The “Big One”(vol event) hasn’t happened yet

Chris Cole explains in this must read interview…The first thing to understand is that volatility is not just the left tail. It’s not just the world ending. One of the highest periods of volatility in history was during the Weimar Republic in Germany when they went into their hyperinflation. Vol went up to 2000%, all on the right tail. So you can have periods where there is a massive amount of volatility with higher asset prices.

A great example of that in recent history was during the Nasdaq bubble in the late 2000s. Volatility was actually averaging higher than where it is today and the market was going up and up and up. You had a 100% increase in the stock market during a period of plus-20% or more volatility. That’s pretty amazing.

You can have right tail and left tail vol. You just need movement. You need change. Vol is the profiting from change.

It’s difficult to explain our entire suite of what we do, but I can give some glimpses of the philosophy behind it. One aspect is you can never predict what spark will cause a forest fire but you can predict the underlying conditions that lead to a higher probability of a forest fire.

An example of that is that if you’re looking to gauge whether or not a forest fire is going to start in California (and the forest service does do this), you look at things like buildup of dry chaparral, high wind conditions, dry weather conditions, lots of lightning strikes. These things, when put together incrementally, increase the probability of a fire breaking out.

On the same vein, we can scan thousands of cross-asset global macro conditions and use those to probabilistically build an expectation as to whether or not right- or left-tail volatility will be
realized in any given asset class. That produces an ability for us to dynamically size that exposure when the probability of a volatility wildfire is greatest. That’s one of the most effective ways that we can do it.

Another thing to do is to use vol arb techniques. There’s situations where you are paid to own volatility – usually you’re just buying into a vol spike when term structures are inverted – is an example of that type of opportunity where you’re actually paid to own that convexity exposure.

There’s other situations where – I think in one of my papers I talked about this – the George Lucas trade where, when Lucas was making a space opera, which we now know as Star Wars, the studio came to him and he was given about a million dollar salary. And he said, well, you know, I don’t want a million dollars. Give me $150 thousand, but I want to own the merchandising and sequel rights to my new property.

Of course, we all know how that turned out. That $850 thousand option that Lucas bought by giving up his carry turned into about $46 billion. Not a bad trade. George Lucas was a very smart options trader.

In some aspects, when you have an opportunity to own some linear carry, you can recycle that carry into very powerful convexity exposure on either tail. And that convexity exposure, it usually takes a big move for that convexity exposure to pay out. But that’s an example of when you can carry volatility in an efficient way.

So it’s a combination of these types of strategies that enables you to own the optionality on change without the significant negative bleed.

Can you do this yourself? Boy, it’s tough. I mean, I’ve got a whole team of PhD data scientists and experts – we even have an Olympic swimmer on staff – it takes an entire team scanning a lot of data and working very, very hard on this one specific task.

So, yeah, you know what? Will you lose money buying VIX futures? Yeah, of course. That’s not a very smart way to do it. That’s why it takes a lot of hard work and a lot of experts spending a lot of time and energy and effort and upfront money to be able to find smart ways to carry long-vol exposure


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