Volatility Trades and Explosive Shorts

Also anti-money-laundering compliance, Uber, Snap, short-termism and collateral.


A basic rule of volatility trading is that if you bet against volatility, you will increase volatility. So a classic way to bet against volatility would be to sell call options, and hedge them by buying the underlying stock. You might, for instance, sell an at-the-money call option on 100 shares of stock, and buy 50 shares of stock to hedge. If the stock price goes up, the price of the calls will also go up; you'll make money on the stock but lose on the calls. If the stock price goes down, the price of the calls will also go down, and again it will balance out.

But if the stock price goes up, your hedge will also be less of a hedge. After all, if the options end up in the money, you will need to deliver 100 shares to the buyer, not 50. If they end up out of the money, the proper hedge will be zero shares. So if the stock price moves, you will need to adjust your hedge. If the stock goes up, you'll need to buy more shares, to hedge the increasing risk that the options will end in the money. If it goes down, you'll need to sell some of your shares. (This is called "dynamic hedging," and the Black-Scholes math that tells you how many shares to buy or sell is pretty well understood. That math also uses Greek letters. The hedge is called "delta," and the change in the hedge as the stock price moves is called "gamma.") The two things to notice here are:

  1. You're buying when the stock goes up, and selling when it goes down. This is bad. (Normally you want to buy low and sell high.) But you have to do it, to keep your position hedged. And the more the stock moves, the more you have to rebalance your hedge -- buying high and selling low -- and the more money you lose. If the stock stays flat, you don't lose any money (and get to keep the premium that you received for selling the options in the first place). This is why selling call options is a bet against volatility.
  2. If you buy stock when the price goes up, you'll push the price up more. If you sell when the price goes down, you'll push the price down more. Your own hedge rebalancing is increasing volatility. Your bet against volatility has caused volatility to go up. You are not just a passive observer of volatility; you are also helping to create it.

Anyway people seem to be pretty excited about the Catalyst Hedged Futures Strategy Fund:

It is the buzz of Wall Street: a five-day, 15% plunge in a U.S. mutual fund whose bearish bets were undone by the S&P 500’s latest run to fresh records.

The Catalyst fund (here's a factsheet) was betting against volatility. Here's one explanation:

The Catalyst fund’s strategy uses options on the S&P 500 index, contracts that allow investors to buy or sell at set prices over fixed time frames. In this case, the fund employed a “butterfly spread” that benefits the fund if the market remains stable, rises slightly or declines in any magnitude.

But we can ignore the options bestiary and just assume that it was short call options. More technically: It was short gamma, meaning that it was in the position of our call seller above, who has to buy stock -- here, S&P 500 futures -- when the stock goes up and sell when it goes down. (Catalyst had also bought options, but its net position, at the relevant times and prices, seems to have been short gamma.) Those "options were set to expire Friday, meaning there was little time for the market to reverse and return the bet to profitability." More importantly, it means they had a lot of gamma: If it's Wednesday, and you are short an at-the-money option on 100 shares that expires on Friday, then you are going to have to come up with either 100 shares or zero shares by Friday. If the stock ticks up just a little bit, you'll have to buy a lot; if it ticks down just a little bit, you'll have to sell a lot. You can see Catalyst's problem, as the S&P crept up on Tuesday and Wednesday.

But Catalyst's big bet against volatility also may have added to the volatility:

Theories abounded Wednesday and Thursday that forced covering by Catalyst was doing everything from boosting stocks to pushing up the Chicago Board Options Exchange Volatility Index, also known as the VIX. Some of the speculation focused on unusual market happenings, like when the VIX jumped as stocks rallied yesterday, a relatively rare concerted move.

“There may have been some market impact from our trading earlier this week, but it’s certainly not the majority of the market impact, by any stretch,” said Szilagyi.

People seem to want absolutes in this story. Did Catalyst cause the market moves? (It's right there in the name! Surely it was a catalyst?) "Our exposure was greatly exaggerated, and our impact on the market was greatly exaggerated," said Catalyst Capital Advisors LLC Chief Executive Officer Jerry Szilagyi. "I’m hard pressed to imagine that a $4 billion fund is moving the entire market," said Edward Walczak, the fund's manager. On one level, I'm sure that's right. On another level, buying is what makes prices go up. It is the nature of volatility trading that they probably had some impact. 

Or: Was Catalyst "forced" to cover its positions? Szilagyi said: "Comments that we were forced to short cover are not correct. We haven’t been forced to do anything." But if you are short gamma going into an expiry, and the stock is going up, the Black-Scholes formula will "force" you to buy stock. (Or get rid of some of your positions, instead.) Not literally. You can ignore it. But if you are a hedged volatility trader, the Black-Scholes math is going to feel like at least a pretty strong suggestion.

I don't have any reason to think that anything weird was going on at Catalyst, any forced trading that would move the market. But probably something normal was going on at Catalyst: It was a hedged option seller, had to adjust its hedge, and in doing so probably had an effect on the market.

Don't do this.

Umm, so:

According to the affidavit supporting the criminal complaint, Barnett offered a confidential source (CS) $10,000 to place improvised explosive bombs in Target retail stores along the east coast of the United States. Barnett created at least 10 of the explosive devices, disguised in food-item packaging, which Barnett delivered to the CS on February 9, 2017. Barnett then asked the CS to place the explosive devices on store shelves from New York to Florida. He also provided the CS with a bag of gloves, a mask, and a license plate cover to disguise the CS’s identity from law enforcement.

Barnett theorized that the company’s stock value would plunge after the explosions, allowing him to cheaply acquire shares of Target stock before an eventual rebound in prices.

I feel like someone needs to go to his jail cell and explain short selling to him. I mean, also lots of other things. But the way to profit from stock prices going down is by shorting the stock, and then covering when the prices go down. That's the trade here! But his (alleged) plan -- not shorting, but waiting until after the explosions and then buying -- makes no sense. What if he blows up some Targets, and the price drops, and he buys stock, and then some other idiot blows up some more Targets, and the price keeps dropping? The future is always uncertain. If you are going to insider trade, or whatever this is, you want your trade to exactly reflect the thing you have the most control over, where you actually have information that no one else has. Here, sure, blowing up some Targets will probably push the stock down, so you want to be short the stock heading into the bombings.

It goes without saying that none of this is any sort of advice.

We talk sometimes around here about the first two Laws of Insider Trading, which are (1) don't insider trade and (2) certainly don't insider trade by buying short-dated out-of-the-money call options on merger targets. I have never thought it necessary to formulate a law like "don't insider trade by planting bombs in a store so you can short the company's stock." But definitely don't do that. That is every kind of advice. We also sometimes talk around here about how all law is securities law, how securities regulators expand their jurisdiction to regulate sexual harassment and global warming and whatever other issues they care about. But securities law is, in the grand scheme of things, not that big a deal. You don't want to get caught insider trading. But you really, really, really don't want to get caught planting bombs in Targets. Come on.


The U.S. Federal Bureau of Investigation, various intelligence agencies and various Congressional committees are investigating whether there are any suspicious connections between Donald Trump and Russia. But so, apparently, is someone else: Deutsche Bank AG.

The scandal-hit bank that loaned hundreds of millions of dollars to Donald Trump has conducted a close internal examination of the US president’s personal account to gauge whether there are any suspicious connections to Russia, the Guardian has learned.

Wouldn't it be funny if Deutsche Bank found things that the FBI, the CIA, the NSA and Congress didn't? And why not? The thing to keep in mind here is that if you are a large international bank, your most important business is U.S. anti-money-laundering compliance. I doubt that BNP Paribas has done too many trades that are bigger than its $8.9 billion fine for violating U.S. sanctions. HSBC paid $1.9 billion. Commerzbank paid $1.45 billion. There are lots more, suspiciously concentrated among non-U.S. banks. Deutsche Bank itself paid $258 million for sanctions violations in 2015, and then paid $630 million just last month for ... facilitating suspicious trades in Russia.

Deutsche Bank has all the right incentives to catch suspicious trades in Russia. If Deutsche Bank is smart, it is hiring the very best people in the world at ferreting out suspicious Russian transactions, and paying them millions of dollars, with performance bonuses for catching anything untoward. How can the FBI or the CIA compete with that? In a sense, the last few years of U.S. anti-money-laundering enforcement have effectively privatized the business of catching foreign financial corruption. If you're an expert at finding corrupt transactions, why would you work at the FBI? The place to ply your trade is clearly at a big bank. 

Oh by the way that might all go away:

America's largest banks are to propose a complete overhaul of how financial institutions investigate and report potential criminal activity, arguing that rules imposed in the years after the Sept. 11, 2001 attacks and strengthened during the Obama administration are onerous and ineffective, sources said.

People are worried about unicorns.

I'm a little worried about one unicorny point in yesterday's Money Stuff that needs to be expanded a bit. We  talked about Uber Technologies Inc., which is buying stock from employees at prices well below where it sells stock to investors. "Uber is, as it were, getting paid the bid-ask spread," I said, and I think that is a true and useful explanation of what's going on. But several readers pointed out: Uber is also buying and selling different things. It's buying common stock from employees, but it's selling preferred stock -- with liquidation preferences and more rights -- to outside investors. The investors should pay more. The difference is not entirely an arbitrage.

Elsewhere in unicorns, Snap Inc. co-founder Evan Spiegel "is set to receive about 36.8 million restricted shares in the company" at the close of its initial public offering, "equal to about 3 percent of its outstanding stock." That's a lot of stock ($588 million worth, at the high end of the IPO pricing range). I don't entirely understand the point of giving a founder restricted equity awards? Like, he already owns a ton of stock (more than $3.4 billion worth). He effectively controls half the company. "The award was granted in July 2015 to motivate Spiegel 'to continue growing our business and improving financial results'"; was he not motivated before? There is an arcane theological feel to many executive compensation discussions, which only make sense if you already have faith. Maybe if I owned $3.4 billion worth of stock in a company that I had founded, my attention might wander, and I might stop caring about growing the business. But then the promise of another half-billion dollars of stock might bring back my focus. It is not impossible? I have no relevant experience by which to evaluate that claim. It does seem odd.

Also this is a little weird?

Snap is reserving 14 million shares, or 7% of its offering, for friends and family of its executives. The company says those may include existing investors but won’t include employees. The friends-and-family allotment could give the impression that buddies of Snap’s 26-year-old Chief Executive Evan Spiegel will be laying claim to a sizable portion of the available shares. They could be long-term investors, or they could be getting the generous gift of the IPO pop.

Elsewhere: "Theranos Had $200 Million in Cash Left at Year-End." Would you have guessed higher or lower?

People are worried about stock buybacks.

Here is Larry Summers on short-termism:

Some companies have great ideas, great management teams, and compelling strategies. They invest heavily, seek to grow revenue, ignore the management of earnings, and do limited stock buybacks. These are the criteria McKinsey uses to measure long-termism. Other companies lack vision and have mediocre management. They invest less, cut costs more, manage earnings, and buy back their stock. McKinsey deems them short term–focused.

No surprise, the long-term companies outperform the short-term companies. But this may be due to their vision and execution capacity, not their long-term focus. 

That is: "Short-termism" (spending money on buybacks rather than growth) may be a perfectly appropriate response to a lack of opportunities, or a lack of ability to execute on them. Companies with mediocre managers and not too many opportunities that invested their money in "growth" would just waste the money (and enrich the managers). Good governance properly demands that those companies give the money back to shareholders, who can put it somewhere useful. The short-termism is -- arguably -- a symptom, not a cause.

Elsewhere, the Roosevelt Institute is worried that a corporate tax cut will just be wasted on stock buybacks:

American businesses already enjoy a historically low cost of capital, and they have more than enough cash on hand to invest, raise wages, and create jobs. Corporations are choosing to make dividend payments and stock buybacks instead of investing because they face a lack of competitive pressure—itself the result of power and wealth shifting toward rich shareholders. Another tax cut for the rich will only make the problem worse.

People are worried about bond market liquidity.

I'll count worries about collateral as a subset of bond market liquidity worries:

The world is running out of safe financial assets. One reason may be regulators’ push to make trading safer.

A scarcity of safe collateral can create bouts of volatility in the markets where investors fund their purchases.

The problem is that clearinghouses have to collect margin and invest it somewhere safe, and as more derivatives trading moves to clearinghouses, there'll be more collateral demand from them. This seems like ... less a new problem, and more just a problem that moved from somewhere else? After all, when derivatives traded bilaterally, the banks collected margin and had to keep it somewhere safe. Broadly, though, they collected less margin and kept it somewhere less safe. The question, as so often, is: Were the banks' economic decisions about margining and collateral better or worse than regulators' decisions?

Things happen.

At Cerberus, Feinberg Built a Web of National Security Ties. Hurdles Mount for Saudi Aramco’s IPO. Public Finance Authority shakes up muni market with help from ‘public good’ evolution. Fidelity Investments Reports Record Revenue in 2016. Mark Zuckerberg has a new mission statement. Samsung Heir Jay Y. Lee Is Arrested on Bribery Allegations. Norway Central Bank Chief Warns of ‘Sharp’ Drop in Wealth Fund. One of Government’s Largest Landlords, Vornado, Pays Millions Each Year to Trump Company. ‘In Trump We Trust’ Is Market Mantra as Turmoil Besets White House. A Little Birdie Told Me: Playing the Market on Trump TweetsMnuchin Warned by Japan, Germany as G-20 Sees New Economic Order. Embattled CFPB Gets a Legal Reprieve. What lettuces tell us about deregulating Britain. Hunter Harrison ‘Disappointed’ CSX Board, Activist Partner Unable to Reach Settlement. Ex-Citigroup Banker Taps Global Talent to Revive India Bank. Explanations for cost disease. Spain looks to overhaul long workday culture. The Beautiful TI-108. Salt bae. 13 pounds of horse genitals concealed in woman's luggage; claimed it was for medicinal purposes.

If you'd like to get Money Stuff in handy e-mail form, right in your inbox, please subscribe at this link. Thanks! 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story:
    Matt Levine at

    To contact the editor responsible for this story:
    James Greiff at

    Before it's here, it's on the Bloomberg Terminal.