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Losing your shirt, institutional style.

By Gontran de Quillacq, Managing Director, SEDA Experts LLC


To start, a quick summary of asset returns as of Friday 3/13/20:



This not a pretty picture, and the situation has actually worsened since Friday.

Everybody will suffer, but probably the retirees the most.

The mathematics of rare events

This may be a large and sudden deterioration, but don’t get fooled. Such events are far from rare.


Previous articles (Gamma Scalping 101 and 102) explain why derivatives traders monitor carefully how frequent such ‘rare’ events happen. Their profitability depends on it, as the returns of a delta-hedged option is quadratic in spot:


On the S&P 500, and equity indices in general, these events are way way more frequent than a standard measure of probability distribution (Gaussian) implies.


The S&P 500 is known to have very “fat tails” both upward and downward, as displayed by this Q-Q plot:


Investors should not bet against the likelihood of such events, precisely because they are more frequent than thought, and because their financial outcome can be significantly large. It’s like picking up dimes in front of bulldozers. It’s easy, because the bulldozer is so slow. You win small but you win so often! Your income is di-ver-si-fied. Until the day where the bulldozer for some reason wins the race.


In investment jargon, selling insurance against market crashes shows attractive risk-adjusted returns, a ‘high Sharpe’. Consistent returns, with little and rare downsides. Usually.


Many investors, from small to large, have fallen into that trap. We have seen this scenario unfold several times the last decade:

  • Victor Niederhoffer lost hundreds of million of client assets in the October crash of 1997, and then again in 2007.

  • AIG was bailed out in September 2008, after selling massive amounts of CDS2 as ‘diversification’.

  • ‘Karen the SuperTrader’ lost and hid hundreds of millions of losses between 2014 and 2016 on S&P straddles.

  • LJM Preservation and Growth Fund (sic) was structurally selling puts on indices, without the protections they pretended to have. The fund lost over 90% of its AUM in the first few days of February 2018.

  • OptionSellers.com managed to blow up hundreds of retirees’ savings in November 2018, after selling naked puts on commodities.

I will repeat it again.

On derivatives trading floors, ‘selling the small puts’ is a beginner’s mistake.

Here is Ray Dalio’s comment, from no later than March 3rd, 2020:


The market movements of the last few weeks will shore up other examples of this strategy. This article explains the latest one, very institutional.



Volatility and variance swaps

Volatility is the main measure of risk in the financial markets. It is the standard deviation of annualized returns. Simply said, when an asset grows, it can deviate more or less from a long-term trend. Volatility measures by how much the asset deviates from this trend:

Options and derivatives are closely related to this metric of noisiness. Daily delta-hedging a call or a put generates returns similar to that volatility. Option traders can replicate and therefore trade pure volatility.


As the markets have grown in technology and technicity, volatility became a more accessible ‘asset class’. There are now exchange-listed contracts exchanging volatility levels. The most famous one is the VIX futures, which pays the 30 day implicit volatility priced in a specific maturity strip of S&P options.


Volatility also trades through OTC contracts called ‘volatility swaps’ and ‘variance swaps’. Like all OTCs (over-the-counter) they are contractual agreement between two individuals to pay or receive the volatility of an asset:

  • The buyer of a volatility swap will receive the value of the realized volatility over a certain period if it is above the initially agreed level. It will pay the underperformance if it goes lower.

  • The seller of a volatility swap will pay the value of the realized volatility over a certain period if it is above the initially agreed level. It will receive the underperformance if it goes lower.

  • The buyer of a variance swap will receive the square of the realized volatility over a certain period if that amount is above the initially agreed level. It will pay the underperformance if it goes lower.

  • The seller of a variance swap will pay the square of the realized volatility over a certain period if that amount is above the initially agreed level. It will receive the underperformance if it goes lower.


For an initial strike at 15%, the payouts are:


Now there are several flavors of these contract. In particular, they have capped and uncapped versions:

  • An uncapped variance swap pays the square of a volatility, whatever that amount will be.

  • A capped variance swap pays the square of the volatility, up to a certain amount.



That cap is typically set around 2.5 x the times the initial level. So, for an initial level of 15% and a cap at 40% (in vol, or 0.16 in variance) the payouts become:


Because the payout of the capped version is lower, its initial price is also lower. As a result, if you buy the capped version and sell the uncapped version, you will collect that difference. The net position will be that slight difference… as long as the volatility remains below the cap.


If the volatility touches or goes above the cap, your payout becomes:


Does this ring a bell to you? When the market crashes, the volatility of the market spikes. If the volatility is above a certain amount, this position starts to cost you a very large amount. That strategy is a ‘short tail’ strategy – you sell the far ends of the Gaussian distribution. It is equivalent to selling insurance on market crashes. Yes, every day you collect a bit. Crashes are rare. But when crashes happen, it costs a lot.


Pennies in front of bulldozers.


Malachite Capital Management

Malachite is a registered investment advisor, based New York, which started in 2013. They specialize in derivatives trading, volatility and variance swaps.


Here are extracts of their risk disclosure:


Read between the lines. Their core business is to sell that difference between the two variance swaps.


They actually described other strategies in this Barron’s interview:

  • selling the time structure of the VIX,

  • selling the difference between historical and implied volatility on the S&P,

  • selling vol-of-vol (options on the VIX).

  • They also sell variance on vol-target funds (Vol-target funds rebalance their assets at regular intervals (by increasing or decreasing the leverage) to remain at a certain volatility level, say 10%. If they can rebalance quietly, the realized vol will remain close to 10%. If the market suddenly moves before they can rebalance, their realized vol can be much higher. This just happened – the coronavirus crisis arrived extremely fast.)

All these strategies have a common thread: they are short-tail. They all generate regular profits, as long as the market is calm or within reasonable bounds. If the market tanks and vols go up, they cost a fortune.


Malachite’s AUM

With a Sharpe of ~2.5, and a history of generating profits in many types of markets, saying you are smarter than the market attracts a lot of interests, awards and assets!


The last form ADV indicates that the fund now stands at $1.6 bn.

Not bad for 7 employees and 4 (?) clients…


The outcome

To generate income for that type of AUM, you need to sell a lot of spreads between the two variance swaps. A lot.

Rumor is, they had maxed out their risk limits with every OTC provider of the industry. That gives you an indication of the notionals and risks.

At the time of writing this article, Malachite is in default of payment; the entire AUM of the fund is not enough to pay the margin calls requested by the banks.

  • That is a pretty bad omen for the investors in the fund. We will know better when the dust settles, but they have most likely lost their entire investments.

  • They will not be the only losers. The broker-dealers who traded the OTCs with Malachite are also in a bind. They bought the tail exposure that Malachite was selling and sold it into the market to hedge themselves. Now, because Malachite is in a credit default situation, they will not receive from Malachite the payout they expect on the uncapped variance swap. Net-net, they are short tail through their market hedges.

How big that one is going to be, is still anyone’s guess at this stage…


Gontran de Quillacq brings his unparalleled knowledge and over 20 years of Securities experience specializing in Portfolio Management, Equity Derivatives Trading, Proprietary Trading and Investment Research.


His work with top-tier banks and hedge funds in both London and New York give him a unique perspective on the financial industry. Gontran actually initiated the distribution of investment strategies with derivatives, an activity now called 'portable alpha' and 'smart beta'. He provides legal consulting / expert witness services for high-stake litigation related to trading fraud, losses, manipulations or wrongful derivatives uses.

This article cannot be published or reproduced without the express consent of Navesink International.


The views expressed here are those of the authors and do not necessarily represent or reflect the views of any other organization, client, employer or company other than Navesink International.

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