Rocky Fishman, Founder and CEO, Asym 500 LLC

[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] It was a pleasure to welcome Rocky Fishman, Founder and CEO of derivatives advisory firm Asym 500, back to the Alpha Exchange.

[00:00:27] An area of specialty for Rocky is evaluating systematic trading strategies like vol targeting that live and breathe within equity markets and potentially sponsor feedback loops.

[00:00:39] The focus of our discussion, the growing universe of leveraged ETFs, a unique product set that has been on my mind, and that Rocky has recently done a deep dive on.

[00:00:48] We start our conversation by revisiting the August 5th VIX event that saw the S&P options market turn highly illiquid as the prices quoted for deep out-of-the-money put options reached unheard of levels.

[00:01:00] For Rocky, while the event came and went, there are lessons, namely that the tails can exert themselves suddenly.

[00:01:07] With respect to leveraged ETFs, Rocky sizes the U.S. universe as $135 billion in assets under management for leveraged and inverse products, $120 billion of which is in equity products.

[00:01:19] He walks through how both the leveraged long and inverse product on the same underlying, non-intuitively, are responsible for buying or selling in the same direction on the same day.

[00:01:30] These amplifying effects, unlike efforts to map the market's gamma profile, are unambiguous.

[00:01:36] As such, they are worth keeping a close eye on, especially as the ETF issuer's daily required rebalancing efforts take place near the close of trading.

[00:01:47] Here, Rocky does observe both more vol and volume in the market near the end of the day.

[00:01:52] I hope you enjoy this episode of The Alpha Exchange, my conversation with Rocky Fishman.

[00:01:59] My guest today on The Alpha Exchange is Rocky Fishman.

[00:02:03] He is the founder and CEO of ASIM 500, a firm that is advising institutional clients on derivative strategies and a lot of the complex mechanics that we observe in markets.

[00:02:17] Rocky, it's great to have you on the podcast.

[00:02:19] Thank you for having me.

[00:02:20] And thank you for having me for a second time.

[00:02:22] Absolutely.

[00:02:23] I'm looking forward to this conversation.

[00:02:24] And I have been thinking a lot recently about leveraged ETFs.

[00:02:29] And it was really almost a coincidence that some of your recent work did a deep dive.

[00:02:35] I just think it's a really unique part of the market structure.

[00:02:38] This is not a Graham and Dodd fundamental investing marketplace anymore.

[00:02:43] There's a lot of feedback loops.

[00:02:45] And some of the leveraged ETFs are very much a part of that.

[00:02:48] So we'll use that as a big part of our discussion.

[00:02:52] Let's get our conversation underway.

[00:02:53] Of course, you have been on the podcast before.

[00:02:56] You've been in a derivative strategy role for a long time.

[00:02:59] And you recently, not really recently, but over the last couple of years, you started your own company, ASIM 500.

[00:03:06] Tell us a little bit about that as we get the conversation underway.

[00:03:09] And then we'll dive into all things vol and leverage ETF.

[00:03:13] Sure.

[00:03:14] ASIM 500 is a company that I started around a year and a half ago.

[00:03:18] It's an independent derivatives research firm.

[00:03:20] I write pieces about derivative markets on an almost weekly basis.

[00:03:25] And investors and individuals can subscribe to my work through my website online, but also through institutional agreements that I set up.

[00:03:34] A very important part of what I do is maintaining a dialogue with a wide variety of institutional investors.

[00:03:39] That's one of the ways that I get market color.

[00:03:42] And it's also a chance for me to present my research to investors that would value it.

[00:03:46] Yeah.

[00:03:47] And of course, I'm biased because our two firms have an interesting collaboration where you're a part of the Macro Risk Advisors broker-dealer.

[00:03:55] And I really value the conversations and the interaction.

[00:03:58] And I have always really looked at your work, especially in terms of framing out pricing and just looking at things in a way that, you know, they say a picture is worth a thousand words.

[00:04:10] And I think your capacity to explain complexity by looking at data relationships in a unique way, I think, is excellent.

[00:04:18] So let's get started.

[00:04:21] So we're just post-election.

[00:04:22] In some ways, as expected by most, the VIX had very little room to keep rising as the event came and went.

[00:04:31] So why don't you maybe start by framing out the big picture of the landscape of option pricing as we sit here right before Thanksgiving?

[00:04:42] What do you see out there with respect to option prices, how they carry?

[00:04:47] Give us the 30,000-foot view as we get started.

[00:04:52] Sure.

[00:04:52] I would say that we are now entering Trump term number two.

[00:04:56] A very hard question is, to what extent does term two look like term one?

[00:05:01] So we certainly saw that there was a lot of focus on the risk around Election Day itself, both in terms of figuring out who is going to win and also any sort of risk of disruption of process.

[00:05:12] We certainly didn't have any disputes of the results this time, which is one of the things that allowed volatility to come down.

[00:05:20] That said, vol is not actually very low right now.

[00:05:23] Trump term number one began with one of the least volatile years in the history of the market.

[00:05:29] So 2017 was an extraordinarily unvolatile year.

[00:05:33] This time around, I believe that conditions are different.

[00:05:36] I think valuations are more challenging.

[00:05:38] The economic landscape with the Fed trying to figure out the right pace of cutting interest rates and the interplay between that and inflation, which is interconnected with some of the policies that are being discussed, and also the valuations of the equity market.

[00:05:53] All of that is creating an interconnected mix that I think is going to make it harder for volatility to come down in the near term as much as maybe one might have expected if you were looking at markets the day after Election Day.

[00:06:04] Yeah, the immediate reaction, equities up, rates up, dollar up, very similar to 2016.

[00:06:10] I think the starting point, especially for rates, vastly different.

[00:06:15] And then, of course, the starting point for inflation was looking at, I want to say core PCE on a year-over-year basis was around 1.7% in and around November of 2016.

[00:06:25] Now it's 2.7%.

[00:06:27] So just a very different backdrop.

[00:06:29] And I think the rate side, you obviously have to keep an eye on it.

[00:06:33] As the VIX is kind of settled here at 16, if you do a GP on your Bloomberg, you're going to just see one day where the VIX just went kind of bananas.

[00:06:43] And that really didn't tell the whole story, but the close on August 5th was around 38.

[00:06:49] And of course, intraday was in the 50s.

[00:06:52] I'd love to just hear what's on your mind as you kind of reflect on that.

[00:06:55] It's more than three months ago now.

[00:06:57] But these types of risk episodes, especially when they involve such an important product like the S&P 500 options market, I think demand our attention and reflection.

[00:07:10] What's on your mind as you think back on that day?

[00:07:13] Yeah, I do believe that August 5th is an important day.

[00:07:16] It is a moment when liquidity and options markets seem to be a lot weaker than people would have expected.

[00:07:23] It's not 100% clear what was the most important flow that somebody was trying to trade through the market.

[00:07:29] I mean, there have been a number of things suggested.

[00:07:32] I think that some have talked about delta hedging of VIX options.

[00:07:36] Others have talked about covering short S&P put positions.

[00:07:39] There is the mechanical loss of vega from those who are trading opposite option-based ETF issuers.

[00:07:46] There are a number of things that might have put market participants at a position to buy options in some form or another.

[00:07:53] And for whatever reason, the market was not able to handle that buying of options or volatility risk without pushing the price of options to really off the charts levels.

[00:08:35] And I think that this really speaks more to the concept that at certain points in time, liquidity can be a lot weaker than it is at other points in time.

[00:08:45] So as we get into this discussion, one thing that always motivates me when I talk about systematic trading flows, so trading flows that are really in response to the market rather than in a response to a slow calculated analysis of fundamentals, is that those trading flows work great when markets are very liquid.

[00:09:05] But when markets are not liquid, those can start to be very, very important to the way that markets actually behave.

[00:09:11] So yeah, we had the VIX at 65 in the pre-market of August 5th and at 55 after the market opened.

[00:09:19] Those are levels that have really not been seen outside of the financial crisis and the height of COVID.

[00:09:25] And it's just very hard to look at anything in the catalyst world from early August that would explain anything near that level of risk.

[00:09:33] Yeah, I think it's a lesson that the markets try to teach us and we just seem to not want to learn.

[00:09:38] Or maybe it's just, this is modern markets.

[00:09:42] This is complex markets, but we just under price the speed with which markets can really turn illiquid.

[00:09:50] And I think for me, just thinking a lot about, okay, you can get into a trade, but you got to get out of it as well, especially on the hedge side.

[00:09:57] And to see the inability or the difficulty with which folks were trying to unwind VIX call options, S&P put options.

[00:10:07] The S&P options complex is a critically important insurance market.

[00:10:12] It's the biggest asset complex in the world.

[00:10:14] A lot of things are tied to it and for that itself to become illiquid, I just think that it's an important thing we're supposed to keep an eye on.

[00:10:21] You did mention the growth of income-based ETFs or just the idea that derivatives are now embedded in ETFs.

[00:10:31] Why don't you take us, I know you've done a lot of thinking on this, a lot of work on this.

[00:10:34] Why don't you take us through what you've learned through the analysis of this kind of growing part of the market?

[00:10:41] Sure. So there are now several hundred ETFs, most of which that have been launched in the last three to five years and carrying around $150 billion of assets that are running some sort of a systematic option strategy.

[00:10:57] When I say a systematic option strategy, I mean that they're really looking at doing the same trade over and over again on a repeated basis, which gives the product some sort of explainable outcome.

[00:11:08] Some of the products are marketed as a defined outcome product.

[00:11:13] So they have a very, very specific payoff profile over the course of some number of months or maybe a year.

[00:11:18] They will have protection between a certain pair of strikes on the downside and give up upside above a certain point.

[00:11:25] Or maybe they sell call options above a certain point.

[00:11:28] And the performance of those funds is almost formulaic.

[00:11:32] There are others that are a little bit less formulaic, but that are running some sort of a systematic option strategy.

[00:11:38] I think that investors are looking for some sort of an in-between investment.

[00:11:42] As equity valuations have risen, they are understandably trying to find ways to get something that's less risky than outright equity investments.

[00:11:51] And at the same time, for whatever reason, fixed income hasn't been as exciting to investors as maybe it should be with rates actually pretty high.

[00:11:58] So this is an in-betweener investment.

[00:12:01] And it has a lot of implications for the derivatives market.

[00:12:05] Certainly, it adds liquidity in the derivatives market.

[00:12:08] But it also potentially could put the market in a position where there is a lot going on at specific strikes and expirations.

[00:12:15] And so, for example, if you have a very large amount of call options that are sold by these ETFs, then potentially it makes it easier for markets to be unvolatile as we rally.

[00:12:26] As markets move up towards those strike prices, the counterparties who have bought back those options from the ETF issuers would be in a position where they're actively managing the risk of those options in a way that involves selling equities as they're going up, buying equities as they're going down.

[00:12:42] Essentially, replicating what the investors have signed up for, which is we don't want to be long equities beyond a certain point of upside.

[00:12:50] And right now, of the $150 billion, the significant majority is in strategies that have sold call options in some form or another, either by outright selling call options against long equity positions or by doing what I call a put spread caller.

[00:13:04] Buying a put that's close to the current market level, selling a farther out of the money put, and then financing that protection by selling a call option.

[00:13:13] So there's a couple of ways to think about this.

[00:13:15] And I want to bring in just very briefly 2017 and 2018.

[00:13:19] One of my little sayings is that risk on and risk off are curious cousins.

[00:13:23] That's kind of a Minsky concept, but the 2017 low vol tail, the left tail of low vol was really unbelievable.

[00:13:32] I think we realized 6.6 or something for the year.

[00:13:36] Vic spent a lot of time below 10.

[00:13:38] And at least the narrative, which I'm sympathetic to because it was just so decided, is that the presence of vol selling put a lid on vol.

[00:13:49] And then, of course, it ended spectacularly badly in Feb of 2018.

[00:13:55] When you look at today's mechanics of the growth of those programs, you've done also some really interesting work over the years on vol targeting strategies, which are not option explicit, but sort of behave like options in some ways.

[00:14:12] The conditionality of buying and selling.

[00:14:15] Is there any comparison of the 2024 markets to 2017, 2018?

[00:14:21] Or is that just that was a very unique point in time?

[00:14:25] Well, look, in 2017, I think that the thing that was most important to creating the conditions for the big sell-off in February of 2018 was the way that the VIX market had become very heavy on short VIX products.

[00:14:39] The inverse VIX ETF and ETN had grown to be very, very large relative to the size of the VIX futures market.

[00:14:47] And that in itself is something that we don't see right now.

[00:14:50] There are short VIX products, but the amount of VIX risk that is in them is very, very much less than what we had back then.

[00:14:58] Right now, I would say that we have a number of systematic players in the market.

[00:15:02] I don't think that any one of them is outsized relative to market size and market structure, but we always have to be aware that the market impact of any of these products is always relative to the liquidity in the market.

[00:15:16] And what August 5th taught us is that there can be significant changes to liquidity conditions.

[00:15:21] So we always need to be monitoring whether the liquidity can keep up with what's out there right now.

[00:15:27] All right. Well, let's move to leveraged ETFs.

[00:15:30] Kind of a fun topic, really interesting.

[00:15:33] I don't think it's hard to argue that some of these products don't really serve the end investor all that well.

[00:15:40] I just was going through one of the prospectuses, the 98-page prospectus, and I know what's going to be in there.

[00:15:47] There's going to be some table that illustrates the ways in which these things can not deliver a return that is favorable relative to just owning the underlying asset.

[00:15:58] And yet, these things have lots of AUM, and there's been a lot of growth in not just on things like the triple Q, but also in single stock leveraged ETNs.

[00:16:10] So you've done some really good work on this.

[00:16:11] Why don't you walk us through the starting point, big picture findings, and then we'll drill down to some of the implications in terms of market feedback.

[00:16:19] Sure.

[00:16:20] So the starting point is that this is one of the players in this complex of systematic trading strategies that has the potential to move markets when markets are moving themselves, right?

[00:16:30] This is a strategy that will be constantly rebalancing its equity position in response to equity market moves.

[00:16:37] And so in the context of things like option gamma and fall target funds and various other things, this is one of the strategies that has the potential to create feedback loops within markets.

[00:16:51] It's a big market.

[00:16:52] I mean, I see around $135 billion worth of leveraged and inverse ETFs and ETNs.

[00:16:58] I'll call them ETFs for our purposes because most of them are in ETF format that are listed on U.S. markets.

[00:17:04] Around $120 billion of this market is in equity products.

[00:17:08] The other 15 is other asset classes that are listed in equity markets, so something like a 2X rates leveraged ETF.

[00:17:15] Crypto is also something that's been a growing space.

[00:17:18] But yeah, it's a little bit unclear what the appeal is for investors to hold these for a long period of time.

[00:17:25] There is a great case to be made that these are efficient, short-term tactical trading instruments.

[00:17:31] If you want to get long a stock or an index over the course of a few hours during the trading day, these guys have twice as much volume and twice as much equity exposure as the same notional amount of another of an unlevered product.

[00:17:45] Or maybe three times, depending on the leverage.

[00:17:47] Or four times, because we have a couple of those.

[00:17:49] So there can be a case to be made that for a quick trader, that these are an efficient way to trade in and out of these markets.

[00:17:57] As you start thinking about holding a leveraged or an inverse ETF for a longer period of time, there starts to be a compounding calculation that can be usually problematic for investors, although there is some cases in which they can actually be favorable for investors as well.

[00:18:13] But the idea is that every single day, a leveraged product is going to have a specific multiple of the underlying indexes return.

[00:18:22] But that doesn't have to be the case over a multiple day period.

[00:18:27] And so there is an effect that we get into, and we can get into it in more detail, of the economics that you get over a one-day period are not always the same as the economics that you get over a multiple day period.

[00:18:38] We have seen some launches of products that have more than a one-day period in which they measure returns.

[00:18:44] So that's an interesting evolution of this space.

[00:18:47] It's small right now, but that is something that I'm keeping an eye on.

[00:18:50] Yeah, I've seen they've got weeklies and monthlies as well.

[00:18:53] But just to stay with the landscape for the dailies, break it down a little bit more specifically for us in terms of whether it's sector, single stock.

[00:19:02] Give us a little bit more detail on what you see in that $120 billion.

[00:19:06] Sure.

[00:19:06] So it's unusual relative to a lot of other derivative markets in that the S&P 500 is really only a small slice of this market.

[00:19:14] I see around $18 billion of S&P-linked leveraged in inverse ETFs.

[00:19:20] And that's whatever, just a fraction of this entire market.

[00:19:24] Tech is very, very heavy.

[00:19:25] The largest individual index is the NDX, the NASDAQ index.

[00:19:30] That is $35 billion, of which 25 is the triple levered Q's product.

[00:19:36] So the TQQQ is by far the largest leveraged ETF.

[00:19:40] So that's $25 billion and $75 billion of long exposure that's built into it.

[00:19:46] There's a growing and pretty new category, which is single stock levered in inverse products.

[00:19:52] So there's over $20 billion of products that are referencing one stock.

[00:19:58] So think about a double levered NVIDIA, double levered Tesla.

[00:20:02] Those kinds of strategies are now less than three years old and they're running over $20 billion.

[00:20:09] And then there are certain indices that are tech heavy that have also gotten a lot of popularity.

[00:20:14] So you have very narrow index products, things like the Magnificent Seven or the Fang, which are just a few stocks kind of built into an index.

[00:20:23] Semiconductors, the index of the semiconductor sector has gotten a lot of activity.

[00:20:27] I think there's around $12 billion in leveraged in inverse products around semis.

[00:20:31] So it is a tech heavy mix of a lot of different underlyings.

[00:20:35] I find it just so interesting to look at.

[00:20:37] And I think maybe big picture, if we're to think about the feedback loop of these, and you and I have talked about this, we talk a lot about gamma.

[00:20:47] We know how gamma can work.

[00:20:50] I certainly think that 2018 is sort of the keyhole effect of having an index need to do something robotically, mechanically, and specifically by the end of the day in VIX futures,

[00:21:02] that just overwhelmed the product's capacity to provide that point in time liquidity.

[00:21:09] I mean, that's really how vol events occur, whether it's a short squeeze like GME.

[00:21:13] But with gamma, you don't necessarily know exactly where this stuff lives and how people trade it.

[00:21:20] There's dispersion trades.

[00:21:22] There's overriders.

[00:21:23] There's so many things out there that we can't really see.

[00:21:26] But, and I'd love for you to just run with this, the mechanistic nature of ETF flows, both on the leveraged long and inverse, are really specific.

[00:21:38] And specific at a point in time, we have an incredibly strong sense as to what they need to do.

[00:21:45] And we can quantify it in a way that I just don't think we can really do with gamma.

[00:21:50] Would you concur with that?

[00:21:51] Like, how do you think about mapping these things in terms of feedback loops?

[00:21:56] Yeah, I think that the way you put it is pretty solid, that these are a very, very well-known and predictable trading flow.

[00:22:03] And I think one of the most important characteristics about them is that they're really going to be concentrated around the close of trading on a given trading day.

[00:22:11] So as people are delta hedging an option position that has gamma, that trading could happen over the course of an entire day.

[00:22:18] A leveraged ETF issuer is incentivized to have the exposure to the equity market stay at the correct multiple of the original exposure throughout the trading day,

[00:22:32] and then right at the close switch to whatever the next day's exposure is going to need to be.

[00:22:37] So they're really incentivized to do that trade as close to the close as possible,

[00:22:42] if not in whatever closing rotation there is for the market that they're participating in.

[00:22:48] What gets a little bit tricky is that this is a feedback loop.

[00:22:51] If you're in a leveraged ETF, as the market goes down, the leveraged ETF issuer is selling some of their shares.

[00:23:00] And if that selling then causes the market to go down more, it could cause the issuer to have to sell even more.

[00:23:07] And so that's a feedback loop.

[00:23:09] And that feedback loop can take place really close to the close of trading on a given trading day.

[00:23:14] It is a very, very concentrated market rebalancing activity.

[00:23:18] I think that as we think about the way the world could be different over the next few years,

[00:23:23] having President Trump back in the White House always brings the risk that he could post something on social media that moves the markets.

[00:23:30] And if that happens at the close of trading on a given day, it has the potential to cause a little bit of this feedback loop to make the move happen faster than it otherwise would have.

[00:23:41] Let me give you a very simple example of how the rebalancing works.

[00:23:46] And then we could talk about gamma a little bit also.

[00:23:48] So a very, very important characteristic of the rebalancing of the leveraged and inverse ETF market is that both long leveraged products and inverse products are all going to be buying on days when the market goes up and selling on days when the market goes down.

[00:24:04] The reason that happens is that when the leveraged product is growing faster than the shares that it holds.

[00:24:14] And so therefore, it needs to add to its existing share count to be double the next day's value.

[00:24:21] And the inverse issuer is finding that the shares that he's short are moving in the opposite direction from the price of the product itself.

[00:24:30] So when the market is going down, the inverse product is getting bigger, but their short is getting smaller.

[00:24:36] So they need to grow that short by selling more shares.

[00:24:40] Just to put this in numbers, if you have a $100 product that's double levered, and let's say that it holds $100 worth of stock, the stock goes up by 5% on a given trading day.

[00:24:52] That'll bring the stock up to 105, but the product had held $200 of that stock.

[00:24:58] So it now holds $210 is the long position that it now holds at the end of that day.

[00:25:05] That's a $10 gain on the $100 product.

[00:25:08] So for the next trading day, when that product starts off at $110, the issuer is going to need to own double that $110 or $220 of long equities.

[00:25:18] So the position that he ended the previous day with of $210 is not big enough for that $210 position, for that $220 target the next day.

[00:25:27] So the issuer is going to buy $10 worth of equities to be ready for the next trading day.

[00:25:32] And at the same time, if you have $100 one times inverse product, so every day it's going to give you negative the return of that stock, it's going to have its short position grow from $100 to $105 short.

[00:25:47] So that's going to be a $5 loss for the product.

[00:25:50] So the product is going to go down from $100 to $95.

[00:25:53] So to be ready for the next trading day, the issuer of that product is going to need to be short $95.

[00:26:00] And at the end of the previous day, he was only short a total of $105.

[00:26:05] So the issuer of the 1X inverse is also buying $10 worth of the underlying stock to get that short position from $105 back down to $95.

[00:26:16] So this is a dynamic that can potentially make market moves happen faster because markets are going up.

[00:26:23] The issuers of both the leveraged and inverse products are going to be buying.

[00:26:27] Going down, the issuers are both going to be selling.

[00:26:30] When we compare this to option market gamma, I think that there's a lot of talk about the impact of gamma in the options markets on the way that markets trade during the day.

[00:26:41] I think one of the biggest misconceptions about gamma is the assumption that the people that are buying options are just sitting on those options until they mature.

[00:26:51] So the fundamental assumption of gamma analyses is that an option buyer buys the option and then holds it to maturity.

[00:27:00] And at the same time as that option owner holds the option, the counterparty that sold it to him is going to be dynamically trading.

[00:27:07] So let's say that the investor has bought a put option.

[00:27:11] As the market starts to fall, the counterparty who's short the put is going to be selling equities.

[00:27:18] The misconception about that is the assumption that the investor who bought the put is going to be holding it forever.

[00:27:24] Once that investor sells that put, he's essentially counteracting all of the selling of equities that his counterparty had been doing along the way.

[00:27:33] And the reason he's going to sell that put is that once it starts to work, it can gain a lot of value.

[00:27:38] And investors don't typically hold on to options that become extremely valuable.

[00:27:43] They see them as something that they can now take a profit on and maybe roll to a lower strike or not be hedged for a given period of time.

[00:27:51] And so the assumption that the end investor in options is just a static player who's not going to be trading dynamically around his position, I think, is something that's missing from gamma analyses.

[00:28:02] So I think that there's a lot of unknowns when you're dealing with option-based gamma.

[00:28:08] Option gamma is large.

[00:28:09] It's important.

[00:28:09] I'm not saying we shouldn't pay some attention to it.

[00:28:12] But the leveraged ETF market is a lot more predictable because there is a formula that these funds really have to follow over time.

[00:28:21] Yes.

[00:28:21] And maybe just to use your example, kind of use it the other way, which is the overrider.

[00:28:27] We talked a lot about these income-generating ETF products.

[00:28:32] So the street buys the option.

[00:28:34] They're delta hedging it.

[00:28:35] The narrative is the street is tripping over itself with its aggregate hedging activities.

[00:28:42] That's muting vol, et cetera.

[00:28:44] And the outright has just sold a call.

[00:28:47] Well, that's just not exactly how people act in the institutional money management business.

[00:28:52] You sell a call and the stock goes up and you lose your delta.

[00:28:56] You don't really want that.

[00:28:57] You can be buying back shares.

[00:28:59] And so you're kind of a delta trader, too.

[00:29:02] You're trading vol a little bit as well.

[00:29:04] Maybe not entirely.

[00:29:05] Some people might say, listen, I'll sell an upside call.

[00:29:08] And if it gets called away, wonderful.

[00:29:09] My return to call is X and I'm satisfied.

[00:29:13] But that's not exactly.

[00:29:15] We can't guarantee that.

[00:29:16] And what you're saying here, what I find so interesting about the feedback for the levered

[00:29:22] universe is it's just so specific.

[00:29:24] And as you really did a great job of outlining, and it's hard to get your arms around, but

[00:29:30] you really explained it well, that both the long and the short effectively do the same

[00:29:34] thing and they reinforce price.

[00:29:37] Now, you've also made the point that the levered side has gotten a lot bigger than the inverse

[00:29:41] side.

[00:29:42] And the question I want to ask you is when you step back and look at the landscape, so

[00:29:47] the triple Q has got a gigantic amount of products targeting it, but it's the triple Q.

[00:29:53] It's darn liquid.

[00:29:55] Where are the imbalances?

[00:29:56] If you were to step back and think about that vol comes from the overlay of a product that

[00:30:03] might introduce a lot of end of day volume in something that the underlying might not necessarily

[00:30:10] be great at accommodating, are there a couple that stand out that are worth keeping an eye

[00:30:14] on?

[00:30:15] Yeah.

[00:30:16] I mean, look, the point that you made about the leveraged long products being large is

[00:30:20] definitely important.

[00:30:21] The long products are almost the entire space right now.

[00:30:24] As we've had a bull market, they've really made it difficult for the inverse products to

[00:30:28] maintain their AUMs.

[00:30:29] Look, I would say that there are areas within tech that are represented in a lot of different

[00:30:34] slices.

[00:30:35] So semiconductor names, NVIDIA in particular, shows up in the sector products because the

[00:30:41] biggest sector products are tech.

[00:30:42] The semis have their own category.

[00:30:44] There are products on NVIDIA.

[00:30:46] Is that one of the reasons why that stock in particular and stocks like it have been so

[00:30:50] volatile?

[00:30:51] I mean, it does create a little bit of an ecosystem of dynamic trading that happens around

[00:30:56] some of these large cap tech names.

[00:30:58] So it is something that potentially is working together with large option markets.

[00:31:04] So people are buying large amounts of call options on some of the large tech stocks.

[00:31:09] So think about NVIDIA, Tesla.

[00:31:11] That's something that is participating in a very large, deep market.

[00:31:16] MicroStrategy also, by the way, is in this category.

[00:31:18] It's a large, deep market.

[00:31:20] So it's hard to picture that liquidity is just going to disappear.

[00:31:24] But there is an awful lot of mechanical trading that's happening around large cap tech stocks

[00:31:29] right now.

[00:31:29] I want to circle back to NVIDIA and how the market prices options on single stocks versus

[00:31:37] indices.

[00:31:38] I also wanted to ask you a question, whether it's your own research or stuff you may have

[00:31:42] seen in the literature around a noticeable effect of end of day vol.

[00:31:48] In other words, have there been any investigations on, hey, from 345 to 4, the market is noticeably

[00:31:57] more volatile than it used to be during that segment.

[00:31:59] And we might be able to tie it to the introduction of these products.

[00:32:03] Have you seen anything or have you done any work on that?

[00:32:06] Look, the end of day and the open tend to be the most volatile parts of the trading day.

[00:32:11] And it's not only because of these products.

[00:32:13] It's because there's a lot that happens around the close.

[00:32:15] Look, in the whole scheme of things, these products are fairly small.

[00:32:19] I mean, they're less than a quarter of a percent of the equity market or something

[00:32:23] like that.

[00:32:24] There is a lot of creates, redeems and mutual funds and ETFs that specifically link to the

[00:32:30] close of trading.

[00:32:31] There are QIS strategies that are systematic trading strategies that often trade around the

[00:32:36] close.

[00:32:36] So if you just look at volatility around the 24 hour clock, volatility tends to be the highest

[00:32:42] both at the close of trading and at the open of trading.

[00:32:45] On a given trading day tends to be the quietest overnight, of course.

[00:32:49] And the middle of the day tends to be quieter than the ends of the day.

[00:32:52] So it's something that's not new.

[00:32:54] By the way, this leveraged ETF market is not new at all.

[00:32:56] Like we've had leveraged ETFs around for almost 20 years.

[00:32:59] The size that they are right now is not economically bigger than it was around the financial crisis.

[00:33:05] It's a noticeable number, but it's not something that's new.

[00:33:08] And it's just really hard to separate out all of the things that happen around the close

[00:33:14] from each other.

[00:33:15] It's fortunate that trading happens around the close because that's when we have the

[00:33:18] deepest liquidity available for sure.

[00:33:21] And it's funny you mentioned the financial crisis.

[00:33:23] As I was doing a little bit of reading in preparation for our call, I looked at FAS, F-A-Z,

[00:33:28] and FAS.

[00:33:29] And that was just a fascinating product that existed during a time when U.S. financials

[00:33:37] obviously became the center of the storm.

[00:33:38] Let's say maybe it starts in 07, obviously gets worse and worse.

[00:33:42] XLF goes from a 12-val asset to a 100-val.

[00:33:45] And these leveraged products are just as wild as could be.

[00:33:49] Kind of the MSTR.

[00:33:50] I think there's MSTU now as the lever in MSTR.

[00:33:55] We talked a little bit about NVIDIA and so many products built around that.

[00:34:00] Tremendous options activity in NVIDIA.

[00:34:03] To me, it's just fascinating to look at the way in which the S&P as an index evolves.

[00:34:09] And so right now you have the biggest, it depends on the day.

[00:34:13] Maybe it's Apple, maybe it's Microsoft, but it's one of those three is going to be the

[00:34:17] biggest stock in the index.

[00:34:18] And NVIDIA is a 55 vol on a normal day.

[00:34:22] Before earnings, it's a 90 vol.

[00:34:24] And that's just really unique to have a stock that's so large and also so volatile relative

[00:34:30] to the index it's a part of.

[00:34:32] And some of this, I think, leads to unique correlation outcomes.

[00:34:36] And you've studied a lot of the ways in which both sectors and stocks interact within the

[00:34:42] S&P.

[00:34:43] Tell us what you see there and maybe what some of the implications are.

[00:34:47] Yeah.

[00:34:48] I mean, look, correlation within the S&P has been unusually low for really a couple of

[00:34:52] years now.

[00:34:53] So that means that you have idiosyncratic moves happening at the single stock level, sectors

[00:34:59] having low correlation both with each other and with the market as a whole.

[00:35:03] I think the utilities sector for the last two or three months has had a negative correlation

[00:35:07] with the S&P or something to that effect.

[00:35:09] There's a lot more going on, I think, than just a few stocks.

[00:35:12] I think if you look at just the average of S&P pairs, I looked at the top 100 stocks and

[00:35:18] looked at the 10,000 pairs between them and just track the correlation between those pairs.

[00:35:23] Those pairs as a whole have an average correlation of around 10 over the last three months, I think,

[00:35:29] the number.

[00:35:30] So it is something that has kept the index from being maybe more volatile than it might be.

[00:35:36] You could see how in a world where you have some of the largest stocks in the index being

[00:35:41] as volatile as they are, maybe the S&P should be more volatile.

[00:35:45] One of the things that's kept it from becoming especially volatile has been this lack of correlation

[00:35:50] within the market.

[00:35:51] It's difficult to understand why that's happening.

[00:35:53] I think it's really easy to point to low correlation as being something that should be the case.

[00:35:59] Right now, sitting here in November 2024, you have a lot of policies that are being discussed

[00:36:04] and getting ready to be launched that can affect one sector at a time.

[00:36:08] It's really hard to say why the last two years have been an unusually low correlation period.

[00:36:14] So it feels like there's something structural.

[00:36:16] I think it's more than just looking at the weight of NVIDIA and the volatility of NVIDIA

[00:36:20] because you see this across a lot of different sectors and stocks, some bigger, some smaller,

[00:36:25] but you just really see a low correlation between different parts of the market that I'm still

[00:36:30] trying to figure out the right way to explain.

[00:36:33] It really is a head scratcher.

[00:36:35] And if you do this stuff long enough, you just see these different cycles.

[00:36:38] I'm certainly remembering in the 04, 05, very benign vol period, but you had implied correlation

[00:36:46] would get into the 60s occasionally.

[00:36:48] Folks would enjoy selling it there.

[00:36:50] I'm remembering 2011.

[00:36:52] So that's the sovereign crisis, the US debt ceiling crisis.

[00:36:55] I mean, implied correlation was 80 something and realized was extremely high as well.

[00:37:01] And so you have this case now, as you're pointing to, where just realized correlation

[00:37:05] among these stocks is super low.

[00:37:07] And like you said, maybe it's just a structural change in how people think about risk.

[00:37:13] Right.

[00:37:13] There's the angle that implied correlation is not at much of a premium to realize correlation

[00:37:18] right now.

[00:37:19] So even if we have, for whatever reason, stocks being very uncorrelated with each other, you

[00:37:24] would expect the market to put some sort of a premium on the risk that in some sort of bad

[00:37:30] scenario, markets get a lot more correlated because people just need to de-risk quickly.

[00:37:35] And they're just not doing that right now.

[00:37:37] It's almost as if to say that markets are saying that the biggest risk to the market

[00:37:42] as a whole is a devaluation within a certain sector.

[00:37:45] Let's say it's AI or tech or something like that.

[00:37:47] And that that's a bigger risk than the economic risk that something really goes wrong with the

[00:37:52] economy.

[00:37:52] As you have conversations with your clients and where they're utilizing your analysis

[00:38:00] on option trade construction and really trying to help them think through maybe it's hidden

[00:38:07] risks, where are those conversations now relative to a year ago?

[00:38:13] And you started off the discussion about the new Trump administration, the potential for the

[00:38:18] Twitter tape bomb that we had to get used to in 2017 and 18 with trade war and so forth.

[00:38:24] Where are your conversations headed relative to where they were, let's say, a year ago?

[00:38:30] Look, I'm surprised that we're not getting more questions about market structure and feedback

[00:38:36] loops and things like that right now in the aftermath of August 5th.

[00:38:40] The number one thing that surprised me in my client conversations is the extent to which

[00:38:45] people have shrugged off the volatility event at the beginning of August as being just a

[00:38:50] one-off that's not something that's interesting to them.

[00:38:52] And I'm trying to get across the point that if liquidity is the fundamental driver there

[00:38:56] and we can't explain why things will be different next time, then it's maybe something that we

[00:39:01] should be spending more time focusing on.

[00:39:03] So I know that there's been a lot of talk about the election and the way that it affects

[00:39:07] policy and the interplay with rates and so on.

[00:39:09] There's been a lot going on in terms of catalysts, but I think that market structure hasn't

[00:39:14] been getting enough airtime recently.

[00:39:16] And then just kind of back to that and highlighting the main topic of conversation here, which

[00:39:21] is these leveraged ETFs and market structure.

[00:39:24] When you look at these things, you look under the hood.

[00:39:26] And this is not in any way alarmist.

[00:39:28] I'm just sort of observing the chain link of different providers.

[00:39:34] There's a swap provider.

[00:39:36] There is an ETF participant.

[00:39:39] There's all kinds of counterparties involved in making these trades occur.

[00:39:44] And because it has to happen every day and it needs to happen near the close, at least

[00:39:49] for me, I just was always a big part of the variant swap business.

[00:39:53] It's a daily reset.

[00:39:54] When something has to happen every day and you got to get it right every day, that just

[00:39:58] to me introduces something a little bit unique.

[00:40:01] It's like a choke point, at least potentially.

[00:40:04] I don't know if you have any just further views on the way in which the ETF universe, the leverage

[00:40:11] ETF universe is a potential source of risk for the market.

[00:40:15] Yeah.

[00:40:15] I guess one thing I would say on the structure side is that many of the issuers have total

[00:40:20] return swaps in place with banks.

[00:40:22] That's one of the ways that they get the leverage into these products.

[00:40:25] So they establish their longer short position through swaps.

[00:40:29] I think that in some of the cases, those swaps outsource the daily end-of-day trading to the

[00:40:35] banks.

[00:40:36] So the banks that have a lot going on in terms of their own option portfolios, in terms of

[00:40:41] their systematic trading businesses, quantitative investment strategies, et cetera, this is one

[00:40:46] of the things that goes into that whole package.

[00:40:48] I think that the concept is that there are strategies out there that really require markets

[00:40:55] to supply trades to them, regardless of price, regardless of liquidity.

[00:41:00] And I think that the aggregate of all of the different strategies that are setting up a

[00:41:06] schedule of trading in response to some sort of market conditions is something that we just

[00:41:11] need to continue keeping an eye on.

[00:41:13] If liquidity is amazing and the strategies aren't trading that much, that's great.

[00:41:18] But if liquidity conditions change, like the assumption that there's always going to be

[00:41:21] perfect liquidity in equity markets is something that I think that we have one more data point

[00:41:27] this year to point to that maybe not being as true as we want it to be.

[00:41:30] I think that's really interesting the way you framed it, that there are products out there

[00:41:34] that require the market to provide price, whatever it is, and liquidity, whatever that may be.

[00:41:41] These things are going to trade, kind of price agnostic, mechanistic vehicle.

[00:41:47] I think that's pretty interesting.

[00:41:48] So we're sitting here, we're almost in December.

[00:41:51] What do you see as 2025 for you in terms of the things that are in the lab for you,

[00:41:59] that you're working on areas of investigation that you want to start to better understand?

[00:42:05] What are some of the things that you can tell us?

[00:42:07] Sure.

[00:42:07] So ASIM 500 looks at option markets and things related to them through three different lenses.

[00:42:12] One is tactical, the second is systematic, and the third is fund flows.

[00:42:16] So on the tactical side, I think that looking at the comparisons between equity options, equity hedges,

[00:42:23] and other asset classes, I think is going to be very important next year.

[00:42:27] Looking at especially the heightened volatility in rates and FX markets versus the very,

[00:42:33] very quiet conditions in credit markets, where does equity volatility and equity options line up

[00:42:39] relative to those other asset classes?

[00:42:40] I think it's going to be a focus on the tactical side.

[00:42:43] On the systematic side, I want to spend more time thinking about how you assess the risk of a portfolio.

[00:42:50] This year has been a year in which the market has rallied throughout the year.

[00:42:55] So investors who are buying put options have been essentially wasting money.

[00:43:00] And yet, if you look at the performance of strategies that use put options as a way of reducing risk,

[00:43:07] and then taking more long equity exposure because they've reduced risk in that way,

[00:43:11] those strategies have been doing well relative to comparable risk multi-asset strategies.

[00:43:17] So understanding what options do to the risk profile of a portfolio

[00:43:21] and how comparable risk portfolios look relative to each other is going to be a focus on the systematic side.

[00:43:28] Then on the fund flow, I would say continuing to watch the option-driven ETF world.

[00:43:32] I think that the amount of growth we've seen in the last year is not ending.

[00:43:36] I think that space is going to become more interesting in that it's going to start evolving

[00:43:41] beyond this couple of core strategies right now that we have.

[00:43:45] And so I think we're going to have a much more eclectic group of option-based ETF strategies.

[00:43:49] And I'm excited to help understand why that's evolving the way that it is

[00:43:53] and kind of track the way that that can impact markets also.

[00:43:55] Yeah, and I think the core part of this conversation around these mechanical products is that when

[00:44:03] trades are overlaid into the market, they can have an impact on outcomes.

[00:44:09] We've seen it again with XIV.

[00:44:12] We saw the USO event in April of 2020.

[00:44:15] This has happened before.

[00:44:17] And I think studying the flows and really trying to understand

[00:44:21] how markets evolve from a product standpoint, that's like the early work.

[00:44:25] And it may emerge as, well, there's really nothing here.

[00:44:29] But if certain products and certain segments get, let's say, bigger and bigger,

[00:44:34] it sort of becomes part of the watch list as they might create some spillover.

[00:44:38] So I think that's definitely time very well spent.

[00:44:41] Well, Rocky, you and I talk all the time, but this was another great conversation.

[00:44:44] And I was glad to have had a chance to bring some of this work on the Levered universe

[00:44:50] to the Alpha Exchange audience.

[00:44:52] So thank you for taking the time to give us a little tutorial on this interesting product suite

[00:44:57] and at least the potential spillover implications for the market.

[00:45:01] Thank you for having me on.

[00:45:02] Awesome.

[00:45:03] Thanks, Rocky.

[00:45:04] You've been listening to the Alpha Exchange.

[00:45:07] If you've enjoyed the show, please do tell a friend.

[00:45:10] And before we leave, I wanted to invite you to drop us some feedback.

[00:45:13] As we aim to utilize these conversations to contribute to the investment community's

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[00:45:23] Please email us at feedback at alphaexchangepodcast.com.

[00:45:28] Thanks again and catch you next time.