AK: June was pretty busy at Real Vision.
On top of two weeks of crypto coverage, every Tuesday we
released a volatility related piece.
A lot of you watched Mike Green interview a bunch of
different vol experts.
And as you’ve seen, the vol markets can get pretty
complicated.
One of our subscribers, Peter J, recently commented that
he was watching the Benn Eifert interview
and he said he understood about 40% of what they were
talking about.
And he recommended that someone at Real Vision break down
this video into simple terms
so everyone can understand. Well, that someone is me.
So today, we’re going to break down last Tuesday’s piece
When Volatility Markets Change.
It’s all going to go down on this week’s episode of Real
Vision’s The One Thing.
What’s going on, investors? AK here. Finance is a really
esoteric industry and volatility exemplifies that.
So, it’s a good thing we got Green and Eifert to help us
understand what’s going on.
So today, we’re going to figure out what a call
overwriting strategy is, who employs them, and exactly,
what do they mean for the market? Been Eifert has a PhD in
Economics and is the CIO at QVR Advisors.
He sits down with Mike Green to discuss the idea behind
the call overwriting strategy.
BENN EIFERT: So, take a pension fund that has 100 billion
dollars of equity assets.
And they implement a 20% overwrite.
So, they sell 20% of that notional in one month, call it
up the money call options, just to be simple.
So, they’re selling some equity exposure when they do
that,
because they’re selling some call options there at the
money. So, call it 50 delta.
So, when they implement that overwrite program,
they take their equity exposure from 100 billion to 90
billion on day one when they do that trade.
But then, that call option is a short term at the money
option. So, it’s very reactive.
It accumulates or de-accumulates equity exposure quickly
as the market moves. And in a sense, that pension fund
is implementing a rebalancing strategy. What it means is
the equity exposure rising as the market falls.
So, this is a call option that they’re shorting. And so,
the example where the pension fund moves up towards
its hundred billion dollar long target is as the market
sells off down below the strike price.
And vice versa, as the market rallies, that call option
becomes longer delta, the investors short it. And so,
the net delta, the net equity exposure of the pension
fund drops down towards the $80 billion threshold.
MIKE GREEN: So, just very quickly, just to make sure that
comes through clearly.
Effectively, what you’re saying is I own $1,000 worth of
stock, I write calls against $200 worth of it.
I write those calls and then at the money so that if the
market goes up,
I don’t benefit from the participation of that $200 worth
of stock.
But if the market goes down, I actually start to increase
my exposure,
I’m now back to owning all of the stock that I actually
owned, even though it’s just worth less.
BENN EIFERT: That’s exactly right.
MIKE GREEN: And the goal in doing that is quite noble.
I want to own more at lower prices, and I want to own less
at higher prices.
So, that doesn’t sound like a terrible idea.
BENN EIFERT: That’s right. And on the face of it, it’s not
an unreasonable thing.
AK: To what he’s saying is that these pension funds are
constantly searching for yield.
And these vol selling strategies are an easy way to
squeeze out a few more percentage points.
Now, Eifert explains that this isn’t a bad strategy on the
individual level,
but when everyone is doing it, it can cause some real
distortions in the market.
MIKE GREEN: The example I always give is, first of all,
put selling or vol selling strategies are functionally
like selling insurance. And so, I always give
the example of a beachfront real estate, and the existence
of the ability to buy an insurance policy on that.
So, the federal government subsidizes flood insurance and
catastrophic insurance for beachfront properties,
which in turn encourages everybody to build beachfront
properties.
You can obtain inexpensive insurance associated with it.
If you double the price of insurance, or you make it
unobtainable,
one of the things that immediately emerges is people can
no longer buy on leverage.
So, I can’t take out a mortgage to buy a property if I
can’t get insurance on that property. And so,
that has a catastrophic impact on prices because suddenly,
people can no longer finance their purchases.
That’s my biggest concern if this doesn’t continue to
grow, or if people suddenly start raising the risk
premium required as they recognize that this is not
working in the manner that they had been led to believe,
that suddenly, there is a need to reprice the underlying
assets because you can no longer obtain the leverage
that you could have when you could have bought insurance.
AK: Everyone selling calls makes it more attractive to buy
stocks, which keeps fueling the bull market.
This causes option prices to be too low and stock prices
to be too high.
And when prices get distorted like this, markets can get
dangerous.
MIKE GREEN: Paradoxically, the crowding into the
strategies has,
I would argue, enhanced the returns to this point.
So, people’s expectations are inflated even versus what
they would be in absolute terms.
And certainly, relative to the levels of these volatility
selling strategies are occurring today.
If you reverse those flows, or simply stop replacing them-
and that’s one of the things
that I think is so fascinating about this dynamic, is that
you’ve now created a market structure that,
by and large, is contingent. The behavior of the market,
as we see it today,
is contingent on the existence of these flows and
possibly, the increased quantity of these flows.
AK: You can really make the case that a lot of the stock
market’s gains have been predicated on this volatility
selling. That means when the music stops, there won’t be
nearly enough chairs for everyone to sit in.
Everyone’s going to end up sitting in Warren Buffett’s
lab, which could get pretty awkward.
So, what?s this mean going forward?
BENN EIFERT: We tend to take as a starting point the
notion that if there are large non-economic flows
in the marketplace, or flows that are driven by some basic
objective that the end user of options
and derivatives has, but that isn’t one that’s guided by a
nuanced view on the right price
for exactly what option or volatility that you’re probably
supposed to be on the other side of that.
AK: So, people are selling options for their own reasons.
And these reasons have nothing to do with
what the option should actually be priced at, then there’s
an opportunity for investors who do care.
Taking advantage though, is really complicated. So, on
Adult Swim stuff. But if they’re right, and the options
market and stock market are being fueled by these
strategies, then we can have a serious problem on our
hands.
People have a hard time noticing these structural changes
because they’re gradual. It’s like boiling a frog.
If you do it slowly, he’s not going to notice until it’s
too late. I don’t know. At least that’s what they say.
Personally, if I’m that frog, I’m going to jump out right
away and get my landlord a piece of my mind.
But if you think about the broader picture here, low rates
are driving people
into all kinds of different strategies, including this
call overwrite. It makes sense that this call selling
is affecting the market just like insurance prices boost
the value of beachfront properties.
So, if you want to better understand the volatility
markets and avoid being boiled alive,
like a frog in a Palm Beach McMansion, then make sure you
subscribe to Real Vision. I’ll talk to you next week.