In their latest episode of the VALUE: After Hours Podcast Jake Taylor, Tobias Carlisle, and Jim Carroll discuss:
- VIX Explained: Demystifying the Stock Market’s “Fear Index”
- Burgelman’s Trap: Identifying Flywheel Businesses for Sustainable Growth
- Be Careful What You Wish For: Risks of Fed Rate Cuts
- The Casino-fication of the Market: Comparing Past and Present
- Black Swan on a Budget: Cheap Tail Risk Protection
- From Monthly to Daily: The Rise of Zero-Day Expiration Options
- Will Short-Dated Options Trigger Future Market Chaos?
- VIX at Lows: The “Nothing Burger” Year
- Election Jitters: VIX Futures Signal Potential Market Turmoil in November
- Short Volatility: A Double-Edged Sword for Investors
- To Hedge or Not to Hedge: Investor Strategies During Market Uncertainty
- Can October VIX Futures Predict Market Behavior?
You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:
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Transcript
Tobias: This meeting is now being live streamed. This is Value: After Hours. I’m Tobias Carlisle, joined as always by my cohost, Jake Taylor. Our special guest today is Jim Carroll. He is with Ballast Rock Private Wealth. He’s a senior wealth advisor and portfolio manager. He’s the vixologist on Twitter. How are you, Jim? Good to see you.
Jim: I’m very well, thank you. I appreciate it.
Jake: Welcome, gentleman.
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VIX Explained: Demystifying the Stock Market’s “Fear Index”
Tobias: Jim, you sent me a through. You did a review of what happened in the VIX and volatility last year. Let’s start there. Why don’t we just start off at a very rudimentary level? Let’s talk about first what volatility VIX is, and then let’s proceed into it from there, if you don’t mind.
Jim: Sure. No, not at all. So VIX is a measure of S &P 500 implied volatility going out 30 days, so it’s looking out 30 days into the future, and it’s essentially taking a strip of S&P 500 index options, both puts and calls and measuring the implied volatility of those options and then collapsing that into one number or VIX.
And what people colloquially know about VIX is that it is the fear index. VIX jumps when things get bad, and VIX tends to drop when things are calm. It’s a little more nuanced than that. There’s kind of an ecosystem that has been built up around VIX. VIX goes back to about 1993. It’s gone through a couple of computation changes to kind of keep up with the modern world, but what people think about when they think about VIX is fear and what’s happening in the market, is it calm? Is everything okay? Or is it agitated? And things are maybe upside down.
It’s become even more complicated over time because somebody said, “Well, gee, if we have a 30-day measure of implied volatility, why don’t we have a 60-day measure of implied volatility? Why don’t we go out three months and six months and a year.” And you can actually create a term structure of volatility from these different [unintelligible 00:02:47] indices. And now we’ve gone all the way down to zero, because obviously, zero day to expiration options are all the rage these days. So, we’ve created this ecosystem.
And another part of that, another important part of that, going back to 2004, was the introduction of VIX futures. So, we have an array of VIX futures and then VIX options that actually trade to the futures, not to the spot index. So, there’s a lot to get confused about, and people are routinely confused about what to do with these things and why is this one going one direction and that one’s going a different direction and so it makes life fun for me on Twitter because I can jump in and try to confuse people even more.
Tobias: [Laughs]
Jake: If Jim it is a zero day, does that– You know we’ve heard about how that has this gamma issues for regular stocks, but does that do anything to the VIX side as well?
Jim: Well, there’s been a lot of–
Jake: Hedging.
Jim: Yeah, there’s been a lot of back and forth on that in the Vol Twit, if you will because if you think about it–
Jake: [crosstalk]
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From Monthly to Daily: The Rise of Zero-Day Expiration Options
Jim: If you’re managing a portfolio and one of the things you do is you use options to either hedge the portfolio or maybe one of the hot topics these days is whether some people are out there using call options as stock replacement. I don’t want to own Nvidia anymore, but I don’t want to lose my exposure to it. So, I’ll sell my underlying stock, but I’m going to buy some call options, so if it keeps going, I can participate.
And you go back and there were monthly option expirations. And then they said, gee, well, if monthly is good, weekly has got to better. And so, the big indices got weekly options and eventually some of the big single stocks got weekly options. Well, if weekly options are good, [laughs] so then you had every other day in S&P, and now we’ve got every day. So, every day is a zero data exploration option opportunity.
And if you think about it, you say, well, gee, it used to be that if I wanted to hedge against some known event on the calendar, I’d have to go out past it and express my hedge out 30-days or more. And now I can say, okay, boom, next Tuesday I’m hedged.
So, the question really becomes, are some of these flows coming down into the shorter expiry periods? And is it sucking activity out of the 30-day VIX calculation? Is VIX broken? Let’s go through that again. And I would argue that VIX ain’t broken, it’s as either useful or useless as it’s ever been. The options out there still trade. People still use it as a measure of what’s going on with implied volatility relative to realized volatility and relative to other things. But clearly the activity at the front end of the expiry structure is a different thing, it’s a new thing, and clearly, it’s having impact, really, at least so far, more on a day to day basis than in the bigger picture of where things are going to go three or six months from now, because dealers obviously have to be in the market. They’re buying and sell in these things.
And if you listen to the experts who are in the pits dealing with this stuff, the only way to hedge as a dealer, the only way to hedge zero DTE is with zero DTE [laughs]
Tobias: So, they’re getting long or short based on what their exposure is.
Jim: They’re getting long or short those options based on flows that are coming to them. One of the concerns was, gee, if the dealers are hedging against these options. If you go out to a 30-day option and a dealer sells you a call or sells you a put, then they’re short that exposure and they will go hedge themselves typically in the underlying, either in the futures or in the cash. So, periodically, there will be circumstances where there can be a big chunk of option that is going to expire, and the dealers need to unwind whatever their hedge was, and that can lead to either buying or selling of the underlying in a way that can potentially move the market. From every expert I know, they don’t really have the ability to do that. Zero DTE, today’s expiry, and so to the extent that they’re hedging they’re hedging with other zero DTE and kind of cancelling out some of the noise.
Although every once in a while, we get one of these days where you look at the price action and you say “Well, I go back to the days when all that shit was happening on the floor of the New York Stock Exchange and you went to Joe and you traded with Joe.” Well, obviously, Joe’s been replaced by a computer because some of the price action you see these days is just inexplicable, except for algorithms trying to beat the crap out of each other.
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Will Short-Dated Options Trigger Future Market Chaos?
Tobias: Do you feel like it’s had any impact on the underlying prices, or is the tail wagging the dog or is that– It hasn’t been around for long enough. We’re just looking at a market that’s sort of done one thing since they’ve come in.
Jim: Yeah, we don’t really know yet. I tend to believe that the derivative tail as it has gotten bigger and bigger and bigger. I live in a part of the country where we have a lot of alligators around, and the one thing you don’t ever want to do is get hit by the tail of an alligator. It can be as destructive as their teeth.
And I can’t help but believe that we’re kind of creating this Frankenstein monster of option flows that will wag the dog at some point in time. If you’re hedging with zero, one, two, three, four, date expiry options and some Tsunami comes in, you got to get further out on the expiry on the term structure to hedge a big event.
And so, what some people are concerned about is that what we’re going to see is whenever this unknown, unknown becomes known, there’s going to be a giant flood of action out to 30-days and three months and whatever time frame people think they need in order to protect themselves. And you could see VIX and other measures of implied volatility just kind of go through the roof again.
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Tobias: Let me just give a shout out to the listeners, and then let’s come back and talk about what happened in volatility last year.
Petah Tikva, Israel, what’s up? Always first in the house. San Diego, Valparaiso, Nashville. Dead cat gully, New South Wales. You and me both, brother. Menomonee Falls, Wisconsin. Santa Monica. Castleford, England Santa Domingo, Dominican Republic, Milton Keynes, Mosfellsbaer, Iceland, sorry. Ahh, there’s another one here, some bangers in here, Jake Taylor:.
Jake: Sound it out, Toby.
Tobias: [00:11:35]
Jim: Who are these people?
Tobias: Bangalore, India. Beverwijk, Netherlands, good one. Tallahassee, Kansas City. Kennesaw. Vancouver. Durham. London. Jupiter. Old Ocean. Harrington, what’s up? Brandon, Mississippi.
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VIX at Lows: The “Nothing Burger” Year
Tobias: Jim, you said were a little bit subdued last year in volatility.
Jim: You know I referred to it.
Tobias: In your presentation.
Jim: Yeah, I referred to it in the presentation. The title page said “nothing burger.” And if you look back at what happened last year. Once we got through the little March meltdown with the regional banks, with SVB and First Republic and such, there really just wasn’t a lot going on and kind of dubbed it the year of no fear.
We had VIX get back to levels that we hadn’t seen since before Covid. So kind of three plus year lows. Realized volatility in the S&P, very low. Some of the highlights, number of days that VIX was above 20 was tiny compared to the last three years. We hadn’t seen that kind of stuff since 2019, really. I think the S&P had plus or minus 2% twice last year, so there just really wasn’t anything going on.
One of the other things. If you go back to 2022, which was a year when everybody was just really pissed off at the VIX, because you had stocks going down, you had bonds going down, and hedges didn’t work for a dam.
Jake: And what happened there? Like what’s your diagnoses of that?
Jim: So, let me put it as simply as possible. If you have a straight line that goes from lower left to upper right, that’s your perfect investment, and it has zero volatility. If you have a straight line that goes from upper left to lower right, you’ve lost all your money with zero volatility. And what really happened in 2022 was you had market moves that really were just kind of stepwise. And so, you really never had the kind of violence that would cause implied volatility to jump. You just had this steady grind lower, this low volatility, demolishing [laughs] the value of your portfolio, whether you own stocks or bonds. But it was like, “Okay, every day we’re going down 1%.” And so, where’s the volatility? VIX and the Vol instruments don’t behave well in those environments.
If you look at some of the tailhead GTFs that were out, I like to look at a couple of indices that the SIBO has, one is a put protection index where you own the S&P and you’re buying put protection. The other one is you own the S&P and you’re buying VIX calls. And in 2022, those were terrible. They didn’t do anything for you. You just were burning option premium.
And in 2023, they really didn’t do anything for you either. We did have some declines in 2023 in the market into the fall. But again, the declines were of the nature where there just wasn’t enough fear to cause those premiums to pay off.
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Be Careful What You Wish For: Risks of Fed Rate Cuts
Jake: Jim, it seems like it’s the sort of implicit Fed put seems like would be a pretty big finger on the scale of this. Everyone knows the Fed has their back, so what do I need to insure myself against like the Fed will insure for me?
Jim: Well, and I think that’s the attitude that a lot of people have, is the Fed is going to– If we go back to Bernanke, you know subprime is contained [laughs]. The Fed is working to contain this, whether it’s through the rescue of the regional banks back in the Spring of last year, whether it’s trying to walk the tightrope of what’s next for interest rates, lots of jawboning going on. We’ll see. I think the market still thinks that the right path is for the Fed to cut rates. It’s looking less and less likely that we sure ain’t going to get six this year. Are we going to get five, four, three, two, one, I don’t know.
Tobias: Do they typically cut when the stock market is at an all-time high and unemployment is at an all-time low? Is that usually the way they do it?
Jim: Well, if you look back and–
Jake: Don’t forget trillion-dollar deficits on top of that.
Jim: Yeah, if you look back in time. And obviously, it’s a small data sample because the Fed’s only been around for 100 years or so. But when the Fed cuts rates, it’s typically because the economy needs relief and it tends to be too late for the stock market. You know if you go back to global financial crisis, if you go back to the internet collapse, go back to any time the Fed has cut rates, it’s typically in concert with the stock market going down.
Jake: Horse has already left the barn.
Jim: Yeah, the horse has already left the barn. It’s like if you look at a chart of Fed funds rate versus the two-year or something like that. You know the two year tells you what direction we’re going in, and then the Fed catches. So, all of these people hollering for the Fed to start cutting rates, it’s one of those be careful you might not want what you’re asking for. Because if the economy is strong, which it appears to be, if inflation is not, if that dragon has not been slain, then they’re going to conclude that they can’t cut rates yet. So, higher for longer, at least in some form shouldn’t surprise people, but people like to be surprised, I guess.
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Election Jitters: VIX Futures Signal Potential Market Turmoil in November
Tobias: Often the term structure has some unusual characteristics about it, so I haven’t looked for a little while, but historically, when there’s an election coming up, there’s often a little bump around the election, is that the case this year?
Jim: There’s a huge bump right now, actually. Let me see if I can pull it up. Yeah, October futures came on the board not that long ago, right now– And October futures, October VIX futures look out 30-days, so they’re looking out beyond the November election. And right now, the September contract is quoted 17.55, and the October contract is 20.
Tobias: Right.
Jim: So that’s like a two-and-a-half-point premium between September and October. So, the VIX futures are saying something’s going to happen and it’s going to cause some turmoil, who knows what’s baked into that? But if you want to buy that kind of insurance, and VIX futures are in some respects an insurance contract, you got to pay up for it.
Tobias: Is 20 is about historical average.
Jim: 20 is. Again, 20 is relative to 17.5, 20 is high. But in terms of history, 20 is not crazy. Right now, the front end is at about 14, we’ve seen it lower. Go back to 2017 when we saw spot VIX get below ten a bunch of times, but that was the anomaly of our lifetimes probably. [laughs]
Tobias: Hold down a thunder, Jim.
Jim: Well, look, nothing would please me more than to have 2017 come back again because it was a good year, let’s just put it that way.
Jake: Good times, can we cut taxes?
Jim: I can’t talk about performance, but it was a good year to be a volatility trader.
Jake: Sorry.
Jim: Go ahead, Jake.
Jake: Something I’ve wondered about with the tail risk products. I find the map actually rather compelling as far as the limiting your downside, the variance that variants drain as you fall off the cliff, and how hard it is to get back once you do. And then Shannon’s Demon Arguments, all those things, I think it’s very compelling, but what I always– it’s a little hard for me to wrap my mind around is when you’re buying the premium for it, like you’re paying this premium, why wouldn’t that be so expensive as to basically neutralize the– I guess I’m asking how properly priced are the premiums in the insurance world?
Jim: Well, it’s really kind of a seller’s market. And so, I think the easiest way to gauge the challenges associated with a tail hedging strategy is to just pull up a chart of VXX and watch it go from upper left to lower right, whether it’s on a log scale or a regular or it’s just– What the heck? Why would anybody ever buy that thing?
Jake: That’s free money, basically, up to the other side.
Jim: Well, it’s free money to be short, except if you were short that going into any one of a number of episodes, the most recent being Covid, you would have been carried out. And so, I’ve always found it a little confusing is a polite word that folks in my little pond of volatility traders tend to be one side or the other, short vol or long vol. Short vault is picking up dimes in front of the steamroller, and you’re going to get killed in Volmageddon. And long vol, you’re just going to bleed to death before you ever get paid.
And there obviously are folks out there who have spent time trying to figure out how you cut that bleed or how you can be short and avoid the catastrophe. And some of us are dumb enough to try to take both sides of the trade, but nobody can time markets, so I must be an idiot. But I do think that if you take kind of a short-term trader, swing trader perspective with some of these instruments, which most people can’t do, they either don’t know how or don’t have the constitution or the focus. But I think there are some ways to play both sides. And I think playing both sides in some fashion is the only way that you have a chance to get the long exposure when you need it without bleeding to death, you’ve got to take both sides somehow.
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Short Volatility: A Double-Edged Sword for Investors
Tobias: That Taleb, Spitznagel style of thing seems to be sell near your money by the tails that’s sort of that–
Jim: Right.
Tobias: Has that worked? I mean, is that a viable strategy and implementation?
Jim: Well, Universa, they’ve done fine. And I think there are a lot of institutional money managers think endowments pension funds, big Goliath organizations that might want a hedge strategy that’s managed by somebody else professionally and so they might put some money with Universa. I think it was CalPERS who famously got out of it just before COVID.
Jake: Yeah, whatever they’re doing you probably want to think about and you want to do the opposite.
[laughter]Jim: And the challenge. And it was funny because Universa obviously put up some great numbers in Covid and it was like they made four trillion%.
Tobias: [laughs]
Jake: In a day.
Jim: But when you actually look at–
Tobias: He’s a goat farmer too, I should mention that.
Jim: When you actually look at what the notional exposure was and what the sort of real impact on a portfolio, I mean, it was nice. And so, I have nothing negative to say about Spitznagel and Universa. It’s a strategy that has validity.
Jake: I think what Mark would say as a counterargument to that was you have to look at the blend of both, let’s say 98% long S&P 500 and 2% hedged, and there’s some magic that happens between the combination of those. And so, just taking it in isolation is not really not a fair assessment.
Jim: No, it’s not. It’s not fair in either direction, either the bleed or the positive impact of having the long vol exposure, the convexity, and I think that’s absolutely right. So, then it’s, what is the impact on the overall portfolio of having a 1% or a 2% or x percent exposure to that particular strategy. Is that going to get you what you want when that stuff happens?
And again, for institutional players who are just trying to avoid really bad stuff happening, and who generally are short vol in their portfolios, they own stocks, they own bonds, they own whatever they own, real estate. Short vol, short vol, short vol, they probably should have something like that as part of their portfolio just to give them a little bit of a breath of air when things get really bad.
Tobias: When you look at VIX below 20, which is sort of below average, do you think about it like a mean reverting type strategy, or is it a thing that has momentum? You say you’re swing trading, is that sort of suggesting it’s got some short-term momentum characteristics, like when it’s cheap, it stays cheap, when it gets expensive, it gets more expensive.
Jim: Yeah. And I look at VIX. VIX is nice, but you can’t buy or sell VIX, right? So, what you really– And again, there are a thousand ways to express a view of volatility, option markets, futures markets, index options, VIX options, blah, blah.
I think that if you think about it this way, most of the time things are on an even keel and you would prefer to be short volatility. Owning stocks, you know is going the right direction, and that means that shorting VIX futures will go the right direction. If spots at 14 and the futures are at 16, and you sell the future, and when it expires, it expires at 14, you’ve collected that 2 bucks, and you do it again.
Jake: Is that hot new ETF XIV?
Jim: [laughs] Indeed. That’s exactly right. And my friends have replicated it with [unintelligible 00:29:35], a better construction, a little more durable, and actually has a little bit of a hedge built into it. So, most of the time being, short volatility in one form or another works. And the thing about doing it in this fixed futures space is it’s kind of like buying a leveraged ETF, right? So, you could buy the Qs, or you could buy the 2XQ’s or the 3XQ’s. [laughs]
Jake: Let’s go.
Jim: Let’s go. And there’s some volatility associated with doing that, but if everything stays going in the right direction, you come out ahead. And so shorting volatility through the VIX futures is really akin to that. You’re getting a multiplier effect versus owning the sort of underlying plain vanilla indices.
And so, you could look at it and say, “I don’t want 100% of my portfolio doing that,” but maybe as a little juicer, you take some short volatility exposure, but when the thing falls off the edge of the table and heads to the floor, you’re heading to the floor much faster than the S&P or the Q’s. And so, you either have to be position sized to deal with that. You got 2% of your money in Universa, not 20%, or you have to have a switch that says, “Okay, I don’t like the current condition of this market. I’ve got my little signals that tell me it’s safe or it’s not safe.” And if the signals say it’s not safe, then you get out of the position.
And again, there are a whole bunch of different ways you could conjure that up, but I would contend that most of the big surprises that we’ve seen in our lifetimes have not been as surprising as people want to portray them. And that includes like the 87 crash. It includes Covid. It includes August of 2011, August of 2015.
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To Hedge or Not to Hedge: Investor Strategies During Market Uncertainty
Jake: How do you know Covid was going to happen before?
Jim: Well, you didn’t know.
Tobias: There was an inversion. There was an inversion.
Jake: Yeah. You did 10-3 inverted, that’s how you would know.
Jim: Well, look, none of us knew much of anything, but if you were reading, if you were paying attention, and I can go back and show you little breadcrumbs that said, which side do you want to be on? Do you want to be on the side that says, everything’s okay, full speed ahead, or do you want to be on the side that says, hey, maybe we should just take a beat here. And how you express that, again is everybody’s different. Some people would say, “I’m just okay, I’m going to put a little hedge on, or I’m going to take some exposure off.” And other people would say, “Get to the other side of the boat. We are loading up. And if this thing goes the way I think it’s going to go, we’re going to make ten years’ worth of money in a month.” And some people did that.
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Burgelman’s Trap: Identifying Flywheel Businesses for Sustainable Growth
Tobias: Jim, we usually do veggies, which is, Jake’s. Jake’s got some learnings for us brought to us from the Sacramento International Airport today. So, there’ll be a little bit of background noise, but then when we come back, we’ll get some predictions from you since COVID was predictable, let’s predict the next thing.
[laughter]Jake: So, this week’s veggies are about this book by– It’s a short little missive from Jim Collins called Turning the Flywheel. And they’re in it. He has this thing called Burgelman’s trap, which we’ll get into, but just talking about flywheels more generally. They’re these mechanical devices which store energy in the form of rotational momentum, and it works because of a principle called the conservation of angular momentum, tickets for physics classes. But basically, torque can be applied to a flywheel to cause it to spin, and it increases its momentum, and this stored momentum could be used to apply torque to any rotating object, so most usually like in machinery or motor vehicles. And a flywheel inherently smooths out these small deviations in the power output of a system, so the stored energy inside of it can donate if there’s a drop in the power input, and conversely, it can absorb excess power that’s being generated in the form of rotational energy.
So interesting that one’s made out of steel are generally limited to a max rate of a few thousand RPMs. But they have these high energy density flywheels that are made of carbon fiber composites and actually use like magnetic bearings, less friction. And it allows them to revolve at speeds up to 60,000 RPMs, which is kind of cool.
I mean, flywheels have been around forever in the form of like spindles and potter’s wheels. 3500 years ago. Or sorry, 3500 BC, they had rudimentary potter’s wheels. So, this idea of like moment of inertia is another physics term, and it plays the same role as kind of in rotational kinetics as mass plays in a linear world. So, they both characterize a resistance to change. It’s resisting you doing something to it. Sometimes you want a high moment of inertia. So, like for instance, a tightrope walker, they use this long rod as a balance and it’s because it has a very high moment of inertia. It takes a lot of energy to make it move rotationally. And so, then it provides– It resists rotation, which gives the walker balance and that’s why they’re able to kind of keep their balance better as they’re walking across the tightrope. Sometimes you want a low moment of inertia. And to improve maneuverability, combat aircraft are designed to minimize their moment of inertia. This is what a lot of the work of like John Boyd was centered on.
And I know, Tony, you sent me some stuff on that, which is really interesting. So back to this book about flywheels in the business context. And Collins is saying that basically every good business has some flywheel to it that gathers momentum as the business gets spun up and what he calls like strategic compounding.
And so, of course, Amazon is kind of like– Everyone has heard, this one is probably the most widely discussed, but here’s a rough sketch of Amazon’s flywheel. You start with lower prices on more offerings, which then increases customer visits, which then attracts more third-party sellers, which then expands the store’s offerings, which then grows revenue per fixed cost, which then allows them to lower prices, and then we start the whole flywheel over again. So, you’re feeding energy into each one of these things, each component, and it’s getting the spinning faster and faster. One way of thinking– Like you should be able to say at the end of each little consequence, you almost can’t help but.
So, for instance like Vanguard has a flywheel that they’ve been turning now for almost two years. They offer low-cost mutual funds, which you almost can’t help but deliver good long-term returns, which you almost can’t help but build customer loyalty, which you almost can’t help but grow AUM, which you almost can’t help but create economies of scale, which you almost can’t help but lower costs, right? So, we’re back up to the top of the flywheel again, so this thing is just spinning.
And so, companies that have survived for a long time often have to discover new flywheels to build, along with the ones that they have going. Of course, everyone knows Amazon and having both AWS and retail operations, but there’s lots of other examples like 3M, they added adhesives like Scotch tape to their abrasives like Sandpaper. Apple PC to the iPhone. Merck actually started out as a chemical company and ended up going into pharmaceuticals. Disney started with animated films, ended up in theme parks and merchandise.
And then maybe one that’s interesting a lot of people haven’t heard but Circuit City, which was sort of like a poster child for bankruptcy, shitty business eventually, they actually created CarMax before going bust, and they applied all the same things that they understood about Circuit City to selling cars, and that’s where CarMax evolved from.
So, this brings us into what I teased at the beginning this thing called Burgelman’s trap. And Robert Burgelman was a Stanford business school professor, and he observed that the greatest danger in business, in life, lies not in outright failure, but in achieving success without understanding why you were successful in the first place. So, if you’re kind of right for the wrong reasons, that’s like the worst-case scenario. And it’s quite likely that if you can’t explain the flywheel of a company that you believe is a superior business that you’re investing in, you might not understand it well enough to consider it within your certain confidence, and you’re therefore falling into Burgelman’s trap. So, a little section on flywheels that you can look for and hopefully helps deepen your understanding a little bit of why some businesses grow to be so dominant.
Tobias: That was brilliant. Thank you. Right, Jim, you’re back in the book.
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Can October VIX Futures Predict Market Behavior?
Jake: Very easily.
Tobias: We’re going to do some predictions now what when you–
Jim: Now I’ve got flywheels in my head the rest of the day. I got to look for my flywheel.
Tobias: When you look out at the Vol or just generally, what do you see? What does it look like to you now?
Jim: So, I think about all the stuff that could have an impact on markets. We’ve had this war in Ukraine for two years now. We’ve got international intrigue in the Middle East and the Far East and this election coming up, I think the one thing that I feel confident about is that October VIX futures contract is wrong.
Jake: Yeah, it’s either way too cheap or way too expensive.
Jim: [laughs] Yes. And I don’t know, and I’m not taking any bets at the moment, but I’ve kind of got one eye attached to that, saying at some point between here and there, we’re going to be fed some additional information that’s going to suggest that you either need to strap your helmet on or you need to increase your equity exposure.
Jake: Jim. AI can solve all that. VIX is going to nine.
Jim: [laughs] We didn’t talk about AI with zero DTE.
Tobias: Is it trading zero DTE?
Jake: Nvidia is.
Jim: [laughs] I’m sure. Look, we’ve got algorithmic trading doing everything, and I keep getting pitched on how algorithms are going to solve all my problems. But I subscribe to one of Jim O’Shaughnessy’s favorite views, which is that the last frontier of arbitrage is human misbehavior. And I changed from being an econ major to a psychology major after the econ guy said, assume rational behavior.
[laughter]Jake: Yeah, those should be the same degree, really, but unfortunately, they’re not.
Jim: Well, more so than they were back in the day.
Jake: It’s true. We have behavioral economic staff.
Jim: Yeah, I guess I would be a bit surprised if this is another nothing burger year in the vol space, but it’s possible. And again, I’ve got my eyes on that October contract as the tell, and obviously we’re going to get some news items between here and there. We’re going to have a couple of political conventions. Couple of [laughs]
===
The Casino-fication of the Market: Comparing Past and Present
Jake: I was kind of surprised to see Buffett say that he thought that today’s markets were more of a casino than when he was first started out.
Jim: Well, I think that’s interesting. I would say that it’s a little bit like sports betting, right? You can now bet in the middle of a game on the next play, how far is the punt going to go? It’s nuts, and it’s very high twitch. And some of that high twitch has entered the markets, whether it’s the meme stock trading, the Robin Hood platforms, certainly AI and machine learning is being applied to markets to try to figure out how to buzz in faster than your competitor, how to take that position in front of somebody else. And so, I think that there certainly are aspects of markets that are much more casino like than they were back in Warren’s earlier days, when he could take his time to find some inefficiency and slowly build a position before anybody knew he was doing it.
Jake: You have Einhorn, on the other hand saying that he can’t get a repricing on any of the things that he used to buy at a ten PE and get back to a 15, and now he has to buy a five PE and hope that they do buybacks. So, on the other hand, it’s like kind of inefficient in the other direction compared to what, you know all the gambling?
Jim: Yeah. I leave the fundamentals to smart people like you guys and David Einhorn. I think that for what I’m trying to do price is the arbiter, and it’s not to say that price is always right, but how many times have we seen price stay wrong for an enormously long period of time. So, I think–
Jake: No comments.
Jim: [laughs] yeah. it’s hard to argue with Uncle Warren on an observation like that. As our buddy Rudy Havenstein, I think just about every day he’s got a post referring to the casino.
Tobias: Casino closed. Jim, I just read Hussman’s interim comment and he’s bearish, but he’s been bearish for a while, but he seems to think the reason it’s an interim comment is because there’s some very near-term volatility, I think is the way that he would characterize it. If you read that and you want to rush out to sort of hedge yourself or what’s the sort of smart way of doing that given where the VIX is relative to the VIX futures and the options and all that sort is it an expensive–
Jake: Not investment advice also Toby.
Jim: It’s not, but I’m going to be writing down the answer.
===
Black Swan on a Budget: Cheap Tail Risk Protection
Jim: [laughs] Thanks, Jake. You took the words right out of my mouth. The Grail is that convex place to be, right? Where is the convexity? And right now, the convexity is in the wings. If you look at measures of SKU, if you look at what deep out of the money hedging costs, it’s very low, so the answer would be, as far out of the money as you can be comfortable and then figure out what kind of position size would achieve the objective you hope to achieve, but that’s what I’m seeing right now is that again, the cost to hedge remains historically low.
Jake: Black swan insurance is relatively cheap, right?
Jim: Relatively cheap, yeah and does that mean it’s going to– And what that means is that if something really does rock the world, that’s going to have a good payoff. The flip side is– And so if you’re not paying a lot for that protection, then you also can comfort yourself that you haven’t bet the ranch and then found out that the bet was a waste of time and your ranch is gone.
Tobias: It’s been a little while since I’ve lost money in the wings, so that would be fine though.
[crosstalk]Jake: One more time.
Tobias: Jake and I used to keep each other going when we were buying tail insurance, and it wasn’t getting paid off, we egged each other on, thank God that finally finished. Did never get paid.
Jim: As part of my 2023 presentation, I showed two ETFs that are designed to provide tail hedges. And I did not identify them. And the purveyors of said ETFs are friends of mine, so I didn’t want to
Jake: Criticize by category.
Jim: I didn’t want to incur any more wrath than necessary. But it just goes to show that this is a hard game, and you need to really kind of invest some time and effort to figure out how you want to play the game, if you want to play the game. Because again, there are a bunch of different ways. If you’re nervous, take some exposure off the table, that’s sort of the easiest way. Now, but Jim, there are tax consequences, I don’t want to recognize gains. Okay, fine, then sort out another way to do it, but recognize that there ain’t no free lunch.
Tobias: There used to be–
Jake: The damn VIX call options. The problem was they’re European, so then [unintelligible 00:50:16] be in the money at one point, but not when it was time to close them.
[laughs]Tobias: Yeah, I’ve done that a few times.
Jake: Ahh, right into that.
Jim: Again, not a recommendation, but there are pretty vibrant option chains on UVXY and VXX. So, if you don’t like VIX options, then you can go to the ETFs and get similar exposure in options that you can close out whenever you feel like it. And there are a lot of really smart people who are active in those option chains. [crosstalk]
Tobias: That’s where you want to be competing with the really smart people.
Jim: [laughs] Well, or just try to get on the horse that they’re already on
Tobias: On the same horse.
Jim: Yeah.
===
Tobias: Speaking of which, there was a trader, and I forget who used to follow this. Somebody on Twitter or zero hedge or someone like that used to follow the Fiddy set. Do you remember Fiddy? He used to come in and, [00:51:29] [crosstalk] huge size.
Jim: Yeah. Fiddy has been identified. It’s a very large UK money manager and who gigantic equity portfolio was looking for hedges here and there, some of which paid off and some of which didn’t.
Tobias: Do you know how they did overall in that trade?
Jim: I don’t. There’s some stuff out on the interwebs [laughs] making reference to it. There are some people who suggest that they’ve done the math and figured out that they either made or didn’t make any money. But again, that’s a classic case where it’s not some hedge fund guy speculating with long, fixed call positions. It’s somebody hedging a portfolio just with enough size that it got noticed.
===
Tobias: Jake, we had a request to repeat the name of the Burgelman, was it Burgelman? Can you spell that?
Jake: Yeah. Burgelman’s trap. It’s B-U-R-G-E-L-M-A-N.
Tobias: Burgelman’s trap. Thanks very much. Jim, we’re coming up on full time. If folks want to follow along with what you’re doing or get in contact, what’s the best way of doing that?
Jim: An easy way is to track me on X. The twitters at vixologist. You can also find me, you can google Ballast Rock in Charleston, South Carolina. There are a bunch of cobblestone streets that are not cobblestones, they are rocks that came out of the old sailing ships that-
Tobias: Oh, wow.
Jim: -may have been leaving cargo of different sorts in Charleston harbor. And back in those days, you needed to weigh down the ship if it didn’t have cargo, so they used ballast rock that resembles cobblestone, but that’s where our name came from.
Tobias: I did wonder about.
Jim: Yeah, yeah.
Tobias: And that’s awesome. Well, Jim Carroll, ballast Rock, and the vixologist on Twitter, thank you very much for joining us today.
Jim: It’s my pleasure.
Tobias: And we’ll be back next week, everybody. Same.
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