Derivatives is an asset class that has lost its relevance in terms of being an active Hedge Fund strategy, given how well modelled and priced it is now. Back in the 1980s, when most could not price let alone spell options, it was an area that saw massive profits for mathematical whizzes and quantitative boutique shops like O'Connor in Chicago.
I still remember the day when Black-Scholes pricing model was handed over to us rookies on the floor when most on the floor could not even understand the mathematical implications. Imagine standing with the Holy Grail of answers in your little hands, looking at the screens pricing in various calls and puts for stocks, and your mind salivating at just how mispriced they all were. If ever one wanted to play God, this was it.
Even if one did not understand how it was derived or the theory behind it, one just needed to stand there and lift offers and sell bids on the screens in line with your in-house proprietary cheat sheet. It was like stealing candy from children, in this case grown men, most of whom could not understand its mathematical complexity when pricing options.
As the news spread, big banks started digesting these smaller, sharper boutique firms. Today, that free money trade is gone as this market is very well understood. Spreads and margins have narrowed trading volatility. The only way to make money is by taking a view -- a real bet on intelligence and market making -- and managing risk.
Even though it is a market of less importance to most investors and traders, its relevance cannot be ignored. It is a huge market, way in excess of equities when taking into account over-the-counter (OTC) options, as well. Firms are long and short these options in size against their balance sheets and the risk metrics around their position dictates futures price action, as the indices are most affected.
Let's take a look at the S&P 500 index, for example. Recently, as the market has touched its all-time highs, instead of doing their fundamental homework, investors are caught in a state of greed, feeling a sense of FOMO (fear of missing out) and investing today at these levels. Classic market psychology: Never buy at the bottom when everyone is bailing. But rather than give a lesson in Psych 101, let's get back to the market positioning.
Most Hedge Funds and institutions run a long portfolio. One can't blame them, look at the performance of the past decade, with "buy the dip" mentality and the Fed "put" in place. To protect themselves, or rather show to investors that they have portfolio insurance, they buy downside puts against the broader U.S. and European markets. Needless to say, when things hit the fan, these puts do absolutely nothing as by the time price moves down, there is so much decay in the actual option that the fund manager loses even more money instead of making from it to protect against market crashes.
Big banks are the counterpart to this trade, as they are short these downside options. What this means is that when the market falls, they are even more long (I will leave the technical gamma explanation for now, but take my word for it) and they have to sell even more aggressively on the way down. Perverse logic?
The average investor has no idea how this works nor the technical implications of delta, gamma and vega metrics on market indices, but these impact the large-cap stocks, so they better try to understand, rather than just follow herd mentality.
In their defence, these funds are now questioning why pay any premium to protect their long portfolios if this insurance just costs them. U.S. indices go through a massive expiration four times a year, in line with their futures expiration. These happen in December, March, June, and September. This is when big positions get cleaned up. In March 2019, the amount of puts' open interest had collapsed. No one is long downside protection in the markets now.
The U.S. put-call ratio has hit a new low since last August. We can see this in the volatility index, as it is compressed to all-time lows -- implying outright complacency in the upward direction of equities. Option traders spent 30% more of their volume on bullish option strategies than downside ones.
In lay terms, what this means is that everyone is long equities and does not own any downside protection. This, at a time when stocks have broken away from their fundamental earnings revisions and trends, seems like an awful leap of faith. It is strange to be this confident and fully invested with no insurance whatsoever.
The contrarian in me cannot help but play the devil's advocate, but then the gambler in me can't help but take the other side of the trade, especially when the odds are stacked up so well.