Chris Cole on derivatives, volatility, market structure and regime change

Really enjoyed this Grant Williams podcast with Chris Cole. In fact, all Grant’s interviews in this series are worth listening to (more than once). There’s a lot of info I didn’t fully understand in this interview. Options and derivatives aren’t my strong point, but the interaction between these variables, volatility, monetary policy, macro and market structure fascinates me. I’ve made a few notes to figure out those areas where I need to dig deeper. I.E. This is more of a summary, than a strategic thought piece. It’s only relevant for investment professionals. I’ve added a few of my opinions and tried to denote them with “RP”.

  • Brief philosophical background:
    • Authorities have used the medium (money) to try and solve problems. Excessive liquidity provision has created the illusion of value, challenging the notion that value is independent of the medium / based on intrinsic value. No surprise that value strategies have been crushed.
  • Options market driving underlying:
    • Options are a way to place a speculative bet and are increasingly popular in a speculative world, where intrinsic value is less NB than liquidity and flows.
      • Call options are particularly popular now, which is uncommon but has happened before. Notably in the 1990s but options market was very small at that time.
  • Options should be the derivative of the underlying market, but the volume of the options market has now overtaken the volume of the stock market. Dealers are required to hedge the options (because they don’t want to take directional exposure). This creates the situation where hedging flows are bigger than underlying flows. One can argue that options are driving the underlying, which is perverse.
  • Volatility:
    • is a combination of liquidity and solvency. Usually insolvency leads to tighter liquidity and higher volatility. Fed has repeatedly injected liquidity, suppressing volatility but it cannot solve the solvency issue. Solvency is now terrible and obvious when you look at debt levels, CNI tightening, bankruptcies, etc.
      • So solvency is deteriorating and liquidity escalating. Volatility is being pulled in contradictory directions by these forces
      • For a long time, liquidity won out, dampening volatility. But It’s a delicate balancing act and liquidity is not solving the problem.
    • 2-wings of volatility:
      • Left-wing: insolvency and default where cash, bonds and high quality perform well
      • Right-wing: declining confidence in the medium where inflation becomes a problem and real assets and gold perform well.
      • Actual directional outcome is unclear (left vs. right). Its dependent on policymakers and the winds of social change. But both events are higher probability events as insolvency builds and requires more drastic correction
      • Right-wing seems inevitable at some stage but not ruling out more left-tail risk
        • Moratorium’s on delinquencies, evictions and student loans must come to an end at some stage and could cause a large deflationary shock when they do.
        • RP: NB to consider the impact of this type of shock on “riskier stores of value” like bitcoin. I would expect sharp bitcoin downside volatility during another global liquidity event (similar to March 2020)
  • Market Structure
    • Throughout 90s-2020 market structure characterised by expectation that Fed will lower rates and provide liquidity in response to volatility.
      • Created a mean-reverting market structure, which further dampened volatility. Buy-the-dip and take-profits were the smart strategies
      • Looking back in history, mean-reversion reached is low in the 1970s. Trend following reached its peak in the 70s had has been declining ever since.
    • We take the market structure for granted and forget that it can change.
    • Signs that market structure is already changing.
      • RP: Volatility hasn’t declined in 2020, despite massive liquidity and rebound in equity markets. I think we’re already in a higher volatility regime and I don’t think we’re going to sustainably fall back into a low volatility regime until there is a clear debt write-down.
  • Potential changes in market structure to watch out for:
      • Left-tail risk: Options can have a higher delta than 1 when interest rates go negative.
      • Right-tail risk: Fed cannot lower rates in response to volatility if inflation is rising.
  • Passive
    • Amplifies market structure because it basically a massive momentum strategy, buying more of winners and selling losers.
    • At some stage, passive will amplify volatility because its pushed active players out of the market who are meant to act as shock absorbers.
    • RP: need to dig deeper here, reread Mike Green’s worth and re-listen to his podcasts.
  • Conclusion/Opinion
    • I think we’re in the midst of a regime / market structure change, so I’m biased towards Chris Cole’s theories.
    • Debt, low interest rates, etc are unsustainable and must eventually correct. Short of a massive technological advancement and incredible real economic growth, the left/right tails are the only real ‘solutions’…
    • I believe that the regime change is already underway, as seen in volatility indices. I think there is value in being humble about the market structure 5/10 years’ time, and the correlations that might emerge. NB to think through the ramifications for institutions that dogmatically apply the investment approach that worked in the last 20/30 years.
    • The actual trajectory between left/right is uncertain. Yes, right-tail is probable at some stage. But it’s foolhardy for investment professionals to bet entirely on the right tail when the insolvency forces (left-tail) remain.
    • While there’s little chance of me changing my ultra-bullish bitcoin and gold outlooks, I am cognisant of the need to provide some deflationary balance. Gold provides much better deflationary protection that bitcoin, in my opinion, so that’s something I’d warn BTC maximalists of. Perhaps OTM call options on Treasury’s are required? Or perhaps some BTC profit taking is required, rather than ‘greedily’ waiting for $100K? I’m not sure I’m willing to see my worth drop 50%. What about you?

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