Minsky was an economist made famous for his financial instability hypothesis.
Basically he proposed that stability begets instability and vice versa and gave cogent reasons why this is so. We have directly observed this for 30 years in the behaviour of implied volatility or the perception of future volatility by investors, the main driver of value of long dated options. I.e. long dated options become super-cheap when stability reigns, only to become super-expensive when instability reigns.
STABILITY BEGETS INSTABILITY
When examining the world of options, it helps to consider other fields in which probability plays a vital role. Let us take the casino as a metaphor.
For my money, gambling is when the odds are against you and you are relying on luck, i.e. you have a negative expected return in the long run. Investing is when you place bets where the odds are in your favour and you do NOT rely on luck.
Many investors seem to view options investing as a gamble. They often focus on two things:Where will volatility be in three months’ time?
My response?Forecasting actual future volatility is nearly impossible.
Let’s look at forecasting volatility first.
Future volatility is essentially unknowable. There. I said it.
Thoughts are free, who can guess them?
They flee by like nocturnal shadows.
No man can know them, no hunter can shoot them
with powder and lead: Thoughts are free!
Translation of German song, original lyricist and composer unknown
When I write my views I seem continually negative and troubled. I often question myself – why do I think like this?
It is because what I observe on the ground seems at odds with what the common gestalt is, i.e. everything is good, nothing to worry about… move along….
But troubled I remain. The main source of my disquiet is found in the cornerstone of investment theory: Modern Portfolio Theory (MPT).
MPT looks not only flawed, but positively dangerous with the current amount of leverage built into the financial system.
February was interesting.
The volatility spike, which retraced pretty rapidly, is reminiscent of all beginnings of a long term rising volatility cycle. Pretty much all rising volatility cycles start like this, like the jolt of a train when it first overcomes inertia as it pulls out the station – then a seemingly long pause until we feel that the train is actually in motion as it accelerates out the station.
Not all volatility spikes transmute into a longer term rise in volatility but pretty much all long term volatility cycles start with a spike!
As someone once said, you can’t predict but you can prepare! There are very few hedges against a correlated downward spiral in equities especially, and being long volatility is the most reliable and consistent hedge.
We note the current interrelatedness of asset prices as all assets have become proxy yield plays. Complexity coupled with systemic complacency?
Liquidity is like experience… You want it just after you need it!
We have long argued at 36 South that the general market was cannibalising liquidity, correlation and volatility in order to obtain diminishing amounts of return.
This juggernaut comes to a shuddering halt when the bear presses the ‘down’ button once every bull is in the lift.
Last week liquidity showed signs of disappearing and disappeared completely in some short volatility products. Perhaps this is the first shot over the bow.
Liquidity is illusory at best, due to the absence of market makers and a preponderance of high frequency traders who turn their computers off at the first sign of trouble.
And, like experience, it will come back just AFTER you need it!
There are so many really interesting discussions regarding investing in volatility assets lately, that I think it is worth taking a closer look – especially given that we are coming to the end of the year, and it has been a particularly difficult one from a long volatility performance point of view.
Firstly, volatility comes in two flavours: noise and direction. We are in the minority, being fund managers who primarily invest in volatility direction or vega (P&L exposure to implied volatility rising and falling).
It is attractive to invest in these assets primarily because volatility direction is negatively correlated to traditional asset performance and has asymmetrical payoff potential.
It is self-evident though that we will therefore have negative performance when volatility direction is down!
The reality is that financial markets are self-destabilising; occasionally they tend toward disequilibrium, not equilibrium.
Frothy is the way I would describe asset prices around the world. Most people cannot afford anything worthwhile without going into debt. E.g. mortgages, margin buying of equities.
Doing that requires divorcing reason from judgement and diving in, fingers crossed.
Bitcoin’s meteoric rise, which looks increasingly similar to the tulip mania of 400 years ago, is attracting mainstream punters including the ‘blue rinse brigade’. Is it a bubble? Undoubtedly. It had the advantage that there was NEVER any value in the first place from which to price it, therefore no logic is required to buy it - at any price. Can it go up 100x more? Yes. Will the price be lower in 5 years than it is today? Probably.
As I write this month’s musing, we have suffered a mind focusing drawdown in our funds so it is with that in mind I tackle the very important question.
What does one do following a negative period in investing, or in life for that matter?
My best guess… re-examine everything you know, including your assumptions. Reflect on whether you have positioned yourself correctly and are merely experiencing the “slings and arrows of outrageous fortune”, whether your strategy was incorrect to begin with, or whether something has changed and thus action is required.
With regards to investing in options, probabilistic instruments which have a wager (premium) and a pay-off (return), one need look no further than the simple ideas of late two-time champion world poker player Puggy Pearson who offers us this set of rules to follow (Wagner, n.d.).
This is your last chance. After this, there is no turning back. You take the blue pill—the story ends, you wake up in your bed and believe whatever you want to believe. You take the red pill—you stay in Wonderland, and I show you how deep the rabbit hole goes. Remember: all I'm offering is the truth. Nothing more.
Morpheus, The Matrix
The Kelly Criterion, well known especially among gamblers as a way to assess whether or not to place a bet (or in financial management terms, whether to put a position in a portfolio) and most importantly how to size that bet or position is, to my mind, phenomenally undervalued as a financial tool.
It is simplicity incarnate: you input only two pieces of information: the probability of winning and the odds you are given, or expected pay-out. E.g. a 125% pay out for winning a coin toss game should be played with only 10% of your bankroll.
The formula gives you in return two important pieces of information:
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