What just happened? Some volatilities were squeezed last week.
By Gontran de Quillacq, Managing Director, SEDA Experts LLC
In case you were hiding in your cave, the financial markets had a little meltdown last week. The major indices lost more than 10%, in a few days. That's a pretty fast "correction". Actually, it's probably the fastest ever:
We all know the official reasons: coronavirus, contagion, pandemic, significant slowdown of the economy. Since nobody can really put a number on how much the impact will be, the markets probably priced also the risk of uncertainty, and priced equities a chunk lower (and bonds even higher).
This being said, not all investors were taken by surprise. World-famous investors like Jamie Dimon, Leon Cooperman or Paul Tudor have issued warnings. They were pointing the fingers towards the democratic boogey(wo)men of Bernie Sanders and Elizabeth Warren as the likely causes of such a retracement.
But there is an investor, who took a decisive step. Last week, he has been ripping the benefits of his decision, while the volatility traders of Wall Street have been reeling it: in November last year, Ray Dalio of Bridgewater invested $1.5 billion (with a b) in S&P 500 short-dated puts. You will find several articles reporting this humongous trade (Wall Street Journal, MarketWatch). He used 1% of his $150 bn AUM, and tapped Goldman and Morgan Stanley for supposedly the March 2650 puts. At an indicative price of $15, that would be 1,000,000 lots. That's a lot of lots.
Several consequences follow this:
Bridgewater is not a volatility trader. They are not re-selling the puts or somehow their vega/gamma. As a result, Goldman and Morgan Stanley became massively short that strike against a trader who was not directional in volatility and not delta hedging in any form.
No bank can carry that kind of position, so there is little doubt that Goldman and Morgan Stanley aggressively bought back that risk in the market through either (other) listed options, structured products or variance/volatility swaps. In other words, they have dissipated the risk into the street, which was now massively short those options, with increased risk of volatility (short option traders buy when the market goes up and sell when the market goes down).
When the market tanked on the coronavirus news, institutional investors looked for protection. Those tiny puts were now 10% lower than the market with 15% delta - the proper insurance for catastrophic risk. They started bidding them up.
When the street is short an asset and the price of this asset rises, the street does what it always does. It squeezes. Market-makers covered their shorts, pain-ly aware of their mark-to-market. They paid pretty much whatever offer was available. In implied volatility terms, these puts gaped up from ~40% vol to ~60%... pretty much on the open of Friday 2/28 (which also happened to be a month-end). They stayed at that volatility level most of the day.
Volatilities subsided at the end of the day (ahead of the week-end), but the damage was done. Here are the vol changes in vol points from 2/27 to 2/28:
Adjusted by the local stdev of the volatilies (aka, expressing the vol changes in units of 'typical changes in vol'):
You clearly see the valley of option buyers. The street bought everything it could at that strike and around that strike/maturity to cover their short. Never mind if the skew became 'almost flat' below and incredibly steep above.
What will happen now? Dalio assured the market that he was not bear, but just hedging his position. This means he still needs those puts. When he bought them, they were worth ~$15 each. On Friday, those same puts were worth $55. If he wanted to unwind them, Friday would have been a great time. He didn't. So what will Dalio do? It's likely that he will keep them.
So what will happen to the market?
At 60% vol, these options price ~4% of daily move until maturity. That's unlikely to realize. They are overpriced, and will surely drip a fortune in gamma/theta. Most likely, the market will reprice them lower, but slowly (market-makers just bought them through their noses).
If Dalio comes on the offer though, the repricing would probably be very quick.
The skew will normalize, on that maturity and in this portion of the surface, so you can expect a steepening of the lower skew, and a flattening of the below-the-money skew.
Once again, how quickly skew will converge to more normal levels will depend on flows. If Dalio was to show up, the repricing would be fast. This being said, he is not the only active player in that area of the market: vol-of-vol traders and VIX traders need to deal in tiny puts. There are large such players around.
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'.