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August 31, 2017 Odds on My D.C. First, do yourself a favor and follow me on Twitter. Dry humor putting in new highs daily. The New York Times’ DealBook had a great piece of journalism a couple of days ago about short VIX carry monkeys. Well, that is what I call them. The Times is more charitable, calling them VIX day traders. It does a pretty good job of capturing the VIX subculture, up to and including StockTwits, which eggs all these guys on. The article features a former Target logistics manager who, by consistently betting that the VIX will go down, has goosed his net worth up to $12 million. He is in the process of raising $100 million for a VIX-smashing hedge fund. I probably had about 20 readers send me this article. They are very scornful of this guy. Is it jealousy? Not really. People who understand the dynamics of these products know that it is the definition of picking up nickels in front of a steamroller. About those nickels... Risk/Reward There are two types of trades: You risk a little to make a lot. You risk a lot to make a little. In gambling parlance, the former is “taking odds,” and the latter is “laying odds.” In a casino, generally people don’t like laying odds. Take the craps table, for instance. All the action is on pass line bets and hardways, where you can risk a little to make a lot. People are very scornful of the “don’t” bettors, who risk a lot to make a little. It’s worth pointing out that the expected value is virtually identical—it’s just a matter of style. The casino is not the only place where people are scornful of laying odds. The stigma attached to risking a lot to make a little goes back to the release of Nassim Taleb’s second book, Fooled by Randomness, in the early 2000s. It wasn’t as big as The Black Swan, but it was very influential in trading circles, and got people to think twice about selling straddles and going to lunch. Mathematically speaking, options are always a tad overpriced, so yes, it makes sense to sell them. But if you do it systematically, you run the risk of being exposed to a true black swan event—and getting carried out. The Day After A curious aspect of all the VIX sellers smashing vol is the fact that they are doing so while staring down the biggest-ever potential black swan—nuclear war. If we attack North Korea, and it goes sideways, the VIX isn’t going to 20. It’s going to 100. People know that deep down, but they think they will be able to “get out in time.” That is the liquidity fallacy—whenever you put on a trade, you must accept that the liquidity that was present on the way in might not be present on the way out. You could be “stuck” short vol at 10, and watch helplessly as it reprices to 100. That’s a bankruptcy trade. So, experienced traders know that this will come to a very ignominious end. But in the meantime, party on? As for the Target manager and his friends, you have to give them credit. They were the first to figure out that the term structure of volatility is nearly always upward-sloping, and when it isn’t, it’s not for very long. But the funny thing about finance is that it exhibits nonstationarity. There is no rule that says the term structure of volatility will always be upward-sloping. Maybe it will invert—and stay there. For years, bonds yielded more than stocks. Now the opposite is true. These sorts of things happen all the time. Mr. Target manager is probably feeling pretty smug. And why not? He’s made $12 million while everyone has been calling him stupid. He who laughs last, laughs best. That is an argument for cashing out and going back to managing Target. $12 million buys a lot of cool s---. Inevitable “Something bad is going to happen sometime” is not an investment thesis, but it’s true. Something bad will happen sometime. Could be really bad. If you’re a short VIX carry monkey, you are betting that nothing bad will happen, ever. That is verifiably a stupid trade. But it has worked for a really long time. And to some extent, it is a self-fulfilling prophecy. If you go in and smash VIX after something bad happens, you make it not bad. This happened Tuesday morning when North Korea flew a missile over Japan. The VIX smash ensued, and stocks rallied back to unch. It’s not sustainable. There was a paragraph or two in the Times article devoted to how complex (i.e., toxic) these products are, and how they are unsuitable for retail investors. I’d bet that most of these guys don’t know anything about option theory and haven’t heard of dynamic hedging. They only know that XIV goes up forever. If this really does blow up, there is going to be some soul-searching at the SEC. If you securitize something really complicated and then apply leverage to it of course people are going to trade it! People will always find a way to blow themselves up—it’s just a lot harder with stocks and bonds. The Daily Dirtnap Conference I haven’t yet mentioned this publicly—I am having a private conference for subscribers to The Daily Dirtnap on 19-20 October, in Pawleys Island, South Carolina. If you’ve ever been to South Carolina in October, you’ll know there is nothing better. I have seven slots left. I am opening it up to you guys. The pros: The smartest speakers Like I said, South Carolina in October Beach and pool Golf Etc. An intimate setting, with only about 75 attendees You’ll meet some amazing people Zero chance you’ll leave without learning something mind-blowing The registration fee is $775. It’s a very affordable conference, and you’ll be hearing from people who manage risk on a daily basis—not the usual folks off the speaker circuit. There is no downside here. It’s at the Litchfield Beach and Golf resort, which is about a 30 minute drive from the Myrtle Beach airport. If you sign up, I can send you tips on logistics via email. If you have some questions about the conference before you sign up, hit me at info (at) dailydirtnap (dot) com. Here is the link to register—remember, only the first seven people get a seat. Hope to see you there.
Jared Dillian
Editor, The 10th Man
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