Tagged: Swaps

Swapping Volatility

Google chose as motto “don’t be evil.” “Beware derivatives” isn’t a bad motto either.

If you’ve read the MSM long, you know we’ve beaten the drum like Boneshaker (when you hear the sound of the drum, here we come) over the risk in derivatives.

Oh please, Quast.  Can’t we talk about something more interesting, like the molecular structure of Molybdenum?

Do you want to know what’s coming, public companies and investors?  We’ve now been warned twice.  I’ll explain.

Before that, this: Recall that we said the market could take a beating this week because of derivatives. A raft of major banks have reported combined damage in the billions from bad derivatives bets by one hedge fund, Archegos Capital.

And VIX bets hit today.  Volatility bets blew up another fund.  Warning Signal No. 2.

Gunjan Banerji wrote about it yesterday in the WSJ (subscription required), admirably explicating the complexities of variance swaps.  The Infinity Q Diversified Alpha Fund shut down.

Diversified Alpha, a mutual fund marketed as a hedge fund for the masses, had roughly $1.75 billion of assets at last word.  The fund aimed in part at volatility strategies.  It said:

“The Volatility Strategy seeks to profit from the mispricing of volatility related instruments across equities, currencies, bonds, interest rates, and commodities markets. These instruments include options, variance swaps, correlation swaps, and total return swaps. The Strategy invests across a wide range of time horizons and takes long and short positions in the underlying volatility instruments.”

The fund went broke betting on volatility – mispricings.  That’s two in short succession.  Diversified Alpha filed its plea with the SEC Feb 21 to halt redemptions. Right after February expirations. Archegos Capital went belly-up with March expirations.

Much of the money in equities trades mispricings. That’s what ETFs do (ETF vs a basket). It’s what Fast Traders do (one price vs another). It’s what derivatives traders do (stocks vs options).  Those behaviors are roughly 80% of US equity volume.

These disasters you describe, Tim, are isolated to leveraged outfits.


Here’s the SAI for the Blackrock Technology Opportunities Fund. I have read a great many SAIs, a reason I’ve in the past highlighted risks, especially for Exchange Traded Funds.

On page 3 is this: Only information that is clearly identified as applicable to the Fund is considered to form a part of the Fund’s SAI.

Then follows a table, with X’s by what applies.  See page 4, the derivatives section. Derivatives for hedges and speculation apply.  Credit default swaps, interest-rate swaps, total return swaps, options on swaps, on it goes.

I’m sure it’s a small part of this fund’s assets, used within rules to true up tracking or remediate some of the unremitting volatility that’s been seeded in all financial instruments by vast artificial quantities of money and low interest rates. But read the SAI on your favorite fund. What’s it say?

By the way, volatility in stocks has plunged by 50% the past couple weeks. Almost like a tide going out ahead of a tsunami. Behind it in other data we track are vast swings in standard deviation between the prices of sector stocks and the ETFs tracking them.

That is, if we compile moves of all sector stocks and the average is a 1.8% decline and the composite average for sector ETFs is 0.1%, standard deviation is 625%.

It suggests to me that ETFs are substituting stuff that moves less than stocks – like swaps or IOUs of some sort, or cash – to get away from the error-inducing volatility in stocks.

But that could blow up derivatives predicated on a statistical equity basket. What the hell is going on?  Exactly.  That’s what I want to know. Something is wrong, and we’re seeing little fissures, seeping steam, wisps of ash.

We’ve long been concerned about these risks. But they’re like the way Ernest Hemingway described how one goes broke (a line I’ve used often): very slowly then all at once.

I’m not wringing my hands. Forewarned is forearmed. Investors and traders, it’s wise to get out of the pool around these things, which we observe in the data, and report.

And for public companies, it’s high time to make sure your executive teams realize risk resides beyond “alternative investments.” It’s everywhere. All around us. 

How central are Morgan Stanley, JP Morgan, Credit Suisse, Deutsche Bank, banks losing on Archegos, to financial markets from IPOs to Treasury Open Market operations?  Derivatives to equity and ETF trading?

It may be the cost of paying ourselves to sit out a Pandemic is the stability of our financial markets. We’re inflating everything including derivatives.  We can survive it.  In fact, it would do us good to roll around in the dirt and develop some resilience.

Whatever happens, we’ve got the data.  We warned EDGE users to be out by last Friday. We can tell you, public companies, if these instruments are large in your price. 

Everybody is swapping volatility. Beware.

Swapping the Future

Whole swaths of stocks moved 3% yesterday. You might thank Dodd-Frank for it, even if David Tepper gets credit (if you heard the Appaloosa Management founder’s interview you know what I mean).

To understand how, ever heard of a Rube Goldberg Machine? It’s an unnecessarily complex device for doing something simple. Cartoonist Reuben “Rube” Goldberg turned his own name into a rubric for obtuse machination with humorous creations like the self-operating napkin.

So your stock rose sharply for no apparent reason. Some will say it’s because David Tepper, who made $2 billion last year on a belief in strong equities, said on CNBC that “shorts should get out the shovels because they’ll be buried.”

But the answer to why your stock and maybe your sector yesterday moved, and how Dodd-Frank is a factor may be more like a Rube Goldberg Machine. MSCI global indexes rebalance today, and ahead of that we’ve seen surging high-frequency trading, telling us money is benchmarking ahead to equity indexes at newly higher rates. Options expire tomorrow and Friday, with VIX volatility instruments lapsing May 22, giving arbitragers better opportunity to pairs-trade.

And Dodd-Frank’s deadlines on swap-clearing rules take effect in June, so this is the last pre-central-swap-clearing options-expirations period, which set dates for swaps too.

Ever heard of single-stock futures? It’s a way to go long or short shares without buying or borrowing. There’s even an exchange called OneChicago owned by the Chicago Board Options Exchange, CME Group, and Interactive Brokers, for electronically trading these contracts where two parties agree to exchange a set number of shares of a given stock in the future at a price determined today. Also popular are Narrow-Based Indexes – futures contracts on a small set of securities, say, from an industry or subsector. (more…)

We were in San Francisco Sunday escaping the heat parching most of the country. Cool heads are better than hot heads, we thought. It was nice to need a sweater.

Speaking of needing things, there’s a flaw in consensus estimates. Consensus by definition means it’s the general view. But the general view reflected by estimates of earnings, revenues or cash flows comprises less than 15% of total market volume.

Across the market, we find that about 12.5% of substantive volume is what we’d call rational – driven by thoughtful investment derived from fundamentals. How can this be? Great swaths of trading today are driven by relative value – the current value of this basket of things versus that basket of things.

Somewhere around 30% of volume is this kind of trading that we consider program trading. It’s driven by market factors and relative value. After all, currencies that denominate securities have only relative and not intrinsic value. Should we not expect trading instruments to behave the same?

What’s more, some 65% of total market volume on average is just air created by the maker/taker model prevailing across global exchanges, in which we’ve all been fed this line of hooey that a massively mediated market is better for buyers and sellers than one with few intermediaries. When in the history of human commerce has it been more efficient to cut the middle man in rather than out? (more…)

Facing the Book Facts

My flight today to Cincinnati through Atlanta froze in the blizzard of lost travel dreams. Which proved fortuitous, as I was able to skip Atlanta and flight straight to Cincinnati, saving me five hours. I love blizzards.

Speaking of sharing personal details, Facebook is the biggest entrepreneurial deal of the current day. It’s also a focal point for the widening divide between public markets and growth enterprises. Facebook may or may not go public. If it does, much of its prodigious progress will already have been funded, and the public markets will serve more as a wealth-transfer device than a capital-raising tool.

It’s a microcosm for investor relations. Speaking of speaking, I’m at the NIRI Tri-State Chapter tomorrow for what I have assured my hosts will be a riveting exploration of how to be cool in an IR seat heated to silliness by transient trading. Hope to see you locals there, by sled, snowmobile or telemark!

Anyway, according to the stock-market newsletter Crosscurrents, the average holding time for institutional positions is now 2.8 months. “The theory that buy-and-hold was the superior way to ensure gains over the long term, has been ditched completely in favor of technology,” writes Alan Newman, its author. (more…)