easy and straight, easy going forward, but at least in terms of the term structure, there’s a normalization taking place at the moment. And the opportunity set becomes more clear, I would say.
Jason Buck:
Perfect. I obviously, I have a bunch more questions for you and I could keep talking to you forever, but I think we should leave it there. I appreciate you coming on and giving your view of the markets in Q4 and your overview. I think it’s going to be very helpful for our clients and always great talking to you, and I appreciate you coming on Bastian.
Bastian Bolesta:
Thank you very much for having us again, Jason, it’s always a pleasure, stay safe and healthy and all listeners as well. It will probably remain challenging for certain period of time in terms of health issues. All good luck, healthy and a prosperous 2021, I would say thank you very much.
Taylor Pearson:
Thanks for listening. If you enjoyed today’s show, we’d appreciate it. You would share this show with friends and leave us a review on iTunes as it helps more listeners find the show and join our amazing community. To those of you who already shared or left your 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 on taylor@mutinyfund.com. And Jason as 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 munityfund.com/newsletter.
PART 4 OF 4 ENDS [01:33:14]
