Patience: Long Dated Vol will go down, the curve will flatten

Patience: Long Dated Vol will go down, the curve will flatten



In all asset classes, we see the same thing, short dated vols are crushed as the market can’t seem to break out of this low correlation upward drift.  It is the max pain path as everyone loaded up on short dated gamma as it “looks cheap”, except all it is doing is getting cheaper and causing option players to re-think continuously what delta they wish to hold against the cheap baby calls they are long.  This is no easy matter, the upward drift pnl loss is real, the OTM call option gain is a combination of marks.  Gamma and short dated vega is littered all over the street on dealer books.  As nothing happens, it is being puked out to avoid paying anymore theta and we should get a move when they finally decide to get short it.  


1. Interest Rate Vols







2. Recently steepness has picked up, giving long dated vol sellers a great entry point

3. Forward Vols Implied are also very high


4. Term Structure is also at extremes

Could we be entering a 2004-2007 low volatility world? All the graphs say yes, but you have to look a little further back in history, otherwise they are all screaming BUY

Could we be entering a 2004-2007 low volatility world?  All the graphs say yes, but you have to look a little further back in history, otherwise they are all screaming BUY



While everyone is focused on what will happen with Greece, specifically the March 2011 bond, the risk on world seems to have looked passed the drachma drama.  Yes, we may have a few bumps along the way, but money is looking for a much riskier home these days


1. High Yield Spreads have come down really fast


2. Large disconnect between credit and Equity - this is more due to the fed then natural forces to keep cheap money around for a long time




3. Even PIMCO’s Bill Gross has leveraged PIMCO to hold bonds and MBS.  A full 180, but also viewed as short vol trade



4. Does anyone care about the Euro Danger?  Vol has dropped really fast, skew however has not, currently in about the 85th percentile.  Protection via tails is getting expensive again.

5. No demand for term structure for the front months.  Record spreads over the last year.  So why does no one “need” vol for anything imminent?  Is the market simply trying to move vol demand forward and into lower strikes with Euro Bailouts?


6. The risk EM/DM/VIX world also screaming to buy vol?  But wait, look to your right and you can see that before all the Euro Drama, the 2004-2007 vol world, post Dot-Com and World Com, the vol markets did nothing for 3 years! and risk on was “ok”



7.  Everything is saying buy vol if we just focus on the last 12 months?  Is the risk on rally finally sending a message to the vol world that things are going to be fine?  
8. According to UBS, global asset class vol viewed in a distribution format shows just have far vols have dropped.  So this is not just a VIX story, in fact risk on this YTD is everywhere, except USTs, as the fed is keeping ZIRP 2014 and keeping the back -end kink in check to get people back into the housing trade (twist) - Remember this includes the risk-on in EUROPE, yields have fallen, buyers have shown up to buy bonds and European Banks stocks have boomed.

9. If we widen the horizon, look at post 2003, is post 2011 going to be the same?.  Most people are looking at these graphs post 2008 and come up with “vol is cheap”



10. Interest Rate world sending same message - Long dated vol is to high and the story is the same, short dated vol smashed, long term vol has very little supply or courage to push it down.

We continue to believe that long term volatility is very overpriced, probably has a few suppliers and holding term-structure trades are the best way to position for the current environment.  No one has any edge over the Euro headlines, as they flip-flop and shake people out of positions.  However, we cannot ignore the massive flow into risky assets and markets making large bets that long term vol will go lower.  Everyone is waiting for a “whale event” to feel better about selling vol, we are not sure they are going to get it or long vol holders will get the expected outcome.

Technically Speaking

We typically don't look at charts for our vega book, but this is interesting as we are showing a 2 for 1 payoff at current spot.  The market is fully priced for perfection.

With the current boom in spot with a boom in vol, we believe a serious payoff is in store for short vol, short delta.  We understand at the recent lows in vol, the marginal buyer will set the price as supply will simply vanish.  However, it seems both cash and vol have over-extended.

Why am I not long Apple? Take risk, it’s ok. Buy upside calls and dump your longs.

Why am I not long Apple?  Take risk, it’s ok.  Buy upside calls and dump your longs.




You are probably reading this because you are not long apple, short the market or pulled your money out - our recent market survey confirms to us the continuation of equity outflow data.  Everyone is bearish, neutral and upset.  Small volume rallies continue to move the marginal price higher.  What feel’s like an amazing rally, is in-fact only taking the vapour out of recent fear that was priced in.  The equity markets maybe a touch ahead of themselves, but as we will see from the charts below, still plenty of upside is left.



People simply don’t trust the market and have piled into bonds.  PIMCO’s Bill Gross has even leveraged PIMCO to hold bonds and MBS.  A full 180.

It’s hard to take risk when see pictures like this below, markets seem to be over-extended and risk premia to low.  This is why we feel it’s better to hold upside calls Still plenty of upside left.

Taking ⅓ off the table: Party Continues, we are sneaking out early.

Taking ⅓ off the table: Party Continues, we are sneaking out early. Also a look at the PFG VIX Model vs VIX Futures



We are going to unwind our second ⅓ of our gamma fund and keep our vega fund the same, currently with average short vega of duration of 2.5y.

Fund Changes by 1/3	YTD Performance
XFN/XLU	14%
EEM/SPX	7.5%
Long/Short	5.3%
Bond	2.7%

Our thesis continues to be the same, we still believe in the positions, however still want to keep bullets in our pocket.  A couple of points

• The rally is so narrow and only paying the beat up stocks of 2011.
• Correlation has collapsed, Long/Short funds are finally getting paid
• Bad to mild news continues to fuel a income targeting rally
• No one is bullish

We are now ⅔ cash, ⅓ is still invested in our gamma fund and our vega fund is unchanged with a thematic short vega position.  Both funds are in positions of strength, taking out healthy gains in January and well funded to add good risk/reward trades. If correlation is a guide and we are moving towards any sort of normality, we expect our PFG VIX Model to be a good guide for us.

Taking ⅓ off the table: YTD Performance and Visual Recap of Global Volatility Levels

Taking ⅓ off the table:  YTD Performance and Visual Recap of Global Volatility Levels



We are going to unwind ⅓ of our gamma fund (gamma will also expire tomorrow) and keeping our vega fund the same, currently with average short vega of 2.5y.

Fund Changes by 1/3	YTD Performance
XFN/XLU	12%
EEM/SPX	4.2%
Long/Short	2%
Bond	2.6%

We learned last year, moving in thirds was the best way to enter and exit into positions.  Our vega fund has performed well YTD (approx 2.3 vega points) and we continue to believe in lower long term volatility.

Our gamma positions that expire tomorrow were the worst performers (-2%) as it would have been cheaper and easier to simply buy dips and not pay 13 vol, what proved to end up realizing ~ 8 vol close to close.

1. VIX drifted downwards and is now below 20, we see some value in owning short dated gamma from a risk reward basis, however best left to single stock pickers, rather then SPY.  From this 5 year graph below (right to left) if we are entering the ever feared 2004-2007 vol world, things on the vix can get a lot worse.


Globally, from the Sept highs, long dated vol has collapsed on average 10 points


2.  We are removing ⅓ as we believe we still have plenty of performance left in our trades, but we want to keep a bullet to add more.

Back of the Napkin: Why are stocks being chased? US Stagnation is forcing risk into portfolios. The market will sell-off on good news

Back of the Napkin:  Why are stocks being chased?   US Stagnation is forcing risk into portfolios.  The market will sell-off on good news

Most folks are now in mild agreement that the US is looking a touch better internally and the best of crowd externally.  The demand for USD$ assets has continued and the money has poured right into risk assets, with financials benefiting the most.

So the large question remains in the face of 100$ earnings this year, why is the market expanding the multiple it’s ready to pay in a bad macro picture?  Last year, it was happy paying 12.5X and now paying 13X?  Answer - you have nowhere else to go.  Money earning interest in the bank will not cover a single expense with a society being forced to take on income targeting.  This manipulation is gearing portfolios into riskier assets.  Whatever the chase, dividends, corporate bonds or beaten up names, you have three choices depending on your cash pile. Keep in mind, people are going into the "blue chip multinational dividend stocks" while the other names are suffering a lack of selling. Just 20 stocks accounting for 40% of the SP500 index rise

1)Large Pile of Cash
Pick your spot on the UST curve

2)Medium Pile of Cash
½ in UST, ½ in Blue Chip Dividends

3)Small Pile of Cash
Stocks + Continuing Claims

Because most folks are in situation 2) or 3), stocks will continue to benefit from US economic stagnation.  Gold and Financials are up about 9% YTD, EM Risk Out-performance 2.3% and risky duration is still flat over UST -which confirms investor 1) and 2)

This is not the first time we have seen the risk of losing money < risk of missing making money takeover, but this is now being superceded by individuals being forced to adapt the following equation

Savings + risk = income targeting


So how does income targeting get replaced?  Job growth.  This will remove the pressure for additional risk into the equation and the markets should have a healthy sell-off.