The VIXgilantes Strike Back

[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] Loyal listeners, it's springtime. I'm back from sunny and 93 degree Las Vegas, where I visited the sphere for the third time, this time to see the Eagles. What an outstanding venue this is. These senior statesmen of rock and roll, including Joe Walsh, Don Henley, and the son of Glenn Frey, Deacon, opened with Hotel California and played all the old hits.

[00:00:44] And in fitting tribute to today's market risk environment, life in the fast lane was one of them. To be sure, markets have been fast. How fast, you ask? In six short trading days from April 2nd to April 9th, the S&P realized as much vol as it did during the entire year of 2024.

[00:01:06] Put differently, if the market were to close for 246 consecutive days, there being 252 trading days in a year, realized vol would be the same 12.7% as it was for all of 2024. This underscores two of the most critical properties of volatility. And that first is that it clusters. Bursts of volatility are a cornerstone of the behavior of the S&P.

[00:01:34] Something happens. In this case, Liberation Day. Giant air quotes included here. The market reacts, processes the new state of the world, and moves accordingly. And the second property is that with respect to vol, big moves matter most. The long vol trader is an interesting character. He or she needs to be patient as most trading days likely produce losses.

[00:01:59] Manageable losses, but losing days nonetheless as the option theta exceeds the gains to be extracted from rebalancing a delta hedge. Losing most days isn't fun. But, but, but, when disruption hits, a trader can make up for these small losses quickly, sometimes realizing substantial profits by trading the explosive volatility. Chris Cole of Artemis once said that volatility was an instrument of truth.

[00:02:27] The disruption that saw a 10-day realized vol on the S&P reach an outrageous 65% is the market's chaotic search for a new equilibrium set of prices. It's the squaring of positioning set against a new handicapping of uncertainty. To be sure, it wasn't pretty. But, there are lessons to be had in contemplating the recent price action over the last few weeks,

[00:02:54] and hopefully I can offer some insights that you find valuable. What follows is my take on the recent chaos in markets and where we go from here. To set the table, and running with the previous observation on the burst of volatility just experienced, if we look at 10-day periods and sum the squared daily returns of the S&P,

[00:03:16] the Liberation Day fallout ranks only behind COVID and the GFC in terms of severity using data going back to 1990. I purposefully exclude the 1987 stock market crash because, well, you know, squaring a 20% daily return is going to make for impossible comps. But the 10 trading days ending with April 16, 2025 ranks ahead of the 2011 debt ceiling crisis,

[00:03:46] ahead of the 1998 LTCM episode, and ahead of the 2002 accounting fraud crisis in terms of severity. Each of those three episodes saw a VIX in the mid-40s. Our recent peak in the VIX is 52, with intraday peaks closer to 60. Late in season four of Succession, in the struggle to buy the Roy family's prized assets, tech entrepreneur Lucas Madsen said, things are going to get nasty.

[00:04:15] He could have said so about markets as well. As the dollar fell, as the basis trade wobbled, as correlations in gold surged, it was clear to most, but perhaps not to Trump, that the financial economy can't run on a 50 VIX. Americans run on Duncan, but the stock market don't run on a 50 VIX. Sure, Scott Besson put on a brave face in the days after April 2nd,

[00:04:42] telling us it was a MAG-7, not a MAGA problem. Remember that? Was I the only one curious as to whether he'd come up with that himself? And here I thought Bill Maher had good writers. Besson has seen a financial crisis or two over his career, and he had to have had some lingering doubts about the sustainability of policy. That was on Friday, April 4th. It would only get worse a few days later, after the market had the weekend to noodle on things.

[00:05:12] By April 8th, the VIX Gelantes, see what I did there? had taken matters into their own hands, and we must recognize their role in motivating the giant climb down by Trump and company on April 9th. Throw in a vulnerable setup in swap spreads, which reached maximum inversion at the same time the VIX peaked, and you are cooking with gas when it comes to fast perpetuating a market risk event.

[00:05:39] Perhaps Besson was at the sphere with me in Vegas, and the Eagles hit, take it to the limit, was on his mind. The precedent for 50 VIX, subset 2, GFC and COVID, is unappealing. It's 50 on the way to 80. Besson didn't take my call or even read my tweet, but hopefully he understood the vulnerability. He should have known better well before April 9th, and his comments were tone deaf at a minimum.

[00:06:08] We know from the history of the S&P that S&P vol is an interesting sale at 20, a really interesting one at 30, a compelling sale at 40, and at 50, it's an exposure to cover as quickly as you can. We also know that a leveraged trade like swap spreads reaches its maximum level of attractiveness at the very time when a counterparty is about to need fresh capital. Just ask John Merriweather.

[00:06:36] Such is the nature of assets or spreads that have high negative skewness. With respect to implied volatility on the S&P 500 index, the forces that lifted the VIX to 50 are exactly those that can propel it much higher, especially when the sellers turn buyers for risk management purposes. First rule, don't die. Each risk episode is the same, but also different.

[00:07:03] I always loved what podcast guest and former FOMC governor Kevin Warsh said about material disruption events. Quote, If you've seen one financial crisis, you've seen one financial crisis. I love that. My policymaking takeaway is that if you are in the business of financial firefighting, you've got to both identify the source of the flames and have the proper tools to douse them. Each of these flare-ups has unique properties.

[00:07:32] What can we learn from April 2nd to April 9th of 2025? Plenty. We can observe highly unsettling price action that bears at least some similarity to that experience during the COVID market shock. I refer to the, quote, liquidation phase of the risk-off from March of 2020 as the roughly one-week period when the stock and bond market crashed together, the dollar surged,

[00:07:59] and assets priced in dollars like gold and crude plummeted. Then, the system's demand for cash-like liquidity was so great that even assets like long-dated treasury securities were no longer considered safe. Only cash was. This time around, the sell-off in long-dated treasuries amidst a sky-high VIX and substantial equity market drawdown was what must have finally gotten Besson's attention.

[00:08:27] Even Trump suggested the bond market got yippee. Perhaps the VIX-Gilantes shouted yippee-ki-yay on April 9th, forcing Trump's hand. As I tweeted on April 8th, reaching 50 on the VIX has meant reaching 80 twice during the GFC and COVID. I didn't expect that to occur again because the truly destabilizing conditions of the GFC and COVID were not in place.

[00:08:53] What also was strikingly different between 2025 and 2020 and 2008 was that this was, again, to borrow in ironic fashion from Besson, an, quote, own-goal risk event. That is, a preposterous, by most counts, self-inflicted wound that was always only a tweet away from de-escalation. And that's, of course, exactly what happened on April 9th.

[00:09:21] What prompted the epic Trump climb-down on tariffs that his Commerce Secretary Howard Lutton assured us days earlier would be in place for days and weeks? Not just the VIX in a rarely observed joint rally in the front end and sell off in the back end of the government bond market, but also, perhaps, the recognition that vol of this magnitude is punishing and causes all kinds of knock-on effects. Margin requirements are raised.

[00:09:49] OTC swap lines are re-evaluated. Hedges encounter all kinds of basis risk. Liquidity plummets. At a minimum, when vol skyrockets, an investor's value at risk does as well. The market made your size larger. You must sell to get back to the same value at risk. It's also worth commenting on financial product innovation. Today's markets bear no resemblance at all to those in which Graham and Dodd would publish their book,

[00:10:18] Security Analysis, in 1994. The TQQ, robotically delivering three times the daily return of the QQ, wasn't around back then. But on the three days of April 7th, 8th, and 9th of 2025, this beast saw a combined volume of 1 billion shares. Predictably, it rose by just about 36% on April 9th when the QQ soared by 12%.

[00:10:46] Imagine for a moment being the portfolio manager for TQQ, coming back from lunch on April 9th, and seeing news of the 90-day tariff reprieve. It's going to be a busy afternoon. Everything seems to have made it through this vol storm intact, but we must appreciate the manner in which products themselves can amplify market moves. Scott Besant would seem like someone with a fair amount of financial plumbing experience

[00:11:15] and an appreciation for the reflexive nature of markets. Once ignited, a financial fire takes both capital and will to put out. Mike Novogratz said during one Alpha Exchange podcast, quote, a crisis event will unwind at a pace that it wants to. I always took that to mean that you really have to respect the force of an unwind, and that policymakers sometimes may struggle to contain the damage.

[00:11:41] In Too Big to Fail, the amazing 2011 docudrama On the GFC, Hank Paulson, played so well by William Hurt, is hit by significant bouts of insomnia. He rightly recognizes that a crash is occurring on his watch. Along with Tim Geithner, also played very well by Billy Crudup, Paulson is playing risk whack-a-mole. There wasn't a risk-off that Geithner didn't want to throw the kitchen sink at.

[00:12:08] Scott Besant told us that leveraged players in the bond market are experiencing a, quote, uncomfortable but normal deleveraging. He would seem to appreciate the leverage in the financial system and how quickly out of hand these things can get. It took him too long, but Besant was finally able to channel more of Paulson and Geithner in recognizing that markets simply cannot self-correct when the forces of deleveraging are set in motion.

[00:12:36] My view is that he was dangerously close to overseeing what easily was on its way to becoming a real crisis. One of the risk indicators telling us as much was not just the surging VIX, but the VVIX as well. This is the measure that helps us quantify the cost of VIX options. On April 8th, the VIX May 35-36 strangle was quoted

[00:13:02] and the prices were an eye-popping 15.25 mid-market. Let's consider for a moment what that price tells us. Your break-evens at expiry are roughly 20 to 51. To get those, I am simply subtracting 15 from 35 and adding 15 to 36. I think most would agree there is a lot of room to make money on this trade at expiration.

[00:13:31] But at a time when the S&P was experiencing outrageous intraday swings and losses were fast accumulating for investors in various types of trades, the expiration break-evens were not at all what this trade was about. Being shorted to expiry is exceedingly difficult. It's simply the case that vols this high demand a giant distribution of potential outcomes. Vol and vol-a-vol are highly correlated.

[00:14:01] As things got more and more disorderly in the days leading into April 9th, for me, it became about trying to balance the inertia of the VIX and the recognition that unwind events can gather self-reinforcing energy against the unique nature of this particular episode, which, as noted, was self-inflicted. The tone-deafness of Lutnik and Besant notwithstanding, one had to believe that government officials were set to blink in some way.

[00:14:31] The scars from the market chaos of the GFC and COVID will always remain. Talk tough to the markets as you might. You simply wind up creating really difficult-to-fix but also urgent problems when markets malfunction. On April 6th, I wrote that I was in the camp that we were setting up for a nicely tradable reversal of unsustainably high VIX levels. As always, calling a top was impossible,

[00:15:00] and for me, it was not appropriate to outright short VIX futures or VIX call options or S&P 500 implied volatility. Sure, the levels were staggering and eye-popping, but the policy incoherence was what got them there. How could one underwrite the risk of even more incoherence? But for me, the beauty of the VIX options complex is that it provides the ability to express

[00:15:27] a premium-contained view on vol going lower through various combinations of puts and one-by-two put spreads. When I say premium-contained, I mean you can spend a defined amount of dollars to play for a lower VIX, and should the system literally blow up, your loss is limited to that upfront premium you expended. About Fannie and Freddie, Bill Gross famously said in 2008 as the GFC was heating up,

[00:15:56] shake hands with the government and buy what they're buying. I always thought his very public campaign was brilliant on this front. In the days before April 9th, I thought there was a chance to shake hands with Scott Besson and sell what he'd ultimately have to sell, that is, the VIX. It was based on a simple but convicted view that the administration would not be able to execute on any policy with the VIX in the 40s and 50s for an extended period of time.

[00:16:26] A 50 VIX is a market moving 3-plus percent every day. That reflects an incredibly unhealthy risk-taking and most likely unhealthy economic environment. So the trade I liked best was some version of a VIX May 1x2 put spread. You're expending a little bit of upfront premium and playing mean reversion lower, leaning into the trade by selling twice as many downside puts as you were buying.

[00:16:56] Now, as you know, no free lunch is the cornerstone of my view on markets. They are damn efficient, and as the grifters tell you otherwise, just ignore them. My 1x2 put spread carries two risks. First, I am spending some upfront premium to implement it. I could lose that if the VIX goes to 100. Second risk is the opposite one. That is, if the VIX collapses, which it kind of has. Because I'm short two downside puts,

[00:17:25] at some point, the reversal lower in the VIX starts to hurt me. Let's briefly look at these two trades, both implemented on April 7th. The May 40-30 1x2 put spread could have been put on for 1.2. Here, I'm buying one May 40 put and selling two May 30 puts for a net premium of 1.2. Your break-evens at expiration, repeat, at expirations only,

[00:17:53] are 21.2 and 38.8. Boy, that does sound good, but it's a long time to wait, and a lot can and has changed. The current mark-to-market price of this trade combination is around 1.75. A good trade, but we already have May VIX sitting here at 23.5. The net delta of this trade is actually now very positive. That is, if you have this on,

[00:18:23] you're actually rooting for the VIX to go up, not down from here. Remember, your best outcome would be for the VIX to finish at exactly 30. Let's now instead look at the May 30-25 1x2 put spread. This came right around even money on April 7th at 7 cents. It closed at 85 cents on April 25th. This, too, has a currently positive delta.

[00:18:52] The best case is the VIX hangs out in this current neighborhood and finishes at 25. These trades are very difficult to hold to maturity, and monetizing them beforehand mostly leaves investors some version of frustrated, angry, and railing about how the VIX market-making crowd picked their pocket. For those who have this on, it's not a terrible spot to try and take some profits. A driving factor behind what motivated this trade idea for me

[00:19:20] was the sky-high level of the VIX. In doing the 1x2, you were leaning into the generous option premium the market paid you for the far-out-of-the-money put on April 7th via the inflated level of implied vol of vol. The VIX closed below 100 on Friday, April 25th. Incredibly, at least to me, is that this is basically the same level as it closed on February 19th

[00:19:48] when the S&P was at its all-time high. The current level now suggests that the outrageous level of realized vol of vol experienced over the past several weeks is very much behind us. I am sympathetic to that, if only because that's a tough comp as much of this discussion has already highlighted. Well, where do we go from here? I'm afraid plenty of damage has already been done. Folks as old as I am

[00:20:17] will remember Gilda Radner and the, quote, never mind bits of Roseanne, Roseanne Adana on SNL. We've got two of these in the past two weeks, April 9th and more recently the nah, I'm not going to fire Powell. We've likely moved past peak VIX, 50 being a difficult comp. In its aftermath is an overhang of uncertainty that may hamper critical decision-making. To be sure, the earnings engine of the S&P

[00:20:46] has been formidable. At every turn, through all kinds of uncertainty, corporate America has delivered the goods. But I see plenty of lingering uncertainties from the uneven communication from the White House, from the unpriced reactions of our trading partners, and from how the market will need to price in the potential economic and corporate profit fallout from the last several weeks. And some part of this is a function of the reality that, quote, never mind,

[00:21:15] isn't really possible when it comes to markets and policymaking. The inconsistencies, start-stop, and general incoherence of the strategy matter deeply. In my most recent podcast, Matt King, the founder of Satori Insights, did a wonderful job of laying out the components of the strategy that have reared off course. There's no crying in baseball. There's also no takebacks in international trade policy. Almost 40 years ago,

[00:21:44] Billy Joel sung to us that it's a matter of trust. He had personal, not trade relationships, on his mind, but it's an apt statement about the risks that linger from the last few months. To recap, I, like Scott Besant, do believe Peak Vicks is behind us. But unlike him, I do not believe this is a Mag-7 problem only. Besant should follow the advice of one of his predecessors, Tim Geithner, who often said, plan beats no plan.

[00:22:14] Markets and trading partners are asking, what's the plan? I think the evidence is mounting that there really isn't one. And if that is indeed the case, the Mag-7 problem is a MAGA problem as well. And here, markets are vulnerable to an ongoing overhang of crippling uncertainty. Let's finish this discussion with two assets I've advocated for strongly over the last several months, gold and Bitcoin. I've done a number of podcasts on both

[00:22:44] and I think the thought process is sound and the analysis still highly relevant. Hit up the Alpha Exchange on Apple or Spotify and have a listen. As we sift through the asset price rubble and as the market seeks to get back on its feet, we can glean a good deal of insight from the behavior of gold. It has shined, to say the least. It has emerged in spectacular fashion from what I think we might describe as a branding exercise, a financial markets taste test,

[00:23:14] if you will. Over a two-month period from February 19th, that being the S&P high, to now, how have sister assets behaved on a relative and absolute basis? This is a period when the VIX reached 52 and the S&P had a max drawdown of 19%. Since Feb 19, the S&P is down 10%. The TLT is flat and the dollar is down 6%. Gold is up 12.5% and Bitcoin is flat.

[00:23:43] If we look at a more narrow slice of time, since April 1st, the S&P is down 2%, the TLT down 3%, the dollar down 4%. Gold is up 6% and Bitcoin is up 12%. About Bitcoin, Mike Novogratz also said, it has value because we say it has value. In a fiat system with more than enough U.S. debt floating around the world, we've come to believe the same about both the dollar

[00:24:13] and the large pile of U.S. treasuries already printed with many more to come. The dollar and USTs have value because the world has decided so. While there are powerful reasons to believe this, nothing should be viewed as permanent. The recent period has been a totally unforced exercise in negative branding for both the dollar and the U.S. government bond market. For the VIX to run to 50 and duration not to rally is a bad outcome,

[00:24:42] amounting to an asset price taste test that went poorly. The TLT fell by 3.4% even as the VIX more than doubled, increasing from 22 to 53 from April 2nd to April 8th. Market prices reflect the experiences of investors. This was an unpleasant one for anyone who thought the bond market was there to provide a flight to safety. Gold's ascendancy was some part about its negative correlation to the dollar

[00:25:12] and some part of the manner in which it serves as a placeholder for investors needing to express their view that, quote, all is not well. It, of course, like Bitcoin, is a FOMO asset. I've likened it to a Giffen good with a positively sloped demand function. Folks chase the return. Gold also recently benefited from Trump's truth social rant against Powell threatening to fire him. Even adjusted for Trump, many found this

[00:25:41] unsettling. Trump's tweets are a component of the branding exercise that has taken place over the last several weeks. It's one that leaves disciplined assets like gold coming out very strongly. As earnings season is upon us, gold will host no quarterly earnings call. It has no management team, no guidance to offer. It has a brand that by virtue of the messy start-stop of international trade policy and the unruly back end of the bond market is strengthening

[00:26:11] by comparison. While Trump is backed down from the intense broadside on Powell, we should remember that Besson has talked about a, quote, shadow Fed. In a recent Bloomberg interview, he suggested they'd start looking at new Fed shares in the fall. It's hard not to see the Fed's independence subject to increasingly overt challenges. This is just one component of an unfortunate U.S. risk, the erosion of governance. It's not one we can easily

[00:26:40] and readily measure, but it's in plain sight amidst a potentially weakening economy and a mountain of debt at interest rates that look nothing like they did five years ago. The ratings agencies, never anyone's favorites, I do realize, are paying attention to our capacity to effectively govern ourselves. Here's Fitch from its August 2023 downgrade of the U.S. sovereign. Quote, the rating downgrade of the United States

[00:27:09] reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to AA and AAA rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions. Unquote. From Moody's November 2023 outlook change from stable to negative, quote, continued

[00:27:39] political polarization within the U.S. Congress raises the risk that successive governments will not be able to reach consensus on a fiscal plan to slow the decline in debt affordability. As you know, I've been a huge advocate for gold exposure with two trade constructions. First, simply having some delta exposure. It has been a consistently trending asset with low volatility and low correlation

[00:28:08] to the S&P 500. As uncertainty started to mount in the markets, I saw a second trade in gold and that was the very long-dated, very far-out-of-the-money call option. The logic here was that we had not yet experienced a true stock-up, vol-up event in gold, but that there was scope for it as the tariff uncertainty increased and as the fear-of-missing-out aspect of gold started to really kick in. The December

[00:28:36] $375 call that I advocated for buying for around $1.3 got to around $7 in premium and is now closer to $5. With both nevermines, the tariffs, and the fire-pal threat, the near-term upside tail outcomes for both gold and Bitcoin would seem a bit lower. So the far-out-of-the-money call option plays resonate with me a bit less now. That said, these assets look quite disciplined, set against

[00:29:06] an unpredictable policy backdrop and continue to deserve some allocation in the portfolio. Having had an amazing run in gold, I'd be a little smaller now. But simply put, gold and Bitcoin are different. They represent not a vote for, but a vote against. Against an absurd last month in policy and as a result in markets. Last point before I let you go and that is on one of the most prized possessions in the U.S.,

[00:29:35] our bond market. If there is one thing you can count on in addition to death and taxes, it's sizable auctions of U.S. government bonds. And it's not to be an alarmist, but simply to state that these auctions must clear for the United States to run. And the auctions do clear. There remains large global confidence in our debt. But when folks like Stephen Mirren, now the head of the Council of Economic Advisors,

[00:30:03] even socialize ideas like user fees on foreign holders of U.S. Treasury securities, or encourages the exploration of terming out of debt as a way of offsetting a perceived overvaluation of the dollar, the knock-on impacts could be more than unpleasant. White papers might remain white papers, but they may also become socialized enough as to make their way into how investors price distributions. A recent Odd Lots podcast featured a

[00:30:33] Virginia law professor and was entitled quote, How Trump Could Restructure the U.S. Debt. I think it's safe to say that restructuring does not involve giving our existing lenders a better deal. I've said this before, the U.S. 10-year note, not the S&P 500, is the risk asset. The real financial tail risk, i.e. a resurgence of a spiral higher in the VIX, would seem to lie in the potential that long-dated U.S. Treasury yields

[00:31:02] rise quickly. From a contagion standpoint, the 10-year note is the vulnerability. It's not being treated as such. Well, that was a lot. If you've got this far, bravo. These are beyond interesting and important times in markets and the global economy. I am thankful for your interest in the Alpha Exchange and I hope you have a fantastic week. Until next time. You've been listening to the Alpha Exchange. If you've enjoyed the show, please do tell a friend.

[00:31:31] And before we leave, I wanted to invite you to drop us some feedback. As we aim to utilize these conversations to contribute to the investment community's understanding of risk, your input is valuable and provides direction on where we should focus. Please email us at feedback at alphaexchangepodcast.com. Thanks again and catch you next time. Thank you. Thank you.