Equity 1 Group
Pushing back the frontiers of economic ignorance and restoring sound financial foundations, one family at a time.

An Expert’s Walkthrough on Exactly How the XIV is Ripping People’s Faces Off.

Pensions Strapped for Money to Pay Retiring Boomers are Going to Die as They Hunt for Yield By Shorting Naked Vol.

See the source image

ZeroHedge  |  by Vince Lanci

The Short Version

History does not repeat itself, It does however, hum the same melody.

There is a lot to read and watch today. As a courtesy, here are the mechanics of what is going on right now in the volatility sector. We focus on Pensions, feel free to substitute any sector you want. It’s all is applicable. I ask you to bookmark and share this with friends and family who may be saying “Why” and “WTF” right now. What follows is the reason and the classes of people to whom you should be pointing your fingers. Here is a key extract from the original post on December 4th post describing the “how” before the turmoil occurred. This is, as I am fond of saying “The Answer Key” for the what, why, and how of this theft of wealth

This is the way the next crash will likely come. The need for yield for pension funds to actually pay their retirees makes them prime targets for bank ideas to create yield. Ideas like “just sell vol”. And like those old school sellers of strangles to capture premium, they have been right almost 5 years running. But it takes only 1 time to be wrong, and that pension will blow up.

Simply put, unhedged stock longs will buy puts hand over fist in a washout to hedge their downside. And that will trigger Pension fund losses from short Vol positions against no other asset, or worse, pensions will have to buy stocks at prices above where they are trading.*

And the more it goes against them, the more they sell. They are betting on a regression to the mean concept with no regard for margin calls or bank roll management.

Here is what is scary. Those Pension managers selling vol are jumping on a band-wagon environment created by the Fed. And, like Portfolio Insurance in 1987, they will sell more as it goes against them. They are doing what is almost exactly like that ill-fated, poorly conceived, no-accounting-for-exit- risk in VAR concept Wall Street sold them that lead to the 1987 crash.

UPDATE 8:40 AM Feb 6: Everybody is talking about the contribution volatility has and continues to make to the slaughter of the stock market. The XIV being the tip of that spear. The unanswered question for many who can catch their breath is HOW DID THIS COME TO BE?

We now know the means by which the markets have begun their meltdown. What we lack is the motive that triggered this. That motive lies in the greed that preceded the fear we are seeing now. And here, from 2 months ago is the walkthrough of the What, How, and Why we are in the free fall we are in now. My intent was not to predict the market drop. It was to explain that if it did, volatility would be the snowball effect factor creating the negative reinforcement we are now seeinb

This is written for the general public, so that they may better understand why they will never be permitted to catch up to their bosses in wealth terms. The custodians of their money are mostly idiots. The rich will get richer.

The Math

UPDATE 1 8:00 PM Feb 5th: Given market behavior the last few days and the destruction of short volatility players who actually sold Vol as a dividend for their portfolios; check that- YOUR portfolios if your money is in a pension fund;

We thought it proper to trot out this rather clear explanation and prediction made less than 2 months ago of exactly how the public is getting the shaft this time. And it is happening right now.

That is how people are getting their faces ripped off. Margin calls are coming in.
Here is a walkthrough of how greed and Wall Street product enablers combine yet again to destroy your wealth.

Pensions Strapped for Money to Pay Retiring Boomers are Going to Die as They Hunt for Yield By Shorting Naked Vol.

History does not repeat itself, It does however, hum the same melody

This is the way the next crash will likely come. The need for yield by pension funds to actually pay their retirees makes them prime targets for bank ideas to create yield. Ideas like “just sell vol” are now being lapped up. And like those old school sellers of strangles to capture premium, and the users of “Portfolio Insurance” pre-1987, they have been right along time now. But it takes only 1 time to be wrong, and that pension will blow up. Who is on the other side of those short vol positions we wonder?

The 1987 Crash Cause was Portfolio Insurance & (No) Exit Liquidity

The ludicrous Wall Street strategy/ idea pitched to investors known as Portfolio Insurance is what caused the 1987 crash. This risk has essentially been recreated from my point of view in the naked selling of the VIX in combination with the passivity of investors as exemplified by products like ETFs.

The New Crowded Trade

With the need for yield, pension funds are now selling volatility for income. One would think this is not unlike selling covered calls on Gold or a stock you own. But that is not the case here at all.

What is happening now is fund managers who need to perform for their retiring pensioners are simply shorting volatility as an asset class itself. They are not writing calls against a long stock to create income without adding to downside risk. In fact, many will be forced to buy stocks at higher values than they are trading in a collapse. They are selling PUTS as well as Calls either directly or via the VIX index. Thier risk is volatility added on top of their stock price risk. They are naked short an asset that is essentially a Texas hedge for stock longs.

Caveat: that is not to say the Fed won’t ensure vol stays manageable to keep from collapse. The proceeds are profits made from vol longs. Buyers are subsidizing pensions.

Remember, the Fed can stay irrational longer than you can stay solvent. And when it comes down to it, pot odds may dictate actions in the future. So while I outline the recipe for disaster below, even the best risk reward scenarios don’t pay off sometimes. Just saying.

How 1987 Happened

Back then, stock holders were told to sell indices if their particular stock went down. How it likely went down as a broker advises his client who is long IBM:

Market lower?… sell stock index futures… If it goes lower, sell more. IBM is great. it is the broader market we have to be careful of dragging IBM down unfairly.

This created a self reinforcing cycle as arbitrageurs sold shares while long stock holders sold futures to hedge their position.

Fundamentals Did Not Matter in 1987 And They Don’t Now

You see, these people believed the stocks in their portfolio were GOOD. The advice given by Wall street at the time was to NOT sell your longs as they were good. But rather sell broad indices to hedge your market risk. This was before the ability to buy put was facile The killer is, these people were told to sell into weakness, not to put on a hedged position at the beginning. It was insane. This was a product/ idea created by Wall street firms to generate commissions with no regard to exit liquidity. It was a crowded trade.

The same thing is happening again. Pension funds are betting on the Fed to give them the “put” back. The much used metaphor of the “Fed Put” is now being assumed to be real. to repeat: They are not short options against an asset. And the more Vol goes against them, the more they sell. They are betting on a regression to the mean concept with no regard for margin calls or bank roll management.

How It Will Happen Again

Pension funds selling Vol, like Portfolio insurers before them, are going to be forced to play the martingale roulette wheel approach to investing. The further your position goes against you, the more you sell stock indices to hedge your particular stock. Double down until you make your money back and no “0” or “00” please.

GOLD EXAMPLE: Stock holders were actually told to sell their Gold instead of selling their stock losers. If you are old enough, Gold was called limit up in 1987, and ended limit down form stock longs selling to maintain their stock positions.

The New Crowded Trade is Short Vol

Volatility of an asset is not risk per-se. Bank roll management, length of time a position is held and other factors reduce it to noise ifproperly managed. But what if Volatility of stocks is the asset being shorted itself as some sort of income stream for a stock portfolio? Not just Calls, but Puts as well. The major component (Volatility / Time value) of the very instrument (Puts) used to hedge directional stock risk is being shorted as well now. The more premium collected the better.

Further, In a declining stock market, Volatility will move consistently with the dominant players position. These are stock longs we speak of as “dominant”. The “tell” of who has the biggest risk is in the volatility smile’s skew. That skew tells me and every other option guy that stock longs are the dominant (not necessarily the strongest) players.

Skipping a few steps; in the stock market, lower prices cause an increase in implied volatility due to an inverted correlation and the stochastic nature of volatility. Simply put, unhedged stock longs will buy puts hand over fist in a washout to hedge their downside. And that will trigger Pension fund losses from short Vol positions against no other asset, or worse, pensions will have to buy stocks at prices above where they are trading.*

And the more it goes against them, the more they sell. They are betting on a regression to the mean concept with no regard for margin calls or bank roll management.

Here is what is scary. Those Pension managers selling vol are jumping on a band-wagon environment created by the Fed. And, like Portfolio Insurance, they will sell more as it goes against them. They are doing what is almost exactly like that ill-fated, poorly conceived, no-accounting-for-exit- risk in VAR concept Wall Street sold them that lead to the 1987 crash.

This is the way the next crash will likely come. The need for yield for pension funds to actually pay their retirees makes them prime targets for bank ideas to create yield. Ideas like “just sell vol”. And like those old school sellers of strangles to capture premium, they have been right almost 5 years running. But it takes only 1 time to be wrong, and that pension will blow up. Guess who is on the other side of those short vol positions.

We bet one pension fund (preferable a union one) will be permitted to fail a la Lehman.

Then the fed will down something about the problem .

Something strange is going on in the financial system. And according to The Wall Street Journal, it’s causing some investors to move massive amounts of money out of the banking system.

Advertisements

No Responses to “An Expert’s Walkthrough on Exactly How the XIV is Ripping People’s Faces Off.”

Leave a Reply

Please log in using one of these methods to post your comment:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

w

Connecting to %s

%d bloggers like this: