Bitcoin, Price / Vol Spirals and MSTR

[00:00:01] Hello, this is Dean Curnutt and welcome to the Alpha Exchange, where we explore topics in financial markets associated with managing risk, generating return, and the deployment of capital in the alternative investment industry.

[00:00:19] Good listeners, Thanksgiving has come and gone. Happy memories will linger, but alas, so too will the calories.

[00:00:26] Your waistline, like the market's multiple, may well have expanded. Not like the premium of MSTR to its Bitcoin holdings, but perhaps your favorite pair of tanchinos has tightened up a bit.

[00:00:38] Sort of like Jay Powell when asked about what he'd do if Trump tried to replace him.

[00:00:43] Who's old enough to remember the stovetop stuffing commercial and the enthusiastic line, I'm staying?

[00:00:49] Seems like our Fed chair likes his seat and ain't going nowhere.

[00:00:52] Looking at the Fed calendar, we've got December tracking to nearly a full rate cut, which likely gets done.

[00:00:59] And then, interestingly, a Jan meeting set to take place barely a week after Trump takes the reins.

[00:01:06] On my mind is the broad topic of uncertainty and how option prices reflect a distribution of potential outcomes.

[00:01:13] Skinny implied vol levels translate to low option premiums and a high degree of precision as to what is coming next.

[00:01:21] Change is not a word that comes to mind in this context.

[00:01:25] A client asked me if I had an idea as to what the cheapest one-day straddle price on the S&P might have been.

[00:01:31] Without being able to actually confirm it through data, I would argue that a top five contender had to have occurred in October 2017.

[00:01:41] I know that because on the eve of the 19th of that month, I hosted a large dinner.

[00:01:46] And on the 30th anniversary of the 87 crash, the one-month straddle on the S&P 500 cost 1.5% of spot.

[00:01:55] One week implied vol got to as low as five and a half.

[00:01:59] And if you use five for the one-day straddle, I get a break-even of 22 basis points.

[00:02:05] You still would have mostly lost money at that price many times that month.

[00:02:11] Seeking insights and edge on the time variation of risk premium is a pursuit that has largely defined my time professionally.

[00:02:18] This is to say that studying the ups and downs of the VIX and its cross-asset cousins is of great interest.

[00:02:25] Under what conditions does the profile of market risk change?

[00:02:29] What is the interplay between policy, the economy, and the market?

[00:02:32] How are clearing prices in derivatives markets arrived at?

[00:02:37] When do institutional considerations leave certain risk premium levels structurally high or low?

[00:02:43] When might a class of trades present spillover risk to the broader market?

[00:02:47] There are so many ways to ask a core question, which I think is the most important one.

[00:02:53] Is there alpha to be generated in identifying value and optionality?

[00:02:57] Can we find options that are good deals to be long or short?

[00:03:01] I don't think you can prove this one way or the other, but the process of trying to do so is what motivates trading.

[00:03:08] And as I've said before, trade makes the world go round.

[00:03:12] What follows are some of my recent thoughts on a favorite topic.

[00:03:16] The interaction between option prices and the assets upon which these options are written.

[00:03:21] Specifically, I want to share some thoughts on price-vol spirals.

[00:03:26] These come in two flavors.

[00:03:28] A, the asset plummets and vol explodes.

[00:03:31] B, the asset surges and vol explodes.

[00:03:35] In the first, which we might call meltdown, the asset nears a bankruptcy cliff as vol explodes.

[00:03:42] We can put the entire U.S. financial system, circa this time in 2008, in that category.

[00:03:48] Things get pretty chaotic near the edge, and it's surely the case that both realized and implied vol are going to explode in the process.

[00:03:58] In November 2008, Goldman Sachs, largely considered a superior risk-managed entity, via the big short, experienced 10 daily moves in excess of 6%.

[00:04:11] Good grief.

[00:04:13] Outside of the center of the storm being the treasury market, there's no market risk more systemic than a U.S. banking crisis.

[00:04:21] It took the kitchen sink of rescue facilities to stem the tide of forced deleveraging during the GFC.

[00:04:27] It took QE Unlimited to save the U.S. treasury market in the bad days of March 2020.

[00:04:33] A more recent example of meltdown would be oil in April of 2020.

[00:04:39] As the USO suffered a 74% loss from March to the end of April, the OVX surged to as high as 325.

[00:04:48] Damn, that's high.

[00:04:49] Now, with respect to the front month future on crude, the negative clearing price was fleeting but altogether fascinating as well.

[00:04:57] Unlike interest rates, stocks do not go below zero.

[00:05:01] And so while things do get disorderly as a stock melts down, we know the stopping point is zero, right?

[00:05:08] Price-vol spirals of the melt-up type have no such boundary.

[00:05:12] There's no one, even Bernie Sanders himself, saying there ought to be a law against an asset rallying too much.

[00:05:19] And because of that, the melt-up scenario brings with it risk dynamics that can be even more powerful than those of the meltdown.

[00:05:26] In melt-up, there's typically some version of a short squeeze involved.

[00:05:32] Everyone's trying to get their hands on the same thing all at once.

[00:05:36] There was a vol short squeeze in 1998, in 2008, in 2018.

[00:05:41] I suppose we have a few years until the next one.

[00:05:45] Each of these is about how a system becomes unstable and prices are forced to gap out to rectify the imbalance between supply and demand.

[00:05:54] But there's something else more interesting and also destabilizing.

[00:05:58] And that is the value of options in a world where the price of an equity is floored at zero but is theoretically unbounded to the upside.

[00:06:07] Black-Scholes math assumes a normal distribution of returns of the underlying asset.

[00:06:12] We know the neat and tidy world of BS is, yes, BS.

[00:06:17] Black-Scholes is a great starting point.

[00:06:19] But we have to incorporate the realities of jump risk, trading frictions, and the frequency that markets go through periods of being considerably more or less risky.

[00:06:28] I've cited both 2008 and 2017 as examples of the extremes.

[00:06:34] We also know that the trades and exposures that live and breathe within the market matter a ton.

[00:06:39] Clearing prices are simply the result of two parties agreeing to come to the table at a given point in time.

[00:06:47] There are sometimes way too many trying to either buy or sell for the market to clear without a huge price concession to the upside or the downside.

[00:06:56] While there's no cap on an equity asset, single stocks are typically escalator up, elevator down securities that experience the bulk of their volatility on down moves.

[00:07:07] Markets crash down, not up, is another way to say it.

[00:07:10] That is the norm, but certainly not the rule.

[00:07:13] And one, only look at the meme stock episode of 2021 for evidence.

[00:07:19] The price vol spiral in GME was a doozy and, dare I say, dangerous.

[00:07:24] The VIX got to 37 on January 27th of 2021, and that was set against one month realized vol of just 13.

[00:07:32] That spread represents a reach for insurance because this formerly irrelevant video game store had entered a price vol spiral of the melt-up variety that threatened to spill over into the broader market.

[00:07:45] Let's have some fun with option pricing on GME on that day.

[00:07:49] My trusted Bloomberg reports that one month implied vol reached 552% on Jan 27th.

[00:07:56] Dropping that into the OV calculator, we see that a call option would cost 57% of the stock price.

[00:08:03] The delta of this short-dated at-the-money call would be a hair under 80.

[00:08:08] What would be the strike associated with a 50 delta call at the same vol?

[00:08:14] Three and a half times the stock price.

[00:08:17] At face value, these numbers are ludicrous.

[00:08:20] No, not the wrapper.

[00:08:21] I just mean these are hard-to-wrap-your-head-around numbers.

[00:08:24] But they do a great job of capturing what happens to option prices when a distribution opens up to the upside.

[00:08:32] You might argue that being short that upside call on GME was an absolute layup.

[00:08:37] Hindsight is 20-20.

[00:08:39] It's worth stating that dislocated prices got that way for a reason, and that same factor could pave the way for even more dislocation.

[00:08:49] Squeezes are a remarkably dangerous risk event.

[00:08:52] And that brings us to Bitcoin and the equity story du jour, MSTR.

[00:08:58] Of course, MSTR is the ticker for MicroStrategy, the Bitcoin buying engine.

[00:09:03] MSTR could also stand for Michael Saylor total return or, less charitably, total rug pull.

[00:09:11] I have to say there's no better salesperson on planet Earth right now than Michael Saylor.

[00:09:16] At the same time, some of his commentary is legit comical.

[00:09:20] I get it that part of the play here is simply to cheerlead the asset higher.

[00:09:24] But overconfidence does come to mind, and one can't help but think of Voltaire's famous quote,

[00:09:31] Doubt is not a pleasant condition, but certainty is absurd.

[00:09:35] He's issuing converts to buy Bitcoin.

[00:09:38] He's created a stat called Bitcoin Yield.

[00:09:40] He's, in his word, taking out billions through the, quote, ARB.

[00:09:45] There's no ARB whatsoever.

[00:09:47] There is a large premium of MSTR to its holdings of Bitcoin.

[00:09:51] It will take every bit of salesmanship from Saylor to keep this premium in place.

[00:09:57] No doubt, MSTR is a really interesting stock.

[00:10:00] It's linked to the second most interesting, most right-tailed asset the market has ever seen, Bitcoin.

[00:10:07] The most right-tailed, I'll argue, is Vol itself, but that's a topic for another pod.

[00:10:12] Let's stay focused here, folks.

[00:10:14] I say often that we market types simply price what we observe.

[00:10:18] In Bitcoin, a substantial component of its volatility arises from up days.

[00:10:23] Since 2017, I count 193 days when Bitcoin has fallen by 5% or more, but 216 days where it's rallied by 5% or more.

[00:10:36] That's 15% of the daily moves.

[00:10:39] How about 10% up shocks?

[00:10:41] Since 2017, the coin has enjoyed 35 daily moves of that size.

[00:10:46] When an asset exhibits that behavior, the seller of optionality takes notice, to be sure.

[00:10:53] Alongside the empirical behavior of the asset, and certainly in some way because of this behavior, is Michael Saylor.

[00:11:00] At the beginning of 2024, he forecast a Bitcoin price of $350,000.

[00:11:05] Whoops.

[00:11:06] No worries, though.

[00:11:07] He recently said that Microsoft, that's another software company, could add $4 trillion to its market cap by buying Bitcoin.

[00:11:16] His distribution as to what is possible in Bitcoin is impressive indeed.

[00:11:21] He predicted a Bitcoin market cap of $280 trillion by 2045.

[00:11:28] Is that all?

[00:11:29] I'm not sure if there's a DCF model linked to that, but the strategy to speak so confidently and compellingly about the future as to make the fear of missing out intolerable is working.

[00:11:40] And when you have so strong a frontman, and with the proof already in the pudding with regard to historical returns, it's difficult not to arrive at a vol surface that incorporates wildly high potential outcomes for the price of Bitcoin.

[00:11:56] Let's move from MSTR to the derivatives built on top of it, specifically the options market and also the leveraged ETF market.

[00:12:04] I've done a flurry of podcasts on leveraged ETFs recently, which I'd love for you to check out.

[00:12:09] First, with Rocky Fishman of ASIM 500, who provided high-level insights on the growth of the product set and the manner in which the products interact with the underlyings upon which they are written.

[00:12:21] Next, Elm Wealth founder and CIO Victor Higani shared his recent work on the MSTR leveraged ETF complex and how dangerous the two long products, MSTU and MSTX, are given the vol profile of the underlying asset.

[00:12:37] Suffice it to say that MSTR, and especially the two times leveraged longs, are not products that Graham and Dodd, pioneers of value investing, would have any relationship with.

[00:12:49] Seth Klarman's margin of safety most certainly didn't contemplate these beasts.

[00:12:54] That's not good or bad. It's just to say that there's no fundamental analysis to be done here.

[00:12:59] But what we do need to do is appreciate the wicked options math for these products and how they could conceivably lead to a price vol spiral of the melt-up variety.

[00:13:11] Let's have some fun here with options on MSTU.

[00:13:14] The analysis will hold for MSTX as well.

[00:13:17] This is a daily two times ETF on MSTR, a stock that is 100 to 200 vol leveraged play on an asset that has no fundamentals and itself is a 50 to 70 vol asset.

[00:13:32] Because investors deserve choice, there are options on MSTU and MSTX as well.

[00:13:38] The implied vol on one-year options on MSTU has been on some rollercoaster ride.

[00:13:44] Starting October at 165, these ramped to 275 and have now retreated to just 230.

[00:13:52] A movement of 100 vols on one-year options is absolutely unheard of.

[00:13:57] These numbers are not common at all to markets.

[00:14:00] Why does it matter?

[00:14:02] Well, as discussed, the Bitcoin MSTR sailor story is one of the truly unique ones out there.

[00:14:08] When prices move the way they have, they reinforce thinking about possibilities.

[00:14:13] It was Rudyard Kipling who said, quote,

[00:14:17] We are in the opening verse of the opening page of the chapter of Endless Possibilities.

[00:14:23] The MSTR Price and Michael Saylor's Media Tours are both there to certify this thinking.

[00:14:28] And products like MSTU, and especially the options on them, can provide a massive tailwind to demand for the underlying.

[00:14:36] There's a fairly obscure Greek out there in derivatives land called VANA.

[00:14:42] We all know about delta, gamma, and vega.

[00:14:45] VANA is the change in delta per change in implied vol.

[00:14:48] For an out-of-the-money call, when we increase the implied vol, the delta rises.

[00:14:53] You know where this is going.

[00:14:55] When you jack up the implied vol by 100 on a longer-dated option,

[00:14:59] the delta rises sometimes by a considerable amount.

[00:15:04] Let's do a quick exercise and price one year 50% out-of-the-money call options on MSTU at 165 vol and also at 275 vol.

[00:15:15] Using 165, the option has a 72 delta.

[00:15:18] If instead we use 275, the delta expands to 88.

[00:15:23] What happens if the vol goes to 350?

[00:15:25] Come on, these are just numbers.

[00:15:27] The delta goes to 94.

[00:15:28] When that happens, the dealer who's short the stock has to buy more stock.

[00:15:33] My two favorite quotes from George Soros are related.

[00:15:37] First, he said,

[00:15:38] When I see a bubble forming, I rush in to buy, adding fuel to the fire.

[00:15:44] Separately, he said,

[00:15:45] I learned the hard way that the range of uncertainty is also uncertain,

[00:15:50] and at times it can become practically infinite.

[00:15:53] A true price vol spiral of the melt-up variety means, definitionally,

[00:15:59] that vol will absolutely surge as the underlying does so as well,

[00:16:03] because there's no other way to accommodate what Soros points to,

[00:16:06] that the range of uncertainty can become practically infinite.

[00:16:10] It's the nature of the event.

[00:16:13] When you add in that MSTU is a derivative on MSTR, which is a derivative on Bitcoin,

[00:16:18] and then add options on MSTU in the manner in which delta interacts with vol,

[00:16:23] especially at crazy high levels, well, now you're cooking with gas.

[00:16:28] We are all about noticing things here at the Alpha Exchange,

[00:16:31] and I notice that when GME spiraled,

[00:16:34] there really was no justification for being short the upside vol,

[00:16:38] even at outrageously high option prices.

[00:16:41] The risk was simply too high.

[00:16:43] It's not as if you have a bunch of trials over which you can earn a risk premium.

[00:16:48] This is a one-shot deal.

[00:16:50] Sizing the exposure becomes very difficult, and most wind up sitting it out.

[00:16:55] So capital gets withdrawn, and the situation can run further.

[00:16:59] Forget valuation, there's a freight train you simply can't afford to get in front of.

[00:17:04] Capital that might lean short is dissuaded from doing so.

[00:17:07] It's simply too risky.

[00:17:09] Prices take on a life of their own.

[00:17:11] Buyer beware?

[00:17:13] Nope, it's seller beware.

[00:17:14] You can have some real fun with options when implied vol are this high.

[00:17:18] MSTR has Jan 27 options.

[00:17:22] MSTU and MSTX do not, at least yet.

[00:17:25] Suppose, however, that MSTU did have options out to Jan 27.

[00:17:29] If we use 200 implied vol, the at-the-money call would have a 91 delta.

[00:17:35] The 50 delta call would be struck at 15,000.

[00:17:39] The stock is at 160.

[00:17:41] Good Lord.

[00:17:43] It's always interesting to compare and contrast how the market prices vol for different assets and at different points in time.

[00:17:50] How has the recent MSTR price vol spiral compared to that of GME, the second round, which was in June of 2024?

[00:18:00] It's really interesting to overlay these two vol surfaces.

[00:18:03] No surprise, both term structures are inverted.

[00:18:06] And both one and two years out, these vols are, in the words of lawyer Trotter, from my cousin Vinny, identical.

[00:18:16] But back then, short-dated one-month GME vol was sky high, 140 vols north of MSTR vol.

[00:18:25] As with just about everything, we can look to realize vol to explain the difference.

[00:18:29] One-month realized vol on GME got to 420.

[00:18:32] For MSTR, it got to just 140.

[00:18:37] Which then forces us to entertain another question.

[00:18:40] Why and how has back-end vol and MSTR gotten so damn high?

[00:18:46] There are two factors here.

[00:18:47] First, it's a function of the unbounded nature of the asset underpinning all of this, Bitcoin.

[00:18:52] No valuation metrics, no management team, no corporate earnings days on the calendar,

[00:18:57] just the circular interaction between price and Michael Saylor's compelling capacity to inspire the imagination.

[00:19:05] Second, micro-strategy implied vol has risen dramatically because MSTR appears to have been forced into the options market on MSTR

[00:19:14] in order to replace the leverage that its swap counterparty decided to reduce the provision of.

[00:19:20] So here you can see the pathway of unintended consequences.

[00:19:24] It starts with the sharp rally in Bitcoin, which translates to an even sharper rally in MSTR,

[00:19:30] which leads to a large increase in AUM in the leveraged complex, which likely amplifies the realized vol in MSTR.

[00:19:38] The swap counterparties reconsider the leverage they provide,

[00:19:42] and the ETF is forced to buy options on MSTR, thus driving up the vol, arguably dramatically so.

[00:19:50] As these implied vols are driven up, so too, via this fancy Greek called VANA,

[00:19:57] are the deltas of the call options creating additional demand for shares.

[00:20:01] Is a single line of this meant to be advocating for Bitcoin or Saylor?

[00:20:06] Nope.

[00:20:06] Is it meant to call for a crash in MSTR?

[00:20:09] Nope.

[00:20:10] This is meant to highlight some interesting and important dynamics that result from leveraged ETFs

[00:20:15] and options written on them on a very volatile stock, which has as its sole purpose the accumulation of a volatile asset.

[00:20:23] It's meant to bring to life some of the real feedback loops that come from the financial products landscape introduced into the market.

[00:20:31] Let me finish with this.

[00:20:33] Batting cleanup in the Derivatives Hall of Fame is Joseph Cassano at AIG Financial Products.

[00:20:40] His appetite to sell subprime CDS was voracious, to say the least, fueled by his confidence that he, like Saylor, had found a money glitch.

[00:20:49] In August of 2007, in remarking on his exposures, Cassano said, quote,

[00:20:56] It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions.

[00:21:08] Ouch.

[00:21:10] Pride comes before the fall is an old expression typically invoked to describe folks whose overconfidence sets them up for failure.

[00:21:18] If pride comes before the fall, then in markets, price runs before the fall.

[00:21:25] How so?

[00:21:26] Vol spirals of the melt-up variety always resolve lower, and mostly violently so.

[00:21:32] The unique behavior of assets like Bitcoin and those cheering on its behalf creates an, anything is possible, psychology.

[00:21:40] Want confirmation?

[00:21:41] Just look at price.

[00:21:42] Price is the giant I told you so.

[00:21:45] Through its compelling past, price seduces us about the future.

[00:21:50] Price, when levitating, means that past performance most certainly is indicative of future results.

[00:21:57] Price validates those who bought and motivates those who might buy.

[00:22:02] Price speaks.

[00:22:03] It's an advertisement.

[00:22:04] Because it's what we observe, price becomes what we believe.

[00:22:08] The right tail of the distribution of potential outcomes really widens out as our imaginations run wild and FOMO does its thing.

[00:22:18] With this in mind, and lastly, as has been said, price is the only fundamental.

[00:22:24] It's a very powerful one for Bitcoin and the assets linked to it.

[00:22:27] Michael Saylor's conviction notwithstanding, a 50-vol asset is going on quite a road trip.

[00:22:35] I hope you've enjoyed this episode of the Alpha Exchange, and I wish you a wonderful week.

[00:23:04] Thanks again, and catch you next time.