After a brief chat with the local Gods (Patrick and Andrew), I thought I would host a Q&A for anybody interested in the life of a hedge-fund volatility trader. Brief background: * Undergrad: abroad so by definition a non-name school :) probably can be described as a double major in math and CS * Grad School: PhD in something or other quantitative, lot’s of math and lot’s of coding * Prequel to PMery: 15 years as an exotic derivatives market-maker, departed at director-level. * Summary: I am not very smart, but I can lift heavy things. I guess post your questions and I'll answer what I can.
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Can you please explain in layman's terms what's been going on with vol products in last several days?
A whole bunch of retail investors thought that selling volatility was a great idea. After all, they make money every day, what's not to like?
Initially they were shorting VXX (which is an ETF that buys a weighted mix of 1st and 2nd VIX futures). Eventually CS came out with XIV and, a bit later, Proshares issued SVXY. Both of these are (or, in case of XIV, was) "inverse volatility ETFs". Essentially, the ETPs are replicating the opposite position of what VXX has - a weighted basket of 1st and 2nd future with average maturity of 30 days. The mechanics are such that the fund manager holds cash and shorts futures to achieve the exposure. Since we literally had zero vol last year, these things became wildly popular, with multiple yards of NAV. More importantly, the futures positions that they held constituted a meaningful portion of the total open interest.
The way rebalance process works, the fund has to sell VIX futures when VIX futures are down and buy VIX futures when VIX futures are up. I guess you can see what's wrong with that picture. On Monday, VIX futures spiked intra-day causing what can be described as "event" in these ETPs. Essentially, if the weighted average between the two futures spikes above a 100%, the fund could lose more than the cash cushion they are holding. To protect themself from such an event (especially for XIV, which has the rebalance process contractually defined), they built in a trigger allowing them to redeem the note should they intra-day NAV cross a pretty low threshold. That's what happened intraday and, since they had to cover, they drove the futures even further. That awesome spike in the front two futures at the close? That was them.
The end result - from Friday, the two funds lost well over three billion. XIV is getting delisted. A bunch of people were long these things on margin, so they owe their brokers money. In short, BOHICA.
$3 billion. Someone's losing their job. Great explanation !
What are your thoughts on how XIV traded on Monday? Why do you think price collapsed in mostly after hours trading, and was there a narrow window to short XIV around an hour before close on Monday? If so, why didn't anyone take that short position, and if not, what was stopping them from doing so?
I don't think retail can cause moves like these. Its got to be algo driven.
what exactly does a volatility trader trade? just VIX futures? you probably also trade options...on what underlying? If so, Are you more often long or short options? What is your bread and butter structures that you watch and trade?...i'm assuming there are a few things that you track and trade more than other things.
its common knowledge that most options expire worthless...so i'm assuming that you are not just buying puts or calls and making directional bets on the underlying...so what is your strategy?
The way the hedge fund business works, a portfolio manager is given a mandate which specifies what to trade and the accompanying risk parameters. Mine is to trade volatility products across all assets classes. Also, the expectation is that net-net I will be mostly neutral in terms of overall exposure. A the moment, I trade equity vol (VIX futures and options, ETF options, various corporate products), bond vol (options on bond futures) and FX vol (in options on FX futures). I try not to touch stuff that’s highly contextual since it’s easy to get fucked (e.g. I don’t trade oil futures options). I also avoid trading OTC, since it’s a pain to execute and could be tricky to get unwind.
The general idea is that if you are trading volatility via options, the idea is that you buy or sell an option accompanied with a delta hedge. That gives you exposure to the “volatility” (well, it’s more complex, but that’s beyond the scope here). My stuff is mostly systematic, but I don't really have a strong short or long volatility lean. So, I try to more or less balance exposures in my portfolio so a day like yesterday would not hurt.
Thanks for doing this!
You mention you have a coding background, what types of languages or software do you use? Are many of your tools proprietary to your shop?
You mention a background of exotic market making, but you avoid OTC/bilateral execution. Certain shops can have an axe to grind on various names/indices, why avoid that source of liquidity? Counterparty risk not worth it?
What type of exotic instruments did you trade back in the day?
Do you have a standalone strategy in it's own vehicle or are you part of a multistrat for a larger fund? Do you just speculate on vol or do you have a risk overly/hedging function at your shop as well?
Lot of questions, feel free to cherry pick what you feel like responding to. Thanks for the time.
Thank you for numbering the questions :)
Most of my coding is in python. I used to do a lot of R, but migrated to python over the years. For stuff that’s more latency-sensetive, I use C++. Truth is, I am a crappy programmer and I could improve there. Most people solve this problem by hiring someone.
Ah, the layoff business. In some types of trades, being a layoff counterpart for dealers is a profitable business. In most cases, however, it’s the type of stuff that I would not touch with a barge pole. For example, recently, a lot of banks were short high strike skew in VIX and were looking to lay off this risk :)
You name it, I traded it. From simple DOP/UOC barrier options to knock-out forward variance swaps to multi-year variable annuity hedges. It’s less fun than it sounds.
I am a part of a multi-strat fund. That’s all I do, mostly vol arb and dabble in stat arb, as the two kinda compliment each other. No hedging/risk mitigation, even though it seems like a few vol traders I know have this type of role and like it a lot.
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Rates are rising, so lets zoom in onto bond vol.
Lets say you think bond vol will increase, so you buy OTM puts on bond futures (maybe the 145 strike on ZBH8), and then go long some % delta hedge of actual bond futures to make you delta neutral. You are now long gamma, and more importantly, theta (time decay will bleed against you). How do you immunize against the theta bleed?
A 1x10 put spread
i may not be an options trader....but i know this is not helpful...
Would you want to do exotics market making again?
Has the market making business changed since you were doing it?
Could you elaborate a bit more on the areas you like to play in?
For example do you do much cross-asset stuff? (I know a guy that likes to ‘borrow’ FX smile in JPY 3-5 year and ‘lend’ that in rates smile.)
Since I restrict myself to the listed products, my maturity horizons are pretty short and I don’t really do the type of stuff you describe. It’s a tough business unless you’re plugged into the flows and it’s easy to get run over. My primary reason for staying away is that most of these trades are explicitly or implicitly short risk premium. Like the trade you describe is primarily driven by PRDC risk and can be very painful to hold when the going gets tough. It’s the same reason I don’t get involved in volatility layoff business.
Thanks for doing this.
How do you measure your total risk? VaR? Some other way? I'm so used to just thinking of AUM and then levered AUM
I am pretty risk-averse, especially a fair share of my compensation re-invested into the fund. Since this is a marathon, not a sprint, it's better this way. So, for my personal use, I look at a whole bunch of things - from name and geographic concentrations to a few types stress-tests and such stuff.
I have been trading vol in a couple asset classes (Eq Index, Commodities, occasional bond ETF). 2017 was so easy it and I was conservative but it paid off this week I got through this VIX spike a couple percent positive even though I was short volatility (not by much and not during the worst of it). I currently work at a FI asset manager creating software for PMs but would like to spend more time trading options.
Do you think it is possible to make a living trading your own money or are the resources of large firm necessary? I don't have the typical target pedigree so I don't think any one would take me on as even an analyst.
Any other advice you think is relevant?
Thanks for doing this, I am a Interest Rate Option MM in a well known prop shop. Few questions:
Totally fine if you are not allowed to answer those, but I am curious to see how another vol guy looks the market.
Do you trade OTC or listed options?
What kind of background are you guys looking if you hire an new/experienced guy?
How about a guy with IT skills and loads of enthusiasm :p
For someone starting out as an options market maker, what does the path look like to moving to a hedge fund? Is it possible to make a direct jump to the right type of fund?
Thanks a lot for your expertise!
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Technically I'm an electronic OMM, but I also run liquidity taking (rather than liquidity providing) strategies.
trading vol is only fun when premiums are fat and the you can sell it all day long usually right after a catastrophe. Buywrites are my personal favorite. Otherwise buying vol is a sure way to the poor house 9 times out of ten. It's very difficult to time. People that say they timed it well, just ask them how much premium they pissed way in the years prior. Think of vol trading like trading credits you buy credits / sell vol when markets in utter turmoil and the sell credits and do nothing in vol as markets rally.
What do you mean by trading credits?
Credits = corporate bonds. Fixed income. Basically, volatility is like a yield, higher vol = higher yield to a seller of vol. Similar to credits....lower bond prices = higher yields. Buy low sell high.
How do you structure your buywrites? At what strike and implied vol does it make sense for you in this current environment?
That’s not the type of vol trading I do, my mandate is to do relative value in volatility across assets. It’s a harder game but it does not lead to the “poor house” as much as outright positioning in volatility can (and eventually does, for a lot of people). I rarely take non-systematic positions (this Monday was a notable exception) and I almost always never get naked long or naked short (in risk-premium terms) unless it’s a day-trade.
I would have thought relative value was still directional in something, so not sure how it doesnt lead to the "poor house" as much?
So how does someone learn about statarb and volarb? Is it something that you only understand by gaining screen time / doing a PhD on such a topic or are there books on these too?
Also can someone invest mostly in bonds and use the interest gained to buy OTM puts and calls on a security for cheap to profit from a movement in the underlying asset in any direction? Well yes the notional amount has to be very large to generate significant amount of income from bonds to invest into buying OTM options but theoretically is that possible? Or will such a strategy just bleed too much money?
Also would love to hear your thoughts on Nicholas Nassem Taleb and his theories.
I'm not an options expert by any means, but you should look into put-call parity and possibly use that as a base for how to think about options.
OTM puts and calls on a security are cheap because of market expectations of future volatility of the stock; if they're cheap, it's because the market does not believe that those options are likely to be worth anything anytime soon.
If you want to profit from a move in the underlying asset in any direction by buying calls and puts, what your inherent assumption is that the market implied volatility of the asset is too low, and that realized volatility will be higher. As assumptions go, being long vol and long black swan events is not the worst thing to be; it's just that your payoffs are large but unlikely, and you'll bleed money until you reach that payoff.
That's all I think I know. I'm interested in hearing what people who do this for a living have to say.
I'm a college senior majoring in Math and I signed an offer to work at a bank on their FX team next year (possibly options after the rotational year, possibly not options). What should I be doing over the course of the next five years if eventually I want to be a volatility PM?
On a serious note.
(a) After the initial "sponge period", you are going to be disappointed - most people on the sell-side have little clue on how to extract alpha. Also, do not mistake your flow for alpha - that happens to dealer-side traders a lot. Be very objective - e.g. if you run a prop book on the side, make sure to put trades there at realistic bids/offers.
(b) Try to gleam more about what your clients do. Record when they trade and how they quote. Try to figure out how they make their decisions, when did they take, when they passed. Go to client meeting and listen to what they ask, that might give you a clue on what they do. Try to hang out with those people socially, you'd be surprised what you can learn over a beer. Even if you learn nothing, they might want to hire you eventually :)
(c) Read research, from your field and from other fields. The more you read, the more you will be able to leverage.
(d) Try to move to the buy-side relatively early on. It's a different skillset. Your best bet at eventually becoming a good PM yourself is working for a good PM.
Is it common for people to move from the buyside to sellside?
Any tips for someone wanting to move to the buy-side early on (from a sell-side vol/macro desk)?
What books have become an essential part of your reading list? Also any book that has influenced the way you think about the markets?
If you are just started, there are a couple books that are worth reading (besides Kama Sutra, that is). Stuff written by Euan Sinclair and Rob Carver is pretty good.
Thanks for the reply. I am reading Euan Sinclar currently and will look into Rob Carver.
Thank you for doing this. One simple question.
For someone who wishes to end up in your position, a Volatility Arb PM, would you recommend that he gets the sell-side market making experience, say 4 years worth?
Sorry for sounding pedantic. Which is better:
a) 1yr Masters in Finance, 2yrs of sell-side experience
b) 3yrs of sell-side experience
I have a target school STEM degree.
So say you go to a top options MM shop out of school, and you do well. What kinds of things would convince you to leave that position to go to a vol hedge fund? How different is the way you look at solving problems and creating trading opportunities?
Hi Mostly Random Dude. Thanks for doing this. I'm an analyst on a sell-side macro volatility desk. I've been curious to ask a few questions to someone such as yourself:
Do you think there is positive expected return from selling "volatility", or does it only appear that way because tail risk is difficult to observe? Is the answer different for short gamma, short vega, or selling vol swaps?
What sort of IT investment is needed to trade volatility on the buyside? Can you buy risk and other systems off the shelf or do you have to build them in house? (I realize the answer may be different for someone such as yourself who's more systematic)
When you were a market maker, did you trade cross-asset vols like you do know? If not, how did you develop that skill?
I'm also interested in the answer to this. I can understand that the proprietary technology would come from the banks. But having worked in two sub US$1b HFs, I always thought it was more efficient to buy the IT set up from third party vendors. In both HFs, they hired an IT team to do it.
If I had to start a HF from scratch, I'll hire 1 CTO, buy the IT set up and have him manage the programs. Instead of hiring like 4 IT staff.
really depends on what you need/want to do. Calculating the greeks has been solved.
On a lighter note, when do you put water on your brush before or after putting toothpaste?
this is a trick question...doesn't everybody do both?
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