TIP702: Hedging Against Market Crashes w/ Kris Sidial

Summary

We Study Billionaires - The Investor’s Podcast Network
Episode: TIP702: Hedging Against Market Crashes with Chris Citiel
Release Date: February 28, 2025

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Introduction

In episode TIP702 of We Study Billionaires, hosts Clay Fink and Chris Citiel delve deep into the intricacies of tail risk hedging—a strategy designed to protect investors against extreme market downturns. Chris Citiel, co-investment officer of Ambris Group, shares his expertise on implementing carry-neutral tail risk hedging strategies, their benefits, and the evolving nature of financial markets that necessitates such approaches.

Defining Tail Risk Hedging

Timestamp: 02:37 – 04:11

Chris begins by demystifying tail risk hedging, explaining it as a strategy that guards against significant market downturns. "A tail risk hedge is something that ends up being uncorrelated to the market, but then becomes correlated when markets are going down," Chris explains (04:11). This approach acts similarly to portfolio insurance, allowing investors to mitigate large drawdowns and achieve a smoother return profile over time.

Implementation Strategies

Timestamp: 04:40 – 06:25

Discussing the tools of tail risk hedging, Chris emphasizes the use of derivatives, particularly options. "They're focusing on things that could pay out one to a hundred times what you laid down," he notes (04:40). Unlike some hedge funds that may employ strategies like shorting futures or buying gold with linear payoff profiles, Chris highlights the advantage of options for their asymmetrical payoff potential. This asymmetry allows for significant gains during periods of high volatility without consistently bleeding capital during stable markets.

Understanding VIX and Market Volatility

Timestamp: 06:25 – 09:08

A key component of tail risk hedging is understanding the VIX, often referred to as the "fear index." Chris elaborates, "It's a calculation that runs... as the implied volatility is increasing... VIX starts going higher" (06:25). He describes the VIX as "volatility on steroids," explaining that during market panics, the VIX can spike dramatically, offering lucrative opportunities for tail risk strategies. March 2020 serves as a prime example where the VIX surged, underscoring the effectiveness of tail risk hedging during such crises.

Historical Market Blowups and Strategy Performance

Timestamp: 09:08 – 15:20

Highlighting historical instances, Chris lists numerous events where the VIX spiked beyond 40, such as the Global Financial Crisis (VIX peaked at 96 in August 2008) and the COVID-induced crash in March 2020 (VIX reached 85). "These events happen much more frequently than people think," he asserts (15:20). During these periods, tail risk strategies have historically performed exceptionally well, often yielding triple-digit returns, providing essential protection and capital preservation for investors.

Market Reflexivity and Self-Reinforcing Dynamics

Timestamp: 20:07 – 24:45

Chris introduces the concept of market reflexivity, explaining how modern market structures amplify volatility. "The new market microstructure has led to this amplified form of reflexivity," he states (20:52). Factors such as the growth of ETFs, passive investing, and regulatory changes post-Dodd-Frank have made markets more susceptible to rapid and violent drawdowns. This reflexivity means that during downturns, selling pressure can intensify quickly, making tail risk hedges even more crucial.

Profit Taking During Volatile Periods

Timestamp: 25:03 – 27:33

Addressing the challenge of taking profits during market crashes, Chris emphasizes a balanced approach. "You can never be fully systematic when you're trading a long volatility style," he notes (25:37). Successful strategies often blend quantitative models with discretionary decision-making, allowing managers to monetize appropriately when option prices surge, ensuring they capture gains without prematurely exiting positions.

Short Volatility Trend and Market Impact

Timestamp: 27:33 – 30:25

Chris discusses the popularity of shorting volatility, a strategy that has seen a sixfold increase in Assets Under Management (AUM) in recent years. "Shorting volatility is a bet against the abnormal," he explains (27:50). While selling options can be profitable when markets remain stable, it carries significant risks during upheavals. Overcrowded short volatility positions can lead to abrupt market corrections when tail events occur, causing substantial losses for those unprepared.

Portfolio Allocation for Investors

Timestamp: 30:27 – 33:45

When it comes to integrating tail risk hedging into portfolios, Chris outlines two primary investor types: opportunistic traders and defensive high-net-worth individuals. "Defensive people are just looking for something to offset the losses in their portfolio," he says (30:35). Allocating 5-10% of a portfolio to tail risk strategies can provide crucial protection during market crashes, acting similarly to holding cash but with the added benefit of appreciating during downturns.

Minimizing Drawdowns in Normal Markets

Timestamp: 38:10 – 43:38

Maintaining capital during stable periods is a significant challenge for tail risk strategies. Chris emphasizes the importance of minimizing "bleed" by employing a blend of quantitative and discretionary approaches. "In normal markets, you just flatten out, but when things become dislocated, the tails just pick up," he explains (38:38). By focusing on short-term edges within U.S. equities and derivatives, Ambris Group ensures consistent performance, offsetting potential losses and preserving capital for when tail events occur.

Future Volatility and Market Fragility

Timestamp: 43:38 – 45:43

Chris anticipates continued sporadic bursts of volatility due to evolving market microstructures and increased options activity. "Every few years you get these bursts of volatility," he predicts (43:38). The proliferation of options trading exacerbates the impact of dealer gamma hedging, making markets more reactive and volatile. He remains confident that their tail risk strategies are well-positioned to capitalize on these future volatility spikes.

Regulatory Risks and Tail Risk Strategies

Timestamp: 47:50 – 49:30

Addressing concerns about regulatory intervention, Chris asserts the resilience of tail risk strategies. "It's very unlikely that regulators will ban these strategies," he states (47:50). By focusing on listed options and avoiding exotic derivatives, Ambris Group mitigates counterparty risks and maintains compliance, ensuring their strategies remain viable even amidst potential regulatory changes.

Inspirations and Influential Traders

Timestamp: 49:30 – 51:48

Chris shares his admiration for legendary traders like Michael Platt of BlueCrest, Vinnie Viola of Virtu, and Ed Thorpe of LTCM. He highlights the importance of discipline, process-driven strategies, and understanding market dynamics. His favorite book, The Misbehavior of Markets by Benoit Mandelbrot, has significantly influenced his approach by elucidating the instability and non-Gaussian nature of financial markets.

Conclusion and Contact Information

Timestamp: 52:14 – End

Wrapping up the episode, Chris encourages listeners to explore tail risk hedging further. Interested individuals can visit AmbrusGroup.com or connect with him on Twitter (@Ksidi) for more insights into volatility trading and tail risk strategies. He emphasizes the importance of sticking with insurance strategies to safeguard portfolios against unforeseen market crashes.

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Notable Quotes:

• "A tail risk hedge is something that ends up being uncorrelated to the market, but then becomes correlated when markets are going down." — Chris Citiel [04:11]

• "Selling volatility is a bet against the abnormal." — Chris Citiel [27:50]

• "In normal markets, you just flatten out, but when things become dislocated, the tails just pick up." — Chris Citiel [38:38]

• "Every few years you get these bursts of volatility." — Chris Citiel [43:38]

• "It's very unlikely that regulators will ban these strategies." — Chris Citiel [47:50]

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About the Hosts:

• Clay Fink: Co-host of We Study Billionaires, bringing his expertise in financial markets and investment strategies to listeners worldwide.

• Chris Citiel: Co-investment officer at Ambris Group, specializing in tail risk hedging and volatility trading strategies to protect and enhance investor portfolios.

For more insights and episodes, visit theinvestorspodcast.com and subscribe to their free daily newsletter for the latest updates.

Transcript

[Tip Host]

You're listening to tip.

[Clay Fink]

On today's episode, I'm joined by Chris.

[Chris Citiel]

Citiel to discuss tail risk hedging.

[Clay Fink]

Chris is the co investment officer of Ambris Group which implements a carry neutral tail risk hedging strategy to protect investors against market crashes. A tail risk hedging strategy is designed to help investors protect their portfolios from extreme market downturns, reducing the risk of significant capital loss. By mitigating large drawdowns, investors can potentially achieve a smoother return profile over time, enhancing their risk adjusted returns in the long term growth of their portfolio. During this episode, Chris and I discuss what a tail risk hedging strategy is and how it's implemented, how investors should think about the vix examples of historical market blowups where a tail risk strategy thrives, the benefits of this strategy to investors portfolios, why the reflexive nature of markets has led to more violent and swift drawdowns such as what happened in March 2020, the legendary traders Chris looks.

[Chris Citiel]

Up to, and so much more.

[Clay Fink]

While we very rarely discuss different trading strategies here on the show, Chris's approach to tail risk hedging very much reminds.

[Chris Citiel]

Me of someone who is taking a.

[Clay Fink]

Value investing approach and applying it to the derivatives market. So with that, here's my chat with Chris Citiel.

[Tip Host]

Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, Clay Fink.

[Chris Citiel]

All right, welcome to the Investors podcast. I'm your host Clay Fink and today I'm happy to welcome Chris Citiel to the show. Chris, it's great to have you here.

Thanks so much for having me. I'm excited. I think today's going to be a good one.

On today's episode we're going to be diving into the topic of tail risk hedging, which is a topic we've touched on only a couple of times over the years of the show. And before this interview I was thinking about how we just live in a world where volatility and uncertainty are features of the world and not necessarily a bug. And it's likely always going to be that way. And for investors, we've been a bit spoiled with this secular bull market since the great financial crisis with a few periods here and there of moderate declines before we roared back to new highs. And I think that this can lead to a bit of just complacency among investors who might not appreciate just how Uncertain the world can be. With that said, how about we just start by defining what a tail risk hedging strategy is?

So it could sound a little bit more opaque than it actually is. And I think an easy way for people to think about this is they could say, okay, if you have a coin and you flip a coin, there's only two outcomes that could potentially occur, right? Heads or tails. But in financial markets, those returns are not evenly distributed. And that's what you call non Gaussian. And all that simply means is, you know, the S and P could go up percent over the next three weeks every single day, and then out of nowhere just go down 20%. Right. Just like very, very abnormal. So these tail events occur in financial markets more than people think. And a tail risk hedge is something that ends up being uncorrelated to the market, but then becomes correlated when markets are going down. Right. So an easy way for people to think about this is like portfolio insurance. When markets go down, volatility goes up. You have this thing in your portfolio that could appreciate significantly in a really quick time period. Right. So at Ambrus, what we do is we've run something called carry neutral tail risk hedging. And the goal is pretty simple. We trade the volatility market so that during normal markets we can remain flattish. But then when markets become dislocated and volatility is skyrocketing, we tend to make a lot of money during those periods, which in turn serves as a good form of insurance, quote unquote, portfolio insurance for investors. So that's what I would constitute as a tail risk catch.

And I think when many people think about buying market insurance, they think about just simply buying put options. And I think many people come to find out that they're just bleeding so much money every month, and it just becomes something that's not really worth the premium or the price of admission of that insurance. So what sort of securities do tail risk firms tend to use when implementing such a strategy where they aren't bleeding so much, but they're still able to capture some of that protection during the market panics.

Yeah, well, I think it's very conventional to use derivatives and more so specifically options. Right. You could get very complex with the type of options, from exotic options to all sorts of weird funky things. But generally speaking, if you're utilizing these listed options, you're focused on things that could pay out one to a hundred times what you laid down, right? That's ultimately the goal. You want something that is convex and asymmetrically moving higher as the odds are now moving in your favor. The thing is that you sometimes get other, let's say products or hedge funds that will say, well, we short futures or we buy gold and that's the form of a tail risk hedge. But ultimately those payoff profiles are one to one, right? Whatever you lay down. And in the volatility world, we call that delta one. So whatever you lay down, you're only going to end up making the most as to what you laid down. So when you think about most professional tail risk funds and tail risk strategies, they utilize the asymmetry that's embedded in these options. And I think the one thing that makes utilizing the option space so special is because of the embedded Greeks and the second order Greeks that come into play. And not to make this too complex, but like, you know, if you buy a put option on the S and P, you could make money on that put option even if the S and P doesn't go down, if the volatility, the embedded volatility in the option starts to rise, right? Which simply means the market sentiment is changing. The market's starting to reprice that risk differently. That option could go up 10 times what you laid down for it without the S and P moving at all. So that's the appeal of utilizing options to structure a good tail risk hedge.

And maybe we can talk a little bit more about the VIX and volatility in particular. So during, say some market drawdowns, you might not have the VIX move all that much, but during other market drawdowns you might have just the VIX sort of explode. So maybe you could just talk a little bit more about the VIX for those investors who might not be too familiar with that.

I know when people traditionally think about vix, they think about it as like the fair index, right? And like the sentiment as to how scared the market could be. And that's a decent way of thinking about it. When you get into the mechanics, what this is is It's a rolling 30 day weighted calculation of a strip of SPX options. And what it does is every 15 seconds the calc runs off of the bid ask spread of the implied volume on that strip. All it is, it's, it's a calculation that runs. And what this is telling you is that as the implied volatility is increasing the spread of the options, the SPX options are widening. And then mechanically VIX starts going higher, right? So during moments where liquidity in the market is coming out and people become fearful, they Start aggressively buying those S and P options. Right, the hedges. And that naturally drives the price of VIX higher and higher and higher. But for those who aren't too interested in the mechanical workings of the vix, it could be looked at as variance. And all that means is that it's volatility on steroids. So when you have S and P, you have S and P and you have the implied volatility in the S and P, and then in that vix, which is variance trades at a premium to that. So the interesting thing about VIX in general is that it's going to be compounding these convex returns because variance is effectively squared. What you could think about this is vix's volatility on steroids. And as the market becomes fearful, liquidity starts coming out. This index will appreciate significantly. Yeah.

And when I look at the chart of the vix, typically it's in this sort of range bound, steady state, Whereas occasionally the March 2000 and twenties, that sort of period, it just sort of explodes. And you can see investors panicking in the chart like that. So in March 2020, that's a perfect example where a tail risk strategy would have done really well and then your returns in a normal month would have been roughly flat or so. And I'd be curious just to learn more about March 2020 as an example. So many in the audience know that market saw a sharp drawdown during that period. So yeah, maybe you could just talk more about that period because that's a period where a tail risk strategy needs to be performing at their best.

Absolutely. I mean, that time period is what it's all about. If you are an investor in a tail risk strategy, that is the time period where you're relying on this to be the workhorse and really save your portfolio. And for a lot of funds, you know, if you're a tail risk fund or a long volatility fund, for the most part, you did phenomenally well during March 2020. Generally speaking, there were firms that put up triple digit returns very easily during that time period. Right. But as you're trading in that environment, as a volume trader, what you really need to understand is the value of the embedded options that you have. Because think about it, you go throughout the year, you're buying these options, really, really cheap options, these, let's call it, lotto tickets that most people don't believe will hit. And then now it finally hits. Right? So understanding the historical relationships and the pricing that those options should be priced at and then being able to sell that risk Back to the market is what the game's all about. And I know a lot of people traditionally think about stocks and not really options, but here's a way how you could think about it. Imagine you own a stock and you've owned the stock for years, and then finally one day you wake up and the stock's up 5,000%. You may say, okay, well, is the value of this Stock really up 5000%? Should this be worth 5000%? If not, maybe I need to remove half of this or one third of this position I need to get out. So from the viewpoint of an option trader during March 2020, your whole focus is understanding the risk that you want to sell back to the market. And what's even more special about that is that the whole world wants that risk, right? Everybody is desperately forced to take in that risk. In an environment like March 2020, you have large foundations, you have pensions, you have family offices, you have individual investors that all are now getting margin called that now need to go and serve that margin call and buy protection. And when you're in an environment like that, they'll pay whatever for the protection, right? Like, it sort of becomes like the guy who's in the desert and he needs a bottle of water. The bottle of water may be worth $2, but when you're in the desert, that bottle of water, you'll pay a thousand for it. So that environment, it really breeds opportunity. And I know that may sound like predatorial, but the reality is, is that as a volume trader, those are the opportunity sets that you look to take advantage of and do really well, especially because for the most part, those opportunity sets don't exist, right? So you're just sort of in this middle ground, waiting until that presents itself so that you could then have this large return all at once. So when those March 2020 events occur, the world looks different. Everybody needs to buy protection. Everybody is defensively orientated. That's when you as a trader, you pivot to the other side. And as the world normalizes, you end up outperforming in a really big way.

It's funny you mentioned the value of the options, because going into this conversation, I very much thought of this strategy almost as a value investing strategy, except it just applies to options where you're buying something that might be a bit underpriced and then selling it once it gets to these egregious valuations. We actually had an event recently. It was on August 5th. That was the day I actually turned 30 this year in 2024, and my friends were joking with me that I was going to be able to go out and buy assets on sale while markets were volatile. But unfortunately I get paid on the 1st, so I had a lot of my money already deployed. So August 5, 2024 was when markets were swiftly dropping due to the Japanese carry trade blowing up. So how about you talk about some of these other examples of periods in the past? Of course, March 2020 stands out to a lot of people in their minds, but there's other periods where there was still a ton of volatility, but it might not have stuck in people's minds to the same extent, at least, because there wasn't a global pandemic.

I think the interesting thing was to see how the people that don't really track the volatility market, how surprised they were when volatility ripped so fast. And if you've been in financial markets for a while, you sort of realize that this is much more common than people think. And I could go ahead and I could give you an example. You know, we'll ask people, we'll say, okay, how many times over your lifetime did you think the Vix got over 40? And they'll probably say something like, well, very rarely. We'll say, okay, well, from a percentage standpoint, what's the percentage of times you think VIX could get over 40? Right. And they'll say, oh, that barely happens. Maybe less than half a percent or something. But what's interesting is that when you go through the data, what you realize is that over the last three decades, there's been 11 situations where the Vix has moved over 40. Right. So once every few years, it's very common to get these behavioral reactions where the volatility market erupts. And I think to some people listening to this that are really tracking markets and really invested in markets, they're just like, yes, absolutely, because we've seen that time and time again. You could think about August 2024 was the yen carry trademark. Then you had Covid, which was March 2020. Vix got to 85. Then Vaughmageddon, which was February 2018. Vix got to 50. 2015 was a flash crash, which was August of 2015. Vix got to 53. August 2011 was a European debt crisis. Vix got to 48. May of 2010 was the flash crash, got to 48. GFC, which was during August 2008, it got to 96. That was the mechanical reprice there. There was the whole accounting scandal scare in July 2002. Vix got to 48 September 2001 Vix got to 49 LTCM in 1998 October Vix got to 49 Asian crisis in 1997 Vix got to 48 we could go on, right? We could go on and on. So I think the thing is that these events happen much more frequently than people think. Once every few years you're going to get these behavioral dynamics where volatility erupts and if you're positioned the right way, you can make a lot of money all at once.

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[Clay Fink]

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[Chris Citiel]

All right, back to the show. So based on my understanding, you sort of have this position that you believe that the market fundamentally underestimates the chance and the magnitude of these types of events. Why do you think the market does underestimate it?

I think it's human psyche. I think what ends up happening is us as humans, you gravitate towards things that are more common and you suppress and repress these feelings of things that are uncomfortable and less common. Right? So if you ask a person how many times have their house been hit by a hurricane? And then you go and you ask them the same exact question, a similar question, you say, is it likely that your house is going to get hit by a hurricane? I think what you'll realize in the way how they're able to express this, you could look more into the subconscious side of this is that they don't think hurricanes hitting their home are very likely. It's just the optimistic inclination of humans and our focus to not like to step into that fear and that feeling of being uncomfortable. And I think that feeds into financial markets in general. But what you also realize is that these tail events occur every single day. Because it's not just the left tail event. If you take a look at single stocks, every day you have single stocks exploding higher over the course of a year, two years. You look back and you look at some of these stocks and you're like, oh, wow, that Stock went up 500% over the last year. That was very unlikely. So it kind of goes back to what I was saying at the beginning of the podcast, was that financial markets are non Gaussian, right? They're not equally distributed. And what you can have is these massive right tails that go in one direction and these massive left tails that go in the other direction. But as humans we tend to think that things will just remain more normal and whenever those events occur, it becomes a shocker for us because we're so focused on the more normality.

Yeah, when I think about the normal times, I think investors or people tend to have a recency bias where the near future is going to look like the near past with while we forget some of these big events that happened even five years ago, for example. And I think the other side of the coin is once those panics do strike, is that markets in itself can be a bit self reinforcing. So that's one thing I sort of wish I appreciated more back in March 2020 where the market's falling, these levered firms are getting margin calls and they're needing to sell positions and leads to the market falling even more. And it's just self reinforcing where the market just can't catch a bid and bounce back. Perhaps you could just talk a little bit more about that self reinforcing nature of markets. You know, the reflexivity or going up or going down.

So we wrote a paper on this a couple of years ago and the thesis of the paper was that the new market microstructure has led to this amplified form of reflexivity, specifically in the equity market. And that comes from multiple angles. It comes from the growth of the ETF market and the rebalancing process that comes with that. It comes from the growth of passive investing and how that can be very reflexive. It comes from the changes that took place during Dodd Frank and the way how dealers are supposed to hedge their books. So I know most people are very familiar with the GME thing. I always like to use the GME reference because it kind of echoes in people's heads. You kind of say, okay, well how is it that this group of Reddit users are able to push a stock up and put these large hedge funds on their knees just by, you know, buying these call options and buying the stock. And it gave people who are non derivative traders a clear look at just how impactful dealer gamma hedging could be. And I'll explain exactly why that is so post Dodd Frank 2008. What ended up happening was that the regulators told the banks, they said, hey, you are no longer able to inventory risk the same way you did pre 2008. Now you cannot take risks from the side of proprietary trader. You now need to take risk from a dealer side. So what this means is that imagine you're Playing blackjack, right? You can no longer sit and play that game. You now can only be the dealer. And effectively what this did was it changed the risk tolerance of these larger banks. So now today, if a bank is under stress from a position working against them, they have certain overnight limits that they need to adhere to, certain Delta limits, certain Vega limits, certain gamma limits. And because of that, they now become forced buyers or sellers of something. So if you think about what drives asset prices, going back to the analogy about the bottle of water in the desert, when somebody desperately needs the water, they're going to pay whatever. And this same dynamic occurred during GME because you had these users that came in and bought a bunch of call options. The dealers sold them the calls, so they're short the calls and they need to buy stock to be able to be delta neutral. So what that did was that drove the price of the stock higher and higher and higher and higher. And you saw from a single stock standpoint just how reflexive that could be. But what's interesting is that this same exact dynamic exists on the index side, which is the broad market side. And March of 2020 was a really good example. When markets become reflexive and a bunch of people are buying put options all at once and dealers are offsides, just how much they could drive the price of the broad market lower and lower and lower, right? So when you mix that reflexive inclination in with the fact that people are getting margin called and the fact that people are scared about the world, asset prices could move lower way quicker than people think. And the same way we see it to the upside, it can certainly happen to the downside. But overall, the market has become much more reflexive than people think. And I think also people see it on a day by day basis. There's traders who have been looking at markets for 20, 30 years, and sometimes they're just there watching screens and they're like, whoa, why did this stock go up 1% in the last two minutes out of nowhere? That's crazy. Or why did it go down 2% out of nowhere? And coming from the other side on the deal side, you kind of realized that that was tagged to a really big option print and that's why the position moved so aggressively. So the US derivatives market is engulfing the equity market at a really rapid rate. And the reflexivity that's being embedded from that is really moving asset prices up and down.

And just to make sure I'm understanding that correctly, during a period like March 2020, many people are going out and Buying put options on, say, the S&P 500. When they're buying that put option, the market maker needs to go out and short the stock, which helps push the prices down. Is that correct?

A hundred percent? Yep.

All right, so you shared a number of those scenarios over the past 20, 30 years where we've had these market panics where volatility has spiked. And one question I have is March 2020, for example. There would have been times where the returns would have just been explosive, to say the least. But it brings to the question of are you taking a systematic approach to taking profits during that scenario, or is there other methods to where it's sort of a case by case basis of how you're taking money off the table? How do you think about taking profits during a time like this?

So you can never be fully systematic when you're trading a long volatility style or a tail risk stock. And it's a dilemma that ends up happening. It's a sample size dilemma. I imagine you trying to optimize for a smaller sample size. So imagine you have 10 sample sizes over the last 10 years. You can't run an optimization process on that because it's just, it's just going to be an overhead process which is just destined for failure.

[Clay Fink]

Right?

[Chris Citiel]

And I think this isn't subjective, it's an objective take because we've seen many, many failures in the QIS world. And then also just in the hedge fund space with systematic long volume guys, it just really doesn't work. On the flip side, if you're fully discretionary, that's a big risk too, right? Because you don't want to be the guy that has 1000% return and then he watches it dwindle away to zero, which again, that's happened also. So where I think we lie is directly in the middle. And I think what the correct way to do this is you build out really good infrastructure, really good systems to identify when the manager should be thinking about monetizing and how much they should be thinking about monetizing at certain levels and certain option pricing. So August of this year was a great example, you know, where our strategy did well in terms of appreciating significantly. And it was one of those things where the model sort of showcased one side to say, hey, this is how much that these prices, you know, these options are really overvalued. You should think about getting some of this off and from a discretionary standpoint and we're able to understand the dislocation and say, okay, this makes sense, let's remove 1/8 of this position or 1/6 of this position. So there's a harmony between the fully quantitative side and then the fully discretionary side. And I think the sweet spot is lying right in the middle when you're thinking about monetization process for tails.

During our previous chat, you mentioned to me that in recent years selling volume has been profitable and quite popular. As the AUM in this arena has grown by 6x in recent years, maybe you could talk about what it means to go short volume and what impact that ends up having on markets.

Yeah, So I want to be sure that this doesn't get conveyed in the wrong way. But you know, there's nothing wrong with shorting volatility. And ultimately shorting volatility is a bet against the abnormal. It's. You're more so betting that the normality will continue. And the way that a lot of people express it is by selling options, right? So you could sell put options, you could sell call options, you could sell covered calls, you could sell put spreads, et cetera, et cetera, right? So what you're doing is you're collecting a risk premium that the market is paying you to bet that the normality continues. And there's nothing wrong with doing that. The problem is that most people do it in a very incorrect way. They do it in a way that is price insensitive and yield focus. So what you'll see is you'll get some people that will say, hey, I could make $50,000 a month by selling options. And every single month their goal is to make $50,000. But the reality is that there are times where the price of that option or the market is not compensating you enough for the risk that is being taken. And this is why you hear about situations of volatility funds and volatility traders blowing up every few years. Because the same way how long volume and tail risk guys make a lot of money every few years, there's people on the other side of that trade that lose a lot of money all at once, right? So when people are not price sensitive and they're not understanding of the price of the option and that risk that they're taking in, this naturally suppresses volatility more and more and more and more until it eventually just blows up, right? Which is why if you get sort of like what you said, right, you look at a chart of the VIX and you look at it and you're like, yeah, every few years I see this thing goes up, right? Because every few years, people suppress it, suppress it, suppress it, and try to really take in that type of risk premium in a way that becomes very crowded and then all at once it just completely unravels. So, nothing wrong with selling volatility opportunistically when the market compensates you for the risk that you're wearing. But for the most part, the majority of the world, I don't think, are volatility arbitrageurs and they don't really understand the price of the option that they're selling it for.

And it actually just happens that I'm currently reading When Genius Fails, which covers the story of long term capital management. And it's a reminder that you might have a strategy that you think works really well and you think it's rational and whatnot, but markets sometimes can behave completely irrational and end up blowing up a strategy like that.

[Clay Fink]

So if we transition here to how.

[Chris Citiel]

Investors should think about this strategy in their portfolios, how do you think investors think about allocating to a tail risk strategy in a portfolio?

Yeah, so from our experience, it's been that there's two main ways and two type of investors that usually gravitate toward this. So one, we get a lot of prop firms and prop traders. And I think the reason why is because sort of what I was saying in the middle of this podcast was that if you've been in financial markets for a while, you've seen these events occur over and over and over and you say, okay, I want to do something that makes money when these events occur. The other type of investor we have is like the family offices and the individual investors, high net worth individual investors that will come in and they say, hey, look, we have a certain amount of wealth. We've accumulated this wealth over a very long period of time. We've worked very hard for it and we don't want to lose it. We're just strictly defensive. And those are the two buckets that I think this falls in, right? Defensive and then also opportunistic. Now with the defensive people, they are just looking for something to offset the losses in their portfolio. So like March of 2020, for example, if you have a tail hedge that you have in your portfolio and the other side of your portfolio is down, and it's attributing a negative 20% to your overall portfolio. But you if you had that tail hedge and it's attributing positive 20% to your portfolio if you're flat during an environment like March 2020, that's amazing, right? Because the whole purpose of a tail hedge is so that you can take that capital out, sell that risk back to the market, and then rebalance and buy these discounted assets like the Apple stocks of the world, the Amazons of the world, that are down 50% or whatnot. And then over a 10 year cycle you realize, wow, my portfolio has really outperformed the S and P, really outperformed everybody. And you look back and you're like, because you had the capital that was there and you were able to deploy the capital when everybody else was panicking. So it's either opportunistic because they're traders and come from that trading community and know like every few years this occurs or is defensive where they say, hey, I want to allocate 5 to 10% of my portfolio to something like this so that when things are hitting the fan, I could sleep well at night.

Yeah, I've seen time and time again where investors, when they get a bit cautious in the market or they think the market's overvalued, they'll just simply build up a cash position. I've even seen examples of professional investors holding 20, 30, 40% cash. And what I find just so interesting about this strategy, sort of what you outlined there, where it can almost be like a cash like position. So when the market's rapidly declining, you have this part of your portfolio that's appreciating rapidly. And of course, with the benefit of Hindsight, April of 2020 would have been the perfect time to go bargain shopping in the markets. And it would have been an excellent time to rebalance out of a segment like this in your portfolio. And I think another way to frame this is that you could have your equity portfolio that has an average return of say 10% over the long term. And you have this part of your portfolio where even if the long term average return is 0%, you might have a case where that 10% return actually gets enhanced because of that rebalancing aspect. And I think that can sort of. It's a bit confusing because it's counterintuitive, right?

Yeah. If we're doing our job well, this looks like a cash position that's ultimately the goal in normal markets. It just looks like a cash position where it's not really doing anything, it's super boring. But when you come into those events, then it becomes very exciting. Right. Then this thing is like picking up tremendously and you're doing really well. But most people don't think about it like that. Right. Most people think about it as like, well, if I have to deploy this and this doesn't make any money over the next three years. It's a wasted opportunity set. But I think they missed the bigger picture, which is just like sort of like what you said earlier on this is like value investing. You're like value investing in volatility. And the chart of what this looks like is right in front of you. You could see every few years this is going to pay out. It's one of those things where it allows you to put more cash to risk assets that appreciate and have something that is not depreciating significantly during normal markets, but then can appreciate significantly when things are crashing.

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[Chris Citiel]

All right, back to the show. Now, if someone were to say to me that in a normal market you would maintain your capital and in a down market year and outsized returns, it almost sounds almost too good to be true. So maybe we could talk about the normal markets, what you would call sort of minimizing the bleed. Typically, I think many firms in this space earn say, a flat return in a normal market. So maybe you could just talk about what allows you to minimize bleed during this period.

Yeah, you know, I think that's the goal of almost every good tail risk. One is to say, okay, how do we try to provide this free insurance? And there's years where that mandate does not get achieved, right? For sure. For some firms, it's a constant effort to make sure that you are delivering a true form of alpha. Because if you are not, it could be a double whammy where you really bleed out significantly on the tails. All right? And then what ends up happening is that investors might redeem at the wrong time and you don't make as much during the crash because your capital balances has depreciated significantly, right? So as a trader you're fighting two things. One, you're fighting the fact that over 200 something years equity markets have went straight up. I mean, granted there's tail events within that, but like they have consistently went up. Right. So you can't just bet against that very naively. And the second thing is that when you buy an option, again there's an embedded risk premium. Same way you sell an option, you're wearing that risk. When you buy an option, you have to understand that you're paying a premium for that and the market prices that premium for the most part correctly until it does. So you have those two factors working against you. One, you're paying for premium for something and then two, you're fighting against the fact that equities naturally drift higher. So if you do not have a form of alpha, if you're not able to utilize a way that is reliable to offset the tails, it's going to ultimately lead to ruin. And a decaying tail risk hedge can be just as bad for a portfolio as no tail hedge because it can cause all sorts of mental stress. It could deplete the capital balance enough to a point where when the tail finally hits, you don't get paid off well enough. So it's a very, very difficult thing. With us, I think we have utilized the model that most derivative prop trading firms have utilized over, let's call it the last like 20, 30 years, which is you inventory a lot of these cheap tail options across the Vix complex, the S&P complex, certain sector ETFs, and you focus on some edges that are very durable and reliable that you're able to trade within these shorter time frames so that those edges you're able to tap over and over and over ends up paying for the tails. And in normal markets you just flatten out. But when things become dislocated, the tails just pick up. Right? So a lot of shorter term edges that are in US equities and US equity derivatives tend to be the workhorse for what we do to allow us to then buy those tail options.

You had mentioned the term to me, hedge fatigue. So a prominent institution had actually pulled their money out of a tail risk strategy just months before March 2020. And if the investment isn't panning out for somebody then and you pull the money out, you simply just aren't treating that like insurance and odds are, that isn't going to pan out well for you. So the time when insurance is needed most is oftentimes when it's too late. So it's really critical to stick with this sort of insurance strategy if you decide that you want it to be a part of your overall portfolio.

I think it's a twofold thing. I think the manager has to make sure they're doing a good job of minimizing that bleed for investors. I think when you come across good managers in the space, investors tend to be happy, but then sometimes the manager isn't able to achieve that and then it could lead to, yeah, that hedging fatigue where over the course of, let's say, five years, nothing occurs. And then you're sitting in like a committee meeting or something and the committee is like, wow, five years went by and we lost 10% on this tail hedge in relation to our overall portfolio. That's challenging for us and we don't know about this anymore and we're going to pivot and it always happens at the wrong times. Generally speaking, I think that it's up to the manager to accomplish their side of the mandate and then also articulate to the investor what the mandate really looks like. Because if the investor understands that they're going to lose a significant amount of money on this insurance, they could size it correctly. Right. And I think that that could alleviate the hedging fatigue. But for the most part, it's just tough to stick with something that just is bleeding out. Which is why we run our business very differently than that. Because I think there's a much more effective way to do this. Just like what we've seen in the world of derivative prop trading. The world where we come from is taking that same sort of model and just applying it into this space.

It's also interesting that you run this sort of strategy, given that I'd say many people would say our world is becoming increasingly more fragile. There's people out there saying that financial markets overall are very fragile and is relying on continued liquidity from central banks and whatnot. Who knows how true all of that is. How do you think about the sporadic burst of volatility today and the likelihood of them continuing into the future?

This is something that myself and the rest of the team at Ambrus, we've done a lot of work on and we've written multiple papers that are on our website about this stuff. And we feel pretty strong that because of the changing market microstructure, it's going to be one of those things where every few years you get these bursts of volatility. And just like what we saw during this past August, the velocity as to how volatility could move will be substantially higher than I think people have thought about in the past. And I think other shops are understanding this as well, which is why you're getting more strikes listed on an index like Vix. You know, like back during March 2020, I think Vix, the highest listing was like 80, and then they went to 150. And then over the last like two years, it was 180. And then after the move in August, they started listing 200 strikes on Vix. People are becoming more knowledgeable that variants could reprice very fast. And because of these liquidity pools that exist in the market, volume could go up a lot further than people think, and equities could go down a lot further than people think. So we stand by the fact that we think that these sporadic bursts will remain in the market. And because of the market microstructure, because of those things like the growth of passive investing, because of a lot of rebalancing flows, because of a lot of the crowding in certain strategy sets, because of dealer gamma hedging, et cetera, et cetera.

How about the increased options activity in the market? Does that play a factor as well for you?

Absolutely. I mean, I think that that plays right into the dealer gamma hedging thing.

Right.

If you have more of these options being listed and more people trading them, the chances of dealers becoming offsides and the impact of their hedging when they're offsides increases tremendously. So because of the fact that there are more options being traded, there is more embedded risk in the system, there are less market makers that are out there. The dealer community has shrunk. It's kind of evident that whenever these dislocations occur, they're going to be very volatile, AKA what we saw during this past August.

Now, the last thing I want to do is talk politics on this show, but regardless of which side of the political aisle you're on, I think many people would agree that the current administration has the potential to usher in a period of higher volatility or at least these sporadic bursts. You think about things like tariffs, what they're doing with Doge and whatnot. Does this change how you would position yourself during this period?

We don't really get swayed by macroeconomic thematics or geopolitical narratives or anything like that. We're very process driven as a firm. But what I would say is that as we come into the Trump administration, it's allowed us to lean very slightly higher in the view of our volume exposure because of the positioning that the Trump administration brings. So we're noticing things like PB net leverage across the entire street has increased. We noticed that domestic RIAs have increased their exposures to equities. We've noticed that foreign pensions have increased their exposure to US equities as well. So I think a lot of people have been set up for the quote unquote Trump playbook. And whenever you get that type of one sided positioning, it could continue for a very long time. Shoot, equity markets could go up another 20% this year. But along the way, whenever they do go down, volatility erupts. And because of the positioning being so one sided volatility reacts in a much more stronger way. So very process driven. But this is one of those times because of the positioning, we're able to pivot a little bit stronger on our volume exposure.

And another point I had come to mind was there's been a previous guest on the show who was actually short financials during the gfc and it turned out that lawmakers ended up banning the short selling of financial assets. So he ended up getting burned for being on the right side of a trade, at least initially. So is that a risk and a tail risk strategy? You know, where you're the one institution or there's a few institutions just making money while everyone else is losing money. So there's a regulatory risk to some extent or does that not really apply because it's almost like an exception with the gfc?

Well, this is one reason why we try to avoid trading exotics because of the counterparty risk that exists with a lot of the exotics trade. And we say, okay, focus everything on the listed side because those are settled, they'll settle up fast and it's very hard to bust those trades. I think what makes this one a little bit different is that we're never leaned like in a certain sector specific or a certain company related name. We're more so from a broad standpoint. So we could be in some ETFs, we could be in S and P, we could be in vix. And I think that you could look at this and say, okay, well if regulators bust trades on downside stuff for broad markets, then that changes the whole capital market system tremendously. Right? Because then nobody would ever buy risk premium and which means nobody would be able to sell risk premium and capital markets in the US would not exist in the same capacity that they do. So you can't have free markets or let's call it Orchestrated markets, if you remove that and then also for the fact that it is hedged related. Right. So this is one of those things that theoretically should be offsetting losses in other areas. And I think that if regulators take that away from investors, markets just really wouldn't make sense. So one of those things where I think it's very unlikely that that occurs because of just the structure of how markets would have to change.

Yeah, that totally makes sense to me. And since we pretty rarely discuss trading and these sort of strategies on the show, I'd be curious just to learn more about what legendary traders you look up to and which ones you think are most worthy of studying and maybe if there's any books that have been really impactful for you and your journey as a trader.

Yeah, absolutely. So Michael Platt from Bluecrest, amazing trader, amazing fund manager. You know, he ran that fund in the way that I thought really embodied what a good trader looks like, which is someone that is super disciplined, someone that is very process driven, someone that understands that markets will be right. It doesn't matter what your view is. It's about what the market's view is and how you can make money off of doing that. I think another one is Vinnie Viola from Virtue. You know, sort of comes from that old school pit trading background. I'm a huge fan of what they've been able to build up, you know, for years. Virtue has made tons and tons of money, especially on the market making side. So just another complete legend in my eyes. I'd say Ed Thorpe, you know, Thorpe mastered the game from so many different levels. And I think that the lessons that he really echoed on is something that is timeless. The way how he thinks about risk, the way that he thinks about opportunity, set some of the sizing that goes into this stuff. Whether you're a believer of in Kelly sizing, half Kelly sizing or not. It's been a very good guide to look at at Thorpe and what he's been able to accomplish in terms of books, personally speaking. I think my favorite market book is the Misbehavior of Markets by Benoit Mandelbrot. And I think that he does a really good job of explaining, way before so many of these more known market crashes, why financial markets can be unstable and less stable than the conventional thinking presents. And I think he does it in a way that showcases the math behind it and showcases the qualitative side behind it. After reading that book, you kind of realize that systems exist and they break. And this is not only markets related, it could be in life in general. And if you could have a structure that alleviates that breaking when they occur, it could take you way, way further in life than many, many things. It could sort of springboard you into other areas of life, which I kind of think about COVID Forget markets for a second. I kind of think about COVID and I'm like so many people became very wealthy during COVID because of the opportunity set that presented themselves in their space because system broke and if you had a good structure that was in play, you took advantage of it. So I think that echoes on to many things in life. But yeah, Misbehavior of Markets by Benoit Mandelbrot Wonderful.

Well, I'm glad you mentioned Ed Thorpe. He had returns, unprecedented returns of 20% per year. And we actually had him on podcast back in the early days, back in 2017 on episode 128. So if anyone's interested in learning more about that investing legend, they can go back to that episode. But Chris, this was a lot of fun. I want to give you the final handoff. For those that are interested in getting in touch with you or learning more about Amber's group, please let them know how they can do so out.

Yeah, you guys could go to ambersgroup.com or, you know, you could reach out to me on Twitter. I'm fairly active on Twitter, just posting stuff about life and trading and volatility trading. My handle is Ksidi, but for the most part, you know, if anyone's interested in learning a little bit more about tail risk hedging and volatility trading, we're very open, very responsive on our website. So please reach out. We always love talking about this stuff.

Wonderful. Well, thanks again Chris. I really appreciate it and enjoy this chat.

Yep, same here. It was a fun one.

[Tip Host]

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