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The Rear View Mirror



I received many emails yesterday about my volatility update, so a few comments are in order. In writing a current piece I assume (rightly or wrongly) that readers are familiar with most of my past comments, especially on the tutorials I have written about derivatives, so what I write currently often uses this as context. Many of the e-mails illustrated that is not the case, so I want to clarify a few things.

First, I do not believe that the market is in a 1987 scenario (although I am generally bearish). If it is, it has a long and specific road to build up to the confluence of factors that led to such a swift and violent correction. The third phase of option selling (and a special fourth phase) that created a wildly over-levered market structure where levered hedge funds and market makers sold options delta neutral to open (opening means creating the position from nothing versus closing which means selling out options that are currently in position) was extreme and lasted for several quarters, perhaps years.

I had a pretty good seat in 1987 to see what was going on, but just like about everyone else, I was not looking in the rear-view mirror and was blind-sided by that infamous few days. Looking back, I think I have a very good grasp on what happened. The market had grinded higher for years with few pullbacks. There were funds set up to take advantage of this type of market action (that became the best performers and therefore, soon had huge amounts of capital) that bought stock and sold calls simultaneously (called a buy-write) to specifically earn the time premium of at the money options. I can remember that they actually calculated a rate of return on the strategy by dividing the time premium (income) by the stock price (the investment cost). An offshoot of these funds called dividend capture funds did the same thing, but sold in the money options against long stock on companies that had a fairly high dividend. These were supposedly bond like returns with bond like risk. Both strategies were essentially short puts, and kept selling and selling them, driving the implied volatility of options lower and lower. This was the first phase of option selling.

At first the market makers and broker dealers took the other side of this strategy, set up the stock delta neutral, and just traded the volatility. Then they started to sell out of the money puts against the strategy to add a "kicker" to the minimal amount of money they were making since the volatility of the market was so low (back then the 30 day volatility of the market ranged from around 9% to 13%). This was not overly dangerous, but left the market somewhat vulnerable. This was the second phase of option selling.

Then the market makers began selling lots of out of the money puts against their long at the money volatility. In other words, they were selling twice as much out of the money puts as they should have to be anywhere near prudent. They thought it was free money. As I said, this lasted for quite a while and became more extreme. This was the third phase of option selling.

In 1987 there was actually a fourth phase. I have never mentioned this, because it will probably never happen again, since it was so stupid. It was called "portfolio insurance".

Broker dealers began to go to straight long funds and offer "insurance": there would be a deductible, say 2% downside, and from there the fund's performance would be insured by the broker dealer for a fee (premium). This looks and smells like the BD was offering the fund manager a "synthetic" put, but in reality it wasn't. It turned out that it was really just a "best efforts" basis and that the ultimate liability was still on the fund. Essentially what the BD was offering was to sell SP500 futures against the fund's amount of capital as the market dropped so that the fund would be short futures in the exact amount of their capital once the market reached the deductible level. If the market began to rise, the BD would have to buy the futures back so the fund could participate on the upside. You can see that the BD had to correctly estimate the volatility of the market: if the market was more volatile than expected, it would cost the fund more than anticipated to insure the portfolio.

Here is the heart of the matter. When a fund buys a real put, the price goes up so that supply matches demand. In this case the market can always bear the demand for puts because the gamma (leverage) goes down as the price goes up. With portfolio insurance, the BD's never raised the price; they stood there and offered the insurance at the same price no matter the demand. So fund managers bought gobs of the insurance for low prices and loaded up the market with a potential disaster: the amount of potential futures trading necessary to insure portfolios dwarfed the liquidity of the market.

So now we had huge funds shorting puts, we had market makers shorting puts, and we had BD's in huge size shorting "synthetic" puts. At this point an out of the money SPX put that now trades at let's say $2 was trading at that time at $.06! When the market began to trade down more than expected (because yields were rising and the dollar was falling), the market began to experience heavy selling to hedge all of these out of the money puts that all of a sudden had bigger and bigger gamma. By Monday morning there was too much gamma for the market to bear and it crashed. In my mind, the 1987 crash had nothing to do with valuation (what is that?), but was purely structural in nature.

Every market is different. I will try to always indicate what I see in options and derivatives because it is important. There is no doubt that leverage like 1987 could come from somewhere else. In 1998 it came from huge leverage in a few hedge funds that were inextricably tied to the BD system. In the future it may come from the huge OTC derivative market that exists today. Although 1987 was extremely special in a terrible sort of way and I do not believe the market is currently in the same structural position today. It was not so special, however, as to think that it could not happen again. I check the rear view mirror at least once a day now.

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