The Exchanges

Q I don't know that people go to high school and college thinking they're going to become volatility traders, derivatives traders. So why don't you start by taking me through your path to harvest?

A I clearly did not do that either. Growing up in Detroit, I was a third generation GM guy, person. So, you know, my goal was to go to Michigan and get a degree in mechanical engineering. I was lucky enough, once I joined GM, they sent me to Harvard Business School, and I ended up at the New York Treasurer's office in New York. So that was the first time sort of financial markets became part of my daily routine, and from a career perspective, it really was exciting. So I switched from wanting to one day run an auto company to wanting to be involved with Wall Street, and that sort of evolved from there. So all of a sudden, you know, you're dealing with Currency exposures and interest rate exposures. At that point, banks start to talk to you about, Hey, would you ever think about coming to the other side when they see someone who understands what corporations need and are looking for? And if you have a temperament, that's, that's good at explaining complex things and making them understandable and helping to sort of solve problems. So that sort of Happened in the early ish nineties and start off in the currency derivative area, which was a lot of fun. And then once the Euro came, it became a little less interesting, um, a lot fewer currency pairs. And I made the switch in the late nineties from the equity, excuse me, currency derivative side over to the equity derivative side. And …

AI assessment note: “I clearly did not do that either. Growing up in Detroit, I was a”

Q management strategy, a hedge fund strategy, that sort of makes sense to say, okay, I, I own my equities and my board's comfortable with that. I'm not gonna really change that up. I'm not gonna get that cute. But I could give money to a manager. What are the strategies that managers tend to pursue in this space that would make sense to take advantage of a low volatility environment?

A One is a manager that uses covered calls, and even though, sort of to our earlier point, even if volatility isn't high, stock prices are high, and so adding some yield on top when the risk of a continued run is more muted and the potential of more of a decline is there can make sense. Or, you know, managers who will use stock replacement at times to maintain Exposure, upward exposure, but, you know, a more cost efficient way of limiting the downside risk, or just more traditional, if you want to earn the equity drift over time, let's say, and you're happy, you know, making four to eight percent, and you'll forego the up 30 year to reduce the down 40 year, you know, then sort of a migrating collar around, around some equity exposure. So, and then the question is, you know, generally how I would want that to work would be, Finding someone who's really good at stock picking, you know, bottom up research, et cetera, and then use S&P index options as more of the macro bet around, you know, macro hedge around.

AI assessment note: “One is a manager that uses covered calls”

Q How should someone think about volatility as an asset class or something to invest in?

A We sort of think about volatility as a way to do three basic things. One is to add yield, and two would be to reduce risk, and three would be to add leverage. And, you know, when you think about the, you know, adding yield part, the most common sort of approach, sort of Options one on one, if you will, is, you know, writing covered calls. And so if you own a stock that's trading at a hundred and you're willing to sell it at one Oh five and you sell a call at one Oh five and you get paid. The idea is, you know, might as well get paid while you wait for the stock to get to the price that you want to sell it anyway. If it doesn't get there, you keep the premium and you can do it again and you can do it again. And so it's a low risk ish way to Use options because you can't lose on both. If the stock drops, you win on the option side. If stock rises too far, you might lose on the option side. You might win on both if the stock goes up only a small amount, and that's what you're really, what you're banking on. Obviously, you sell a covered call. It's not a hedge. It's not protection, but it is additional income, which can, you know, help dampen things a little bit. But that is sort of the basic use of options. And then The second most common clearly is buying protection. And so if you are long the market and either you're nervous about an eventual correction or you would be adversely…

AI assessment note: “We sort of think about volatility as a way to do three basic things.”

Q systematic program of selling Is there a rule of thumb about sort of the optimal way because of the term structure of volatility? Is this like, if you want to do it, you should just do it on a monthly roll basis and keep doing it and keep doing it and keep doing it? Or should you go out six months? Or is there just a general rule of thumb?

A It's tough to have, you know, one solution for all markets. What I would say is that because of time decay, Selling shorter dated options, you know, is a way to maximize that decay. However, that's requires more work and more attention. Um, and it will lead to more execution costs and it will lead to, you know, option strikes that are closer to spot. And so if you don't want to get your stock called away, it's, you know, it's going to require much more handholding and attention. The flip side is you could, you could make it really simple and just go out one year. But when you go out a year, A, the vol that you're getting is usually pretty dampened, and so that's not beneficial. The time decay doesn't really kick in until three months and in, and so that doesn't make a lot of sense. You know, and markets can move and change so much in a year. So I personally think sort of that one to three month window, you know, is really the optimal and depending on, you know, and if, if you think the stock's at a higher level, Um, and vol is attractive. You might want to punch it out three months. Um, and if you want to have the ability to roll strikes higher, et cetera, you might keep it in a little shorter dated, but that's where experience and expertise and, and understanding the curve and where opportunities are in the curve really comes into play.

AI assessment note: “So I personally think sort of that one to three month window is really optimal”

Q Let's move on to the third category, leverage, which Is so synonymous with risk when people think about derivatives. Where do people trip themselves up?

A I would say when, when someone gets overly complacent, thinking that, oh, this certain outcome could never happen, but not thinking about what if it did happen, and what would be the impact. So I think that generally, if you buy a call, or if you buy an option, the good news is, is your risk is limited to whatever premium you paid. So it's a, it's a way of, of taking a measured amount of risk to have an asymmetric potential outcome. You can pay a dollar for an option and maybe make three or four. However, the, the odds are pretty good that you're going to lose the dollar. And so it's a good news, bad news. My risk is limited, but my potential to lose all that is pretty high, but that's on the, on the buying, you know, no one's ever been really hurt. Well, let me rephrase that. You're less likely to be hurt buying an option. You might bleed to death over a long period of time, but you're not going to be, you know, taken out tomorrow on a stretcher if you're, you know, buying options. Conversely, when you sell an option, you get paid, and even if you're wrong, you can win, meaning, you know, you think the market's topish, you sell a call that's out of the money, the market still goes up, but it doesn't go up far enough to get to reach your call strike, and you Guess what? You get, you still get to keep the premium. Or you think the market's bottomed, and you sell a put, and the m…

AI assessment note: “when someone gets overly complacent, thinking that, oh, this certain outcome could never happen”

Q Well, I want to turn to the current environment because we've been planning to have this conversation for a little while, and maybe we would have ended it there if it was about a month ago, but a lot changed. What's going on?

A A lot. But what I, I guess I'd start with, you know, we've had a market, the S&P, which, you know, hadn't had a five percent pullback in 400 trading that, you know, call it two years, which is the longest streak in since the fifties. So you just had this market that has been very complacent. It only goes up. Every dip is to be bought. You've had central, you know, global central banks pumping in liquidity. And, and so as a result, you had, you know, VIX levels in the low teens or slightly below last year. The VIX averaged about 11, which was its lowest level, I think, since 1990. And, um, we all knew at some point we were due for, you know, a healthy correction. What I, to me, which was, was really extraordinary, was not that last year we would have an up 20% year, you know, in the ninth year of a, of a bull market, but that January would come out of the chutes on top of All time highs and be up seven and a half percent in the first, I don't know, 11 or 12 trading days. I mean, that, that was screaming, you know, this is too euphoric, way too much too fast, and lo and behold, uh, you know, we, we see the reversal in a hurry. And so, when you look at a graph of the VIX over the last, you know, 20 plus years, It's about every 24 months or so that you see one of these spikes where the, you know, the VIX will get up to, you know, certainly 30 plus, if not, not touch 40. Tends not t…

AI assessment note: “we've had a market, the S&P, which, you know, hadn't had a five percent pullback”

Q on each of those. So in the first case, covered calls, we've been in a muted vol environment, And I would think, yeah, okay, there's a dividend yield on the stock. You're probably not getting paid that much on the covered call. So as you've talked to people about it, and over the years, how do people think about sort of what's the right price that the yield makes sense?

A It's a great question. It really is. It's two part. You know, part of it is how much appreciation in the stock that you want to retain versus how much Income you want to generate from the option premium. I would say that the less bullish you are on your stock, you're not necessarily bearish. You're not looking to sell it. Maybe you have a very low basis, but maybe it's, it's going to be stuck in the, you know, in neutral for three to six months. In that case, someone might get a more aggressive and sell call option. That's closer to spot and be able to add a lot more premium. In those cases, you know, again, it all depends on the price of the stock. It depends on the volatility of the stock. It depends on the time and maturity, all of those things, and whether you're rolling or, or not. But, you know, generally speaking, you know, I, I think you can adding two to three percent, sort of doubling the yield is, is a reasonable expectation. If you're trying to do more than that, either you're selling calls on a really volatile stock, which in effect is giving you a synthetic Short put position. But I think if adding two to three percent sounds reasonable, then you can sell options that are, you know, sort of 25 ish delta, which is another way of saying, you know, three out of four times they will expire worthless. One out of four times they will, you know, be in the money, which me…

AI assessment note: “adding two to three percent, sort of doubling the yield is, is a reasonable expectation”

Q You mentioned the iron condor, which, you know, is almost the epitome of this insurance strategy, or the iron condor is you're selling insurance on the market and you're buying reinsurance. If you looked at either that index or managers that pursued it, is there over time a structural return from effectively selling insurance to the market? And, and that strategy could epitomize it because you're not naked selling.

A Correct. We think there is, which is why we're in the business and have been successfully for, you know, 10 plus years. There's lots of research that supports it. This thing we talked about earlier, this spread of implied or realized and this risk transference mechanism is there. And so, just like there are insurance companies that make a lot of money by providing homeowners insurance, for example, property, casualty insurance, but they're very good risk managers. You know, we think that that's the analogy, you know, here. We know there will be storms along the way. If there were never any storms, there would be no need for risk transference. And the key is, is how, you know, how do you weather those storms? How bad does it get? How quickly do you recover? And the one thing I'll say is, like the insurance analogy, is when there is a storm, it's not good for For the policies you've already written, but it's very good for the policies you you're about to write. And if you are sort of a systematic volatility seller with guardrails, like the iron condor strategy, then, uh, those VIX spikes aren't good for the positions you've already written, but they're also decaying. And as you replace those structures with new structures, you know, you benefit from higher vol leads to wider bands. Uh, leads to more premium collected, and leads to fairly rapid recovery, so you're back on track ag…

AI assessment note: “Correct. We think there is, which is why we're in the business”

Q Yeah. One of the things I struggle with when I think about this is it's almost a different world than universe, right? So we can go out and try to pick our favorite stock picker. That's fine. The options trading world has, well, there's a different language. It's Greek. It's not English. It's how do you assess as an, as an allocator if someone's good at derivatives trading?

A I would start by looking at the team and to see what kind of, you know, experience and how much time they've been in the market, et cetera. Cause if you're not good, you don't last. If you're not good, you don't Advance. So I'd start with that for, for proof of knowledge, experience, depth, et cetera. I would also look at track record clearly, you know, someone with a fancy back test who hasn't done it for very long versus someone who's done it for a long time through all types of markets, several different market cycles, bullish markets, bearish markets, low vol, high vol, spikes and vol. So I'd look at the team. I'd look at the track record. I'd look at the AUM. Growth allocators are very smart, and if capital continues to flow into a manager because of the other two points, that's, those are all going to be pretty important things, and, and how long has the team been together when you have a group that you don't have a lot of defections, you don't have a lot of people coming and going, and which is, could be a sign of dissatisfaction or potential trouble ahead, if you will. I think all those things are, you know, are really important.

AI assessment note: “I'd look at the team. I'd look at the track record. I'd look at the AUM.”

Q about is the, the line about old, bold cowboys, right? There's old cowboys and there's bold cowboys, but they're no old, bold cowboys. And people do associate the derivatives market with cowboy-like behavior. Where have you seen firms get too bold? And how can someone who's looking at it say, okay, that is a red flag in the way they're executing the strategy, whatever the strategy is within the space?

A Usually when you see really outsized returns, and I'm not talking about slightly outperforming the benchmark, which is what, what clearly you'd like, but, you know, strategies that, you know, there's not a good explanation. There's not a, a clear articulation of how this could blow up and why, but, you know, you hear certain things about strategies that are collecting nickels in front of a freight train. I would want to know that there are guardrails in place, and so it's more like picking up nickels in front of a tricycle. Understanding that there's risk, but I'd rather skin my knee than, than get taken out. And certainly, the spectacular blow-ups that we've heard over time are usually on that, on that side. They've been short, they've been levered, they don't have guardrails, and probably a little arrogant, and not being able to You know, put in a stop loss and manage risk and thinking, you know, they're right and the rest of the world is wrong. And I think that interviewing, you know, looking at someone's background and interviewing them and their approach and their firm's approach, you can get a pretty good sense of, is this someone who's swinging? Is this Dave Kingman or is this Rod Carew or Tony Gwynn? And we are more Tony Gwynn, Rod Carew. We're going to hit a lot of singles. We're going to hit for high average. We're not going to strike out. But we also are not going to…

AI assessment note: “outsized returns... not a clear articulation of how this could blow up”

Q What's next on the frontier in terms of new strategies for this use of derivatives for sophisticated traders and for allocators?

A Yeah, I mean, I think the growth of In volatility-related instruments will continue, because as people understand how they can be used properly, as we mentioned earlier, like the pharmaceutical, you know, as the drugs get better, and the doctors get better, and the research gets better, we'll continue to see growth, and I, and I see that similar thing happening in the volatility space. So the original three are still, you know, adding yield, and how do you do that most efficiently, most effectively, Effectively, you know, reducing risk, and how do you do that most efficiently, most effectively? Obviously, buying puts is, is the norm, but maybe there's more stock replacement that's built into that as an alternative. But I know, again, that will be between experience and technology and research, et cetera. I see that continuing to evolve. And then when you get to the leverage side, whether it's leverage or it's synthetic replacement, you know, one of the things we're excited about is Is sort of an alternative to being long. The market is using volatility instruments to more efficiently get that beta. All right. And the idea of that I mentioned earlier, when you're along the market, you're effectively long a call and short a put. And so half of your Delta, let's say comes from the long call side and half comes from the short put side. Well, let's be more thoughtful about that. And…

AI assessment note: “using volatility instruments to more efficiently get that beta”

Q So he looked really bad for a while, but then he, he viewed it as an insurance business. As you're talking to your clients and prospects and institutions, how do you see people wrestling with a true understanding of the space as opposed to the perception that this is a financial weapon of mass destruction?

A We spend a lot of time on education. We really want to make sure people understand puts and calls and long and short, and most specifically what each of our strategies, you know, is meant to do. When it'll work well, when it won't work well, and most importantly, you know, how bad can it get? You know, and on the Warren Buffett example, I recall when he did the trade and, you know, if, if you're a natural buyer of the market on dips and you know that, uh, there's this spread of implied or realized, which is some edge, uh, that's being handed potentially to you. And you know, that skew is really rich for those downside puts than someone like You know, Warren Buffett says, Hey, I'm a buyer on dips anyway. If I don't get my dip, I'm going to make a lot from the premium. And then lo and behold, the financial crisis happens. And if I recall correctly, explaining these positions and the, the, the pretty big mark to market hit that he had to take, you know, was a fairly predominant part of, of the, of at least one of those letters and probably only one letter because it was only a problem in the fall of a weight and Q one of Oh nine. And then ever since. I guess what I would say is, is anybody who buys a stock, it's the same as being long a call and short a put, you know, at current level. And so if you decouple those things, um, you can be a naked put seller and that's less risky tha…

AI assessment note: “We spend a lot of time on education. We really want to make sure people understand”