UGO03: This Isn’t 2008. That’s the Problem ft. Benn Eifert

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[00:00:07] Intro

Welcome to U Got Options, an exciting series right here on Top Traders Unplugged, hosted by none other than Cem Karsan, one of the sharpest minds when it comes to understanding what’s really driving market moves beneath the surface.

In this series, Cem brings his deep expertise and unique perspective, honed from years of experience on the trading floor, to candid conversations with some of the brightest minds in the industry. Together, they unpack the shifting tides and underlying forces that move markets and the opportunities they create.

A quick reminder before we dive in, U Got Options is for informational and educational purposes only. None of the discussions you’re about to hear should be considered investment advice. As always, please do your own research and consult with a professional advisor before making any investment decisions.

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We wouldn’t have it any other way because this is as authentic as it gets. And with that, it’s time to hear from those who live and breathe this complex corner of the market. Here is your host, Cem Karsan.

[00:01:27] Cem

Welcome back to another episode of U Got Options from the CBOT floor we brought to you by Top Traders Unplugged and Kai Media. Today we get to talk to no other than Benn Eifert, the Professor.

He dives deep today on options, vol, and the coming regime, where we are in correlation with what happened recently with the, the tariffs and what does that mean going forward? What are interest rates doing? How is that going to change the market structure for volatility for different products? Tune in, I think you’re really going to like this one.

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So today, after a couple macro conversations on U Got Options, today we get the Professor. We’re going to dive deep with Benn Eifert, CIO and managing partner at QVR. Hey, Benn, how you doing?

[00:02:32] Benn

Dude, It’s great to see you, man. Thanks for having me out here. I’m really excited.

[00:02:35] Cem

Thanks for coming all the way. I know you took the red eye in from San Fran today, so, we really appreciate it. You know, it’s like summertime in Chicago and we’ve got pouring rain, 24 hours of rain, unfortunately.

[00:02:45] Benn

It’s all good.

[00:02:46] Cem

But welcome to the Chi. This is fun. This is one I’ve been kind of looking forward to having for a while. I think, as I was saying before, there aren’t many people who kind of see the big picture in vol and can dive as deep as you can.

So, I want to start out today talking about kind of one of the most important things with options and implied volatility is their relationship to equity markets and kind of the beta that they have, the correlation they have, when it works, when it doesn’t.

Maybe give me your thoughts on what happened at Liberation Day, how vol performed there and maybe why, and how you see that performing going forward as well.

[00:03:21] Benn

Totally. So, this is a really, really important topic, right?

I mean, so a couple of key things, you know, when you think about how is vol going to perform in a market event as markets are falling, there are a couple key things. One, there’s like the speed of the event. And a lot of people don’t think about this, they just think about, oh, the S&P is down 10%, how much is vol going to go up?

But it’s like if that’s 10% is in one day, or in one hour, or in 10 minutes, that’s going to make vol spike like crazy because the value of convexity, of like re-hedging your delta and your gamma on a move like that, is really high.

If that 10% is a slow-bleed down over a month or two, vol might barely even rise, right? It might start to rise at first and then kind of fade. Because underlying like the value of volatility, again, is in that realized volatility – how much money that a dynamic hedger can capture as they’re re hedging.

And so, you know, you get like a 22 style sell-off, right, where the market was down very significantly over the course of that year, but vol kind of tried to rally, you know, in the early parts of the year and then just faded and didn’t perform because you’ve got that like slow, choppy, grind down. So, that’s really, really important.

And then related to that is, you know, positioning. And that positioning drives a lot of the speed of moves down. But, you know, if the market is pretty well hedged, if the buy-side isn’t overextended, long levered, you know, if market makers aren’t too short gamma, like it’s really hard to get that really heavy significant vol performance. To the upside, you really get that huge vol performance when everybody’s over levered, everybody’s bullish, everybody’s crazy. People are selling vol like nuts and then they’re scrambling to cover – they’re getting blown out. Like that’s when you get that vol event.

[00:04:54] Cem

Supply and demand, right?

It’s funny how you can get into all the quantitative kind of details and Greeks, but at the end of the day, supply and demand is the most important thing, and particularly in a convex instrument like an option, I think.

[00:05:05] Benn

That’s exactly right.

[00:05:07] Cem

I think, you know, I focus a lot on dealer positioning, I know you do as well. I think it’s interesting if you walk through the history of the correlation of vol relative to declines, it’s almost like a sine curve. And what do I mean? If we go back to August 15th, the yuan devaluation (you probably remember this), it was a massive vol event.

Screens kind of went black. It wasn’t that big a move. It was the biggest move that we had had since ‘09. But I think it was an 8%, 9% decline. But it happened quickly. It was a matter of a couple days. And that vol exploded, right? So, what happened six months later? Everybody’s always fighting in the last war.

[00:05:44] Benn

Bingo.

[00:05:44] Cem

All the short vol entities got washed out to sea. The long vol traders all got sort of taken on flows and they had made a bunch of money, so they had more to invest. February 16, oil goes to $20, high yield starts blowing out, and everybody’s like, here it is, it’s coming back. And they load up on puts.

[00:06:04] Benn

It doesn’t work.

[00:06:05] Cem

It doesn’t work at all. And I think the important part there is not just that the implied vol doesn’t work, but reflexively, it drives less realized vol.

That decline was much slower, stair steps. But also very interestingly, it was a bigger decline. So, Instead of the 8%, 9%, we got 12% because hedges were not working.

[00:06:25] Benn

Yeah, that’s exactly right.

[00:06:26] Cem

And then we can go right back to, like, 16. Then what happens? We go through 17, vol selling. Why would I own puts?

Because in February 16, the biggest decline since ‘09, it doesn’t work. So, vol selling comes in, XIV gets shorted, shorted, shorted, shorted -Volpocalypse kaboom.

[00:06:40] Benn

Yep, it’s very cyclical because, exactly to your point, it’s driven by positioning, and positioning is very heavily driven by what just happened last time, and everybody’s got a short memory.

So, it’s like, yeah, you have a huge blowout of short vol positioning and you have big inflows into tail hedges, big inflows into long vol ETFs from retail. And then you get the unsurprising underperformance of like long vol positions. They bleed to death. Short vol’s performing really well. Everybody’s piling in, a couple years later, like now we’re massively crowded – Short again, and we repeat.

[00:07:12] Cem

Totally, and actually if you just continue that, just to finish the thought here, because I want to illustrate how sinusoidal it is. October, November, December 2018, 19% decline, right? Like the biggest by far again since ‘09. Yeah.

[00:07:25] Benn

And December, just every day, 1% or 2% down, 1 or 2% down, no realized vol.

[00:07:30] Cem

That was awful, That was like so painful.

[00:07:31] Benn

Yeah, exactly.

[00:07:32] Cem

Covid, massive evolve, explosion again, 22, then slow grind down. And so, the question now this leads to, right, is we just had 22 and then we had a vol event in Liberation Day, a pretty big one, right? What does… Are we going to get the vol compression decline? And again, that doesn’t mean it’s less of a decline. It doesn’t mean decline’s not coming. But it could be an even bigger decline in theory, right? With less, like a little bit slower. And so, the question is, is that what you think is the case? And if not, why?

Talk to me a little bit about what you see coming, if we get a decline, and let’s just say the next decline, if it happens, it happens the next year or so.

[00:08:11] Benn

Yeah, absolutely. I mean, when I look at positioning today, and market dynamics today, you know, you’ve got institutional investors pretty bearish, pretty underweight, you know, chasing a little bit of upside, but again, like very low net leverage. That started really with like the Deep Seek sell sell-off, and the factor rotation blowout that happened in February. And then again with Liberation Day, reevaluation of the macro landscape. What are the macro risks out there? Policy instability, tariffs, all this kind of stuff, right? So, give institutions really, really underweight.

You really don’t have much of like the crazy short tail-risk selling, crazy vol selling. You know, there’s a ton of vol selling through things like call overwriting, cash secured put selling. But those are actually like market stabilizing forces, right? Those don’t create tail-risk. Those are unlevered strategies. They supply gamma to the street, they supply gamma to guys like us. And we Dynamically re-hedge that we suppress volatility.

You don’t have, you know, the net 2019, 2020 dynamics with people selling variant swaps and people selling crazy stuff that’s going to, you know, blow up in a nuclear bomb.

[00:09:12] Cem

Right.

[00:09:12] Benn

So, without over levered fast money positioning, without super over bullish, you know, institutions, without tail-risk sellers, it’s really hard to see that really big vol event, that huge outperformance of vol and that fast crash.

I think, you know, that if you see a sell-off over the next six months, over the next year, I think it’s going to come from, you know, kind of fundamental headwinds and challenges in unstable policy environments. It’s going to come from declining earnings and then you’re going to see retail trying to buy the dip. You’re going to see kind of a more of like a slow choppy sell-off where explicit, simple, long vol positioning just might not work.

[00:09:46] Cem

Right. I completely agree.

And I’d be remiss if I didn’t talk about the TACO trade and the reality of the vol compression that’s coming from the administration. Talk to me a little bit about how you see that playing in here and if that’s having an effect. I’d love to hear your thoughts.

[00:09:58] Benn

Yeah, I mean, I think the way that I think about the administration’s stance here, with respect to volatility, is, in some sense, there’s like a Trump put, an administration put in the market where you know, even if Trump says he doesn’t care what happens to markets, I’m not sure that’s right.

I think that he doesn’t like it when there’s bad headlines about equity markets are down, and if there’s some set of policies that the market’s pushing back on, eventually he’s responsive to that. So that compresses the downside to some extent.

[00:10:21] Cem

It’s also polling. Right. Because the market goes down and that’s bad for polling his first hundred day.

[00:10:25] Benn

Very much so.

[00:10:25] Cem

So, there is almost a force kind of reaction function.

[00:10:28] Benn

Very much so.

And then, I think, on the upside, when vol starts to fall, when markets start to rally back to highs, this is an administration I think that’s very dedicated to like being disruptive and doing new stuff that people don’t necessarily expect and that’s counter to the economic consensus or whatever.

And so, I think as they get emboldened that, you know, vol is low, then it’s more likely to see new policies kind of thrown at the market that can create some volatility and create some uncertainty. So, I think it’s this very like rangy kind of dynamic where I think volatility is supported, you know, from below by the fact that you’ve got administration that wants to do tariffs and wants to do a bunch of new stuff, but at the same time they don’t want to see a crash and you don’t have the positioning in place to get a crash.

[00:11:08] Cem

Yeah, we need a new acronym for like the upside part of that trade.

[00:11:12] Benn

Yeah, exactly.

[00:11:13] Cem

Yeah, if there’s a listener who has another food item acronym…

[00:11:17] Benn

For sure.

[00:11:18] Cem

I do think you’re right.

I think the second markets start grinding up, Trump and the administration feels emboldened to institute some of their big policies which are disruptive, obviously. And so, you can kind of get these quick market rallies, we’re going to kind of push out some policy that’s scary, and then a saving of the market below which can create that range bound trading.

The other thing I want to highlight, which I thought is very important, that you brought up, that I don’t think gets talked about enough, is structured product issuance – the amount of not just structured products but also ETFs, now. We have seen an increase in the last three years from $500 billion of structured product issuance to $1.5 trillion. It has almost tripled. I mean that’s hard to like comprehend. But the majority of those structured products are vol compressing. Not to mention all the ETFs and everything. So, there’s a structural offer in equity vol, particularly, at the index level.

[00:12:13] Benn

Very much so.

And it’s part of this broader trend of retail investors, high net worth investors getting involved in options, and derivatives, and futures, and crypto, and you know, risky, risky trading. Yeah, the structured product boom has been wild. So, you know I’ve been involved in structured product markets for decades. That used to be in a Europe and Asia thing.

It used to be that US folks traded stocks. But what you saw, after 2020, was a huge migration to where the big growth in structured product markets was in the US, and not just in the US but actually unusually kind of evenly split where, with index, which has always been a big thing, but also single names. So, when you look at a lot of the structured product baskets that trade now are all of retail’s favorite names. It’s and Palantir, and Tesla, all the momentum names.

And so, what that does is most of those products, there’s a million different kinds, but the core thesis is usually it’s selling long term crash risk to get yield. So, what you see is the long term vol and option prices in the downside wing and all those names, and an index gets crushed and goes below the call side.

And so, you know, I’m sure we’ll talk about this later, but when you’re thinking about where is there cheap convexity in the world, you know, being on the other side of that kind of long term crash risk is a really nice way to get.

[00:13:21] Cem

We might as well talk about it now. You dove in like, I think that like, dispersion, right. I think you’re seeing so much index vol compression and some of it’s the macro. The reality is we are seeing more different news in big ways that is changing outcomes for single names. But we are also seeing a dramatic amount of vol compression, at the index level, that then is pushing correlation away from each other. Maybe speak to that a little bit. Again, a big idea that not a lot of people get, but I think a very important one.

[00:13:52] Benn

Yeah, very much so. So, you know, dispersion is a very standard trade that a lot of people have been involved in vol markets for a long time. So, a dispersion trade typically is where you’re buying a bunch of single name vol on the index weights, you know, kind of buying the index weighted basket of single name vol and you’re selling index vol against it.

So, historically index vol used to be pretty expensive. And so, people thought of dispersion as like a risk premium where you were just always supposed to do that trade. But exactly as you allude to now, there’s a lot of index vol compression, right. And it depends on what 10-years you’re looking at. But especially in the short end, there’s a ton of index vol selling.

And so, you know, that trade has very much moved away from being like an all-weather risk premium kind of thing to more like a tactical thing depending on opportunities. And sometimes you might want to actually totally be the other way. You might want to be short the single names and long the index.

And so, what we’ve seen is a huge amount of crowding from time to time in that trade. If you looked in February of this year, the pricing was reaching just incredible historical levels where single name vol was really expensive relative to index vol. There are tons of tourists involved in dispersion trades.

People able to actually use like QIS at bank desks to do dispersion without even knowing how to trade options themselves, like all this kind of stuff. Then Liberation Day and Deep Seek really blew that out and came back to much more normal kinds of levels where, then actually, we got involved very heavily.

So no, it’s a really interesting trade and dynamic to watch, but it’s very different now that you have this heavy index vol compression, you know, coming out into the market.

[00:15:13] Cem

Yeah. In 2017 I believe the stat is we had 30% lower realized vol than any other time in history. And we had also, simultaneously, 25% lower correlation between the constituents at any other time in history. That is not a coincidence. And people’s first order effects are like, oh, the index is just a measure of what’s happening to the single names.

But the reality is often the opposite. The index itself is forcing this compression. And if certain names idiosyncratically need to go one way, by definition, by arbitrage, stuff has to go the other way. And I think that’s really driving… Like again, if you look at history, implied correlation and correlation in general is just off the charts. It’s completely different than it was prior to this period. And it really is because this world is becoming central to the whole conversation.

[00:16:01] Benn

Yeah, very much so.

And I mean, this last couple of years you’ve seen, you know, especially with the rise of very aggressive retail option trading, and that trading shifting from sector to sector, and moving around. You know, you’ve had a lot of like sector and factor rotation within the equity market universe.

That has really driven a lot of real realized dispersion. You know, it’s interesting. So, people talk about it and there’s a common meme like, well, in a crisis all correlations go to one. That’s not actually totally true. There are crises that are very high correlation and crises that are very low correlation. It depends on what’s driving it.

So, when you have like a macro crisis that’s like sovereign risk related, you tend to get very high correlations between different equity markets because it’s not a fundamental thing, it’s not an issue in certain sectors. But like if you go back to 2008, like we had days in the 2008 crash where banks were limit down and energy was limit up on the same day. And actually, that was a very relatively low correlation environment given how high volatility was.

And so, that’s been much more similar lately. Even with COVID, there was some very high correlation bits of it. But then you had tech reacting very differently than to consumer products and stuff. And on the back of the pandemic and all the fundamental moves you were seeing that.

[00:17:10] Cem

Yeah, I think it’s an interesting crumb, like an important little detail that maybe people aren’t thinking about, because we had 2020, I think everybody saw correlation go to one or even above one. It’s kind of a weird concept, but it did. That dynamic was very much focused on the fact that vol was at the center of that issue on a macro level. That the S&P vol, the macro vol was kind of driving everything.

I wonder in this environment, to your point, not just because of the macro but also because of the order of maybe with vol, people are more prepared for this one, etc. Even though it might be a big decline. Maybe correlation doesn’t work the way it’s been working. And I think we’ll talk about that if and when that happens. I think that’s an interesting point.

That leads us into big picture a little bit. Let’s talk a little bit more kind of macro 10-year kind of picture. You know, obviously we’ve been talking about this for a while. I know you have too. But I think we’re getting to a point where something different seems like it’s happening. It’s not exactly the same as the last 30, 40 years, especially as it relates to populism, and protectionism, and long-term interest rates.

You know, if interest rates continue to go higher here, and we continue to deploy these policies, these protectionist, kind of unconventional, let’s say, policies of the last 40 years what does that do to vol? What does that do to vol in different parts of the market? Vol is not one thing by the way.

Vol is, you know, we have FX vol, we have a commodity vol, we have equity vol, we have bond vol. We have all kinds of things. We also have, even within an equity vol, we talked about dispersion – but you have the long end of the curve, you have the short end of the curve.

Give me your thoughts on what you think vol will do more structurally, and how that might be different than what we’ve seen for the last 10, 15 years. I’d love to hear your thoughts.

[00:19:01] Benn

Yeah, totally. So, I think there are a few different things. So, first of all, in a rising and high interest rates and inflation environment, that drives a lot more kind of cross asset class vol than we’ve seen for, you know, the last 20, 25 years.

So, like when we’ve had pretty low and pretty stable interest rates, for the most part, that’s kept currency vol pretty subdued. That’s kept certain parts of commodities vol pretty subdued. That’s kept rates vol pretty subdued again, depending on where in the curve. And we’re very much shifting out of that kind of environment.

I mean we’re seeing 10, 20 basis points moves in rates at different points in the curve, on a daily basis. We’re seeing, obviously, big moves in gold. We’re seeing big moves in oil. And I think that’s one thing that is just kind of structurally higher cross asset vol.

Then, next up, I think inflation, higher interest rates, and also policies – protectionist policies like tariffs, create winners and losers at different parts of the equity market. So, I think that is like a pro dispersion dynamic where you could see, you know, you could see significant pressures upward on vol in some sectors, certain pressures downward on vol in some sectors. Again, companies that are responding very well, companies are responding very poorly. And so, I think there is kind of a structural bid to like single name vol and to, you know, sector vol relative to index from that kind of dynamic for sure.

And then I think, you know, longer term one of the things we think about is just, we’ve had really this notion of US exceptionalism, the exceptionalism in American markets driven by the fact that all the smartest people in the world come to the US to study, to work, to create companies. You have every sort of big meaningful tech company in the world is started in the US and ends up in the S&P 500.

And a lot of the current policy mix is potentially challenging that thesis on a go-forward basis and what that does to long term equity returns and sector mix in the US. Do you start to see tech and some of the innovative sectors move elsewhere? It’s a really interesting set of questions. I don’t know the answer to it.

[00:21:02] Cem

What does it do to the US dollar?

[00:21:03] Benn

What does it do to the US dollar?

[00:21:04] Cem

And maybe the most important thing, what does it do to the Federal Reserve and the exorbitant privilege of the US dollar? And I think those are big, big questions. It doesn’t happen overnight, but it kind of happens very slowly and then all at once. So, I think that’s something that obviously we need to think about.

I think one of the things I really think about as it relates, I completely agree with you on this kind of structural change is the Federal Reserve itself. We had this Fed put that was unbreakable forever, for 40 years, since 1982 really. And the reality is that was because we had structurally low inflation. We had a deflationary environment which allowed the Fed to come in and rescue, you know, if they have dual mandates, you know, price stability and let’s say GDP (I know it’s maximum employment), but GDP growth. It was pretty easy to just keep on coming in and saving the market with an infinite supply of money when necessary. There’s a big question.

If this inflation is structural, and we are truly in a stagflationary environment which protectionism and populism (a lot of the policies you’re talking about) drive, then the Fed gets put in a box. And so, if the Fed’s in a box, I’m guessing that the bottoms aren’t V bottoms as much.

I’m guessing there’s a different kind of equity vol price action that tends to come from that in a bigger crisis when it happens. So, I think it’s a really important point. I think this moving away from supply-side economics and the Federal Reserve running everything to a more demand-side policy really drives a different vol outcome, particularly for equities.

I did some historical research on this a year or so ago and I think it’s very interesting. The highest vol of the ‘60s and ‘70s, particularly like’ 68 to ‘82, that rising interest rate environment, was gold. I guess, not too surprisingly there, on some level. But also (and this is kind of counterintuitive) bond and FX vol.

If you look at equity vol, and if you look at other commodity vols, like industrial commodities, vol is actually structurally way lower. Short-term vol is about the same, meaning like 1 month, 3 month vol is about the same, maybe even at points higher at the very short end of the curve. But if you think about it, that makes sense. Equities did not move structurally for 14 years, ‘68 to’ 82, because it’s a nominal asset.

[00:23:31] Benn

That’s exactly right.

[00:23:31] Cem

The market didn’t go anywhere. So, you had this push/pull of two factors which I want you to dive into, which is one, you know, as inflation happens, the market gets cheaper – by definition, the market’s at the same, it gets cheaper right.

At the same time you get multiple contraction because the discount rate or the divisor to equities, in terms of price earnings multiple, is driven by that 10-year bond. And so, this push/pull really is just kind of almost like a vice that drives implied vol long term lower and lower.

With the structured product issuance increasing the move into these things, I could see a really counterintuitive long-dated vol compression into a decline. Not yet. And again, it doesn’t mean there aren’t great short-term opportunities, by the way. It doesn’t mean the market’s not going to have… There are actually more recessions, more vol events in that period. But I think that’s really interesting and kind of might rhyme.

[00:24:19] Benn

I think that’s right.

And even if you look at previous environments where we didn’t have major inflation, but we had sort of a longer-term bear market, you look at the tech bubble unwind and the bust 2001, 2002, 2003, long term vol really underperformed in that kind of environment because you had structured products, you didn’t really have a bid for vol on the way down because you had this sort of choppy, rangy downside. And I think, yeah, exactly. With inflation surging, you think of inflation as having these mixed effects on equities. Because, exactly to your point, the divisors getting cut but equities, you know, there’s real asset ownership involved in equities and so, that gets repriced higher with inflation.

And so, you know, overall, equities are probably a better place to hide than bonds, through inflation, in some sense it obviously depends on all the kind of spillover effects. But it’s very push and pull, right? There are very mixed effects going on.

[00:25:07] Cem

Yeah, yeah, I completely agree. You know, things like oil by the way, just talk about something other than equity vol here, actually had incredibly low vol in that period. You would think, oh, OPEC crisis, it must have been crazy.

The reality is it was like a steady grind higher, and the trade was actually to sell puts in oil and to buy calls in gold. Because the vol gold was crazy, but it was also the best performing asset during that ‘60s and ‘70s period. So, kind of an interesting mental model to put around things.

[00:25:37] Benn

Yeah, very much so.

[00:25:37] Cem

From a macro perspective, it’s hard to put these two things in your mind, that vol on a longer-term basis may not perform, but you might get much more pinball, or that it might be a much weaker environment for equities and you might get bigger declines along the way.

So how do you, as a vol manager, how do you deal with these two kinds of conflicting notions? What are some things that you do in order to take advantage of a need for much more non-correlated, much more need for hedging, not relying on 60/40 stocks and bonds? We need a much bigger toolkit. How do you do that at the same time?

[00:26:17] Benn

I think that’s exactly the right question. I mean, you think about traditional asset allocation, like 60/40 stocks and bonds, that works in a traditional macro environment where equity market downside is cushioned by falling rates. Like we very may well not get that.

If you think about potential equity market downside scenarios from here being caused by some combination of, you know, policy uncertainty, of kind of concerns about the US Government, or about inflation, those are things that make bonds and equities sell off together. And so, you know, that traditional portfolio really doesn’t work.

And then you think about the institutional variation of that where, you know, big endowments and foundations and pensions have adopted huge exposures to privates that also, you know, we’ve reached huge valuations and a lot of that stuff, it’s kind of not being marked. The liquidity profile is really dangerous. Like, how are those portfolios going to work out over the next five, ten years?

[00:27:03] Cem

I love that. These are called alternatives, right?

[00:27:05] Benn

Exactly.

[00:27:06] Cem

You’re like, what alternatives? And like they’re like, oh, private equity and private credit.

[00:27:09] Benn

That’s right.

[00:27:09] Cem

You mean 2x levered equities or credit, with 10 year duration with no liquidity, and 2 and 20 fees?

[00:27:18] Benn

Exactly.

[00:27:19] Cem

I mean, it’s not an alternative.

[00:27:20] Benn

It’s truly not alternative. And a lot of those institutions are like 70% in those assets and have contingent private capital calls. They really don’t have the liquidity. They’re going to be, you know, in a bad market, they’re going to be selling that stuff at a discount in the secondary market. It’s going to be a very bad scene.

[00:27:34] Cem

And they’ve gotten away with it for 40 years. Right? And that’s why, I mean, recency bias, that’s why it’s grown to the size it has. Because any decline we’ve had has been that kind of Federal Reserve put driven quick recovery.

[00:27:45] Benn

Don’t have to market.

[00:27:46] Cem

Don’t have to market because it’s a 10 year window. What happens (big question)? What happens if we get a ‘68 to ‘82 environment where over 10 years you have a decline in markets then you have to see the mark to market. And that’s when, on a levered product with 2 and 20 the pain could be really bad. There’s no liquidity getting out of out of a lot of these names.

[00:28:05] Benn

I think that’s totally right.

And if you get a proper recession and a credit cycle, at some point in there, you wind up with private credit having gotten so overextended in terms of every small business has 10 private credit guys knocking on the door trying to lend the money for absolutely anything. And a lot of that stuff comes home to roost.

So exactly to your point, I think the need for alternative assets, and alternative exposures, and ways to make money over the next 10 years that aren’t just driven by that.

[00:28:28] Cem

True alternatives, I want to be clear because you go to your wealth advisor, you say, I need alternatives, 80% of that is private credit, private equity, real estate and all of those have the same problems.

[00:28:39] Benn

I think that’s exactly right.

You know, so, to your point, how do you manage, this kind of environment? What are some of the things that vol managers think about?

So again, we talked about not necessarily really expecting or seeing like a big sudden market crash with a big vol event because you don’t have the catalysts in place for that, you don’t have the market structure in place for that. you don’t have the positioning in place for that.

You know things that we think about in 2022, actually being short delta versus short vol, worked out really well. So, on a market neutral basis you get that kind of grind down, vol’s underperforming, the short delta works really, really well. That’s one trade that’s performed really well.

You can think about different kinds of option structures like longer-term downside put flies, things where you’re not betting on that big crash, the big crash isn’t going to work out. You’re spending a little bit of premium but doing really well if you get that 10% grind down, or that 15% grind down. A lot of those trades can work out really well in that path. Yet just getting out there and you know buying a whole bunch of vega may really not.

[00:29:36] Cem

Yeah.

[00:29:37] Benn

You know the other thing, you alluded to this, but there’s so much supply of short-dated options in the world, all the call overwriting, all the cash secured put selling at big institutions, and everything, inevitably, that gamma in the front of the curve stays kind of cheap. And you know, folks like us usually end up staying long that. And then you think about this environment with you know, tweet driven policy or reversing with the market down, market up. Like, you know, new tweet, market gaps up 2% in the futures and then sells off the next day. Owning that gamma is really nice because you can just scalp that sort of P&L from market movement.

[00:30:08] Cem

Right, because at the end of the day if you are more likely to get those declines, and they are, actually, more likely to even be bigger because the hedges aren’t working, you’re going to get the realized move, and again it may not be as fast, but you’re going to get some type of meaningful decline likely in those scenarios. The key is managing the implied vol part which can be a little hard.

And when interest rates go higher, I mean, I can’t emphasize this enough, as interest rates go higher, you get to now stack a return on top of a T-bill yield which is going higher. You know that dynamic, which isn’t very well understood, is what’s driving the structural product boom by the way. People don’t really understand this because if you could get let’s say a 3% yield on, or 4% yield on something, but you were getting 0% underneath the hood on the risk free rate, it wasn’t competitive.

But guess what, when you get to a 4.5% risk free yield, and you stack, let’s say, 4.5% all of a sudden it’s very compelling in a non-correlated way with way less risk. Why would you be in equities given the risks when you could do that?

And so, I think that story is very compelling. And I think everybody needs to be looking more non -correlated.

[00:31:11] Benn

Yeah, very much so.

I mean one thing that we do, obviously we run the absolute return hedge fund stuff but we also work with big institutions that need to think about this kind of hedging question of how do we manage a big decline in equity markets, and think about all these questions about the path?

But the amount of capital involved can be very small. Because you’re running derivative overlays for someone with a ton of cash efficiency and can generate, you Know, a ton of P&L in the scenarios they’re worried about with very, very, very little capital.

[00:31:35] Cem

I think the challenge obviously is, you know, 60/40 scalable, it’s easy. And so, when you look at non-correlated assets, it’s hard, like we were saying.

And so, I think we’re seeing a ton of innovation and a ton of growth in the space. But I mean this is still 1% of the space. And what we’ve seen is, I mean we were just at an equity derivatives conference, it’s like, almost a doubling of the people there every year. Much like the structured products doubling. I’m here to tell you, you know, we went from 0.5% to 1% in the last several years. And this should be 10%, 15%, 20% in terms of non-correlated products.

If you look at a 60/40 portfolio, people don’t talk about this, but a 60/40 portfolio, over 125 years, we take this last 40 years in that data, and you really need to look at a broader data set. And people look at me like I’m crazy because the last 40 years have been top left to bottom right interest rates, which is the most important thing.

So, if you look at a broader picture, the 60/40 portfolio has a 0.45 Sharpe.

[00:32:33] Benn

That’s right.

[00:32:33] Cem

Stocks have a 0.32 Sharpe. I mean you and I know in our world, right, like risk adjusted returns, that’s awful if you can only manage that in your portfolio.

[00:32:43] Benn

And people look back at equities the last 15 years and they think it’s like 1.5 Sharpe game. It’s not.

[00:32:47] Cem

Right.

[00:32:49] Benn

Not through the cycle.

[00:32:49] Cem

And actually, the other part is that’s over 125 years. So, we’re talking 60/40 in general if you don’t know where things are going. But after periods of increasing interest rates, you’re more likely, obviously, to get… Sorry, declining interest rates, you’re more likely to get increasing interest rates. And if you get increasing interest rates, those periods are the times when the 60/40 portfolio gets hurt the most.

[00:33:12] Benn

Right.

[00:33:12] Cem

Because the divisor as we’re talking about, the discount rate, affects bonds and stocks and pretty much every other asset.

[00:33:20] Benn

Completely, and you look around the world, obviously US equities have been incredible, and again, this American exceptionalism dynamic. But you can look at markets like Japan where you had, you know, 10, 15, 20 years of, you know, flat to down equity markets. That’s a realistic scenario. In some cases where you start at really high valuations, you have kind of a big shock to the nature of things. A lot of that comes out of the market. And American investors just are not at all psychologically prepared for the idea that that can happen.

[00:33:44] Cem

Yeah, I’ll tell you what, this floor will be a lot more full and there’ll be a lot more of us, you know, in these conversations. But I think it’s important to do it now. I’m fearful that like people will start doing this more in 5, 10, 15 years after it’s too late. And by then 60/40 might work a lot better.

[00:34:05] Benn

It’s totally true. And it’s always a dynamic. Even, again, I mentioned we help folks with tail hedging. You always have the most interest in tail hedging right after a market crash. Come on, guys.

[00:34:15] Cem

Well, this is like fighting the last war.

[00:34:18] Benn

Fighting the last war, right, what you said.

[00:34:19] Cem

Yeah, completely I couldn’t agree more.

So, what about zero DTE? Right. Obviously, we’re talking about front end of the curve, back end of the curve. Do you use zero DTE options at all? How do you use them? Obviously, the moment on the distribution that is the most impactful. Give me a sense of your thoughts on zero DTE. Obviously, I think it’s almost 60%.

[00:34:40] Benn

Yeah, they’re up to about 60% of volume. I think there are a few different big flows there, as far as I see. One, there’s a lot of people using them for intraday levered directional exposure, and that’s both retail and hedge funds. So, there’s big macro hedge funds that they want to get long today. They get in there and they buy upside 20 delta calls, their call spreads, and big size. So, that’s one big flow.

Another big flow, on the other side of that, is there’s a lot of income type sellers. So, there are people that just sell them outright. The downside, the nearer the money, there are people who sell, who do call overwriting, like daily call overwriting. They own some equities and just every day they come in and sell the zero DTEs. And you’ve got some pairing-off between those two flows. It’s not one way. There are buyers, there are sellers.

And then I think the third big category, and that’s a big, decent part of the volume, is just a lot of like big complex option portfolios, market makers, prop firms, us. We just use it to constantly clean up the book. Like every day it’s like oh, I’ve got this expiring. In the old days you just had to hold whatever weird gamma positions that you had at different strikes and now you can just come in and kind of clean up your book on a day-to-day basis. So, there’s a lot of vol in that. So, I think it’s actually a really tool.

So, we do, again, some of that from a portfolio management perspective. We do have strategies where you know, we’re getting in and trading the 0 DTEs, usually looking for days where we think that it’s just gamma’s too cheap, like the straddle’s too low, and we’ll come in and buy some zero DTEs, and maybe near the money, maybe a little further out of the money, and kind of let it roll, let it run. But yeah, it’s a really interesting space.

[00:36:08] Cem

Are there any structural things, on the 0 DTE side, that you think are like hedges because of supply and demand? I don’t want you to give up your secret sauce or anything but if you think there’s any parts I’d be curious to hear your thoughts on this.

[00:36:21] Benn

Yeah, really, I think the only part of the distribution where there’s, I think, a pretty net supply/demand imbalance is there’s some pretty big selling of the of crash in 0 DTE – of crash puts. There’s like an account out there, for example, that trades actually OTC with a bunch of banks, to get more leverage, and is sized such that probably if there’s a big one day down move it’s going to be a major issue for a lot of the banks on their side of that. There are not too many buyers of that stuff.

You can see it in the skew curve if you look at the term structure of skew. It’s a fascinating thing, for people who believe in emerging markets, because the term structure of skew is like this super inverted U shaped thing where skew at the front end is really low, and the middle of the curve is really high, and the back end is really low. Structured products are selling the back, hedges are buying the middle, and then you know, crash put sellers are selling the front. And you just see it right there in the price.

[00:37:12] Cem

Totally, and we see the same thing, obviously, an incredible opportunity. Skew itself is like probably the biggest structural opportunity, right? The question is how do you manage that tail-risk? What are your most favored (and you can list several) ways to kind of think about getting convexity in general, managing what’s already a steep skew out there and trying to get that convexity not just in equities, maybe other parts of the market, different parts of equities? I’d love to hear your thoughts.

[00:37:46] Benn

Yeah, totally. So, there are a couple different things. Whenever we’re thinking about how we want to structure the portfolio, both for absolute return and tail hedging stuff, we’re always thinking about, okay, what’s oversold, where are their structural flows in the market that you want to be on the other side of and then what can you sell against it? And so, in that example we talked about structured products.

So, there’s a ton of selling of long data downside, both in index and in the momentum, single names that are investors favorites. So, what that lets guys like us do is we’ll be buyers of that long data downside. Call it like, you know, 2 year, 10 delta, 20 delta puts, for example.

And in the absolute return business, we will sell something else against that. Maybe six month, maybe nine month 10, 20 delta put and then buy a little bit of gamma at the front end to neutralize the thing. And what you end up with is a curve trade where you’re buying vol, you know, 10 or 15 points below where you’re selling it. And then the dynamic there is, because structured products typically are effectively what investors are doing, they’re selling knock inputs. They’re not just regular puts. They have a barrier where, if the underlying hits that barrier, the note goes away, the investor just loses a bunch of money. And then the bank loses its long vol position. So, when the bank issues these, they immediately are going on the market and selling vanillas against it. They’re selling those crash puts.

And so, when the market goes down enough, when those names go down enough, they start hitting those barriers. All of a sudden the banks lose all their long vol positions. They have to scoop up all the shorts, they have to buy it all back. And there’s like this big short squeeze in long dated vol.

So, you have a mechanical long convexity of that position that comes from knowing that you own the stuff, that there’s going to be a short squeeze in, if the market sells off.

[00:39:14] Cem

Supply and demand.

[00:39:14] Benn

Supply and demand.

[00:39:15] Cem

Yeah, I agree. I couldn’t agree more.

And importantly, and I think you alluded to this, even when that doesn’t happen, at least you’re getting the benefit of that long data compressed vol eventually sliding up the curve, and other natural buyers coming in and kind of supporting it.

[00:39:28] Benn

Exactly. So, you have a nice positive carry to that long convexity position.

[00:39:31] Cem

I couldn’t agree more. That’s a great point.

Anything else that’s on your mind these days, things that you’re kind of thinking about here as we move forward to this summer and into the fall?

[00:39:42] Benn

Yeah, I mean, I think that the interesting thing, with the summer here, is really going to be to see, I think, what sticks in kind of tariff policy, what doesn’t. You know, we’ve had a lot of back and forth. Obviously, we had Liberation Day coming in really high with those numbers. Then we had a lot of it walking back. And now we’re actually getting some pushback the other way where, you know, Trump is kind of coming back out and going after China again and saying, oh, you’re not negotiating in good faith, coming back after Europe.

And so, you know, I think it’ll be interesting to see whether this just kind of keeps on going and we keep rolling the timelines out or whether we actually start to get some of these levels put in place, and some really big changes. I think that’s going to be a big driver of what we see in near-term economic performance and earnings for a lot of corporates.

[00:40:22] Cem

Yeah, I couldn’t agree more. The long end of the curve, we’ve kind of alluded to inflation long term, we’ve yet to see the effects of the increase in tariffs, and not just what’s going to happen, but what are the net effects of what’s already been instituted going to happen? Part of that’s been particularly muddy because, obviously, if you say we’re going to do tariffs in 90 days, everybody’s going to pull forward demand.

And so that pull forward of demand is actually really muddying even more. We don’t know what lies on the other side of this, not only in terms of policy, but even in the current policy structure. You know, this is a much less linear kind of outcome. Actually, it could be very kind of, again, front loaded and empty on the back end.

So, I think there’s a lot going on there. And as we’ve alluded to a couple times, the long end of the curve in terms of interest rates, look, if this keeps going higher, I mean we have a ton of refinancing that needs to happen, not just in commercial real estate, not just in private credit, non-investment grade equities. I mean we could go on, and on about it.

The majority of the refinancing happened in 2020 and 2021 and the average duration was five to seven years. So, you do the math. If you look at Shiller’s like Cape index, right. You know, obviously we’re at record kind of levels. But the reason that doesn’t work so well as a timing indicator is because there are long and variable lags to interest rates. And the reason they’re variable lags is because it’s very different if interest rates are steady at 4% in the amount of refinancing that’s happened relative to, let’s say, they go to 1%, guess what, everybody’s in. And the lag is going to be a little bit longer.

So, I think we’ve had this real lag on the exposure to interest rates and that check’s coming due. You know, that’s my opinion. I think we have people like, oh, interest rates went for 50 basis points to you know, 4.5. Everybody said interest rates are going to be a problem. See, not a problem.

It doesn’t matter until supply and demand. And so, I think that’s a really important point. I think people are kind of whistling by the graveyard and I think that’s why the long end of the curve, by the way, is just like tick, tick, tick, like slow motion, you know, train wreck happening there. And the administration knows it’s a problem, but they haven’t been able to do anything about it.

[00:42:36] Benn

Yeah, I mean just think about the housing market. I mean the valuations, you know, the price to buy a house relative to people’s income in the US has gotten so out of control, especially in San Francisco and major metropolitan areas. And it was one thing when, you know, rates were zero and you could get that 30-year jumbo at 2.8% or whatever. But now it, now you’re 7%, 7.5%, 8%. And like you just, you know, housing prices haven’t really adjusted yet.

But you know, as more and more people need to come into the market and need to buy a house, how are they possibly going to be able to come up with that kind of cash?

[00:43:05] Cem

Yeah, they still have to buy. Right? And that’s the thing. We are sending money from the top more to the bottom. It doesn’t feel like it, but at least in the last eight years. And protectionism does that to some extent. So, that policy is ultimately driving more demand. We’re creating more households, we’re sending more money to millennials who are chasing, you know, these crazy market prices, but have to. If you want to start a family, you need a place to live. And yeah, it’s a crazy dynamic and very different, as we’ve said, than the last 40 years.

[00:43:34] Benn

Very, very different.

[00:43:35] Cem

It’s a very macro driven world. Definitely a time for a need for non-correlation, you know.

Thanks for joining us today, Benn. I appreciate the conversation and look forward to having one again sometime in the future.

[00:43:46] Benn

This was so much fun, man. Thanks for bringing me down.

[00:43:48] Cem

Great to see you, buddy.

[00:43:49] Benn

Awesome.

[00:43:53] Ending

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