Derivatives Trading Legend: "As Little As A 4% Decline In One Day Could Start A Critical Crash"

After building out Merrill’s mortgage trading floor basically from scratch, then moving to the buyside at Pimco, several weeks ago Harley Bassman, more familiar to many traders as the “Convexity Maven” – a legend in the realm of derivatives (he helped design the MOVE Index, better known as the VIX for government bonds) – decided to retire (roughly one year after his shocking suggestion that the Fed should devalue the dollar by buying gold).

But that did not mean he would stop writing, and just a few days after exiting the front door at 650 Newport Center Drive in Newport Beach for the last time, Bassman wrote his first full article as a “free man”, in which the topic was, not surprisingly, derivatives and specifically the recent collapse in vol – and convexity – what prompted it, but most importantly and what everyone wants to know: what threshold would be sufficient to finally launch the next “critical mass” market move (i.e. crash) and, just as importantly, what could catalyze it.

He answer all of the above in his latest fascinating note.

Bassman’s full thoughts below:

“Rambling near the Edge”

Last month I attended the EQD (Equity Derivatives) Conference in Las Vegas. Diverse speakers opined upon a variety of topics, but a common theme was noting the near record low of both Implied and Realized Volatility in the financial markets. But despite the VIX kissing its nadir, realized volatility has plumbed even lower depths, and thus it was reported that strategies that engaged in selling Equity Volatility had both superior returns as well as the loftiest Information (Sharpe) Ratios among the dozens of strategies offered.

What was of special interest to me was that while many strategies involved the direct selling of Volatility via listed or OTC options, there were many other investment themes that had at their core a “sell Volatility (Convexity)” profile; thus, their recent success may not be due to the cleverness of the strategy, but rather is just fully coincident to the success of any short volatility investment.

There are many vanilla investment constructions that decline to use derivatives, yet are actually negatively convex portfolios in sheep’s clothing. These include:

Low Volatility – An equity portfolio devised by purchasing the least volatile stocks. Over the past few years these portfolios have generally out-performed the generic Index;

Equity Volatility Targeting – Embedded in many equity-linked insurance products, these risk targeted (often called “Managed Risk”) portfolios increase/decrease investment leverage on a formula based upon realized volatility;

Risk Parity – Similar to Equity Volatility targeting, but here the investment universe is widened to include fixed-income, currencies and commodities.