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"The Swarm Effect": Every Trader Today Has Just These Two Choices

Few have dedicated as much time and effort into explaining the behavioral aspects of trading in a time of central planning (or "metastability") as Deutsche Bank's whimsical derivatives-philosopher, Aleksandar Kocic.

Three weeks after becoming the first Wall Street strategist to quantify (and qualify) the concept of market "complacency", and one week after explaining that the Fed has effectively created a state of "permanent state of exception" from conventional asset relations (and logic), one in which everyone is incentivized to perpetuate the "exception" (i.e., sticking their head in the sand and just BTFDing), where QE has become "universal basic Income for the rich", and as a result the Fed is terrified to unwind 8 years of monetary policies, today Kocic released his latest meta-financial stream-of-consciousness explainer, which highlights the choices faced by the current crop of traders every single day.

Picking up on a tangent touched upon by Canaccord's Brian Reynolds on Wednesday, who wrote that the relentless lack of volume in recent years "is more reflective of paralysis than complacency among equity investors", and then pointing to the sharp rise in NYSE short interest, countered that "investors are not complacent. Their stances range from extremely aggressive to bearish", Kocic takes the analysis one step further and writes that "the current mode of market functioning is really not so much about complacency as a result of willful blindness or ignorance as it is about difficult choices and high costs associated with those choices."

Referencing one of our favorite psychological tropes, namely the "learned helplessness" experimental framework, Kocic writes that "more than eight years of monetary stimulus and forced status quo have created a situation where change has become impossible." And adds that "to facilitate a change that would improve market conditions, there have to be multiple concessions to those forces against which change is directed. This has set in place the swarm effect: You can say no, but it is inconsequential."

Never one to shy away from expanding a market analogy into the ontological arena, Kocic, in attempting another explanation for why the market volatility is so low, then writes that "the resulting calm of the markets we have been experiencing lately has a special quality to it, like the calm one sees in people who have been talked into believing that they have found their peace."

Just think of going deeper into your cave until you find your power animal...

To be sure, it is an uneasy calm:

Markets are calm, but they are not content. Although nominally things do not look bad, there is no joy when it comes to the state of the US economy. Despite tapering of Fed purchases, rate hikes and  announcement of balance sheet unwind, financial conditions have not tightened. This triggers flashbacks of the troubling aftermath of the 2004-2007 tightening cycle. Then, why is vol so low? This question continues to puzzle market players and inspire its commentators. We know there will be tears at the end, but can we be certain that if we internalize this message and “do the right thing” along the way, there won’t be tears in the meantime?

This, in turn forces traders to make a decision: be aligned with the crowd (which is making money), or stay separate and continue suffering an indefinite, slow bleed:

Being long convexity means that your prospects are inversely correlated with the fate of the market. You will monetize only in an adverse scenario, when the rest of the market posts losses – your profits have negative correlation to the profits of the market. This is the main feature of an insurance policy - and a reason convexity carries a premium relative to other assets. By selling vol, your prospects are positively correlated with everyone else’s. Those assets generally trade at a discount -- you get paid to sell convexity. At the end, it is all about the decision whether to aligning your prospects with or against everyone else’s.

Kocic's punchline follows: a look into the mindset of today's traders. This is how Kocic breaks it down:

At the moment, investors face a difficult choice. On one side, you are tempted to join the crowd. After all, the Fed is the “guarantor” so, despite the downsides, embracing the carry trade might not be a totally unsafe option (and you get rewarded for that). For most people who operate over a short time horizon, this is the only option. However, it is well known that collective IQ is always considerably lower than the average IQ (the evidence is purely empirical, but supporting examples are convincing). So, there is some wisdom in not joining the crowds (2008 financial crisis is a good example). If you can endure time decay and  negative carry and are looking over a long time horizon, why not go against the consensus?

From a practical standpoint, this results in just two possible decision "choices":

Framed as a financial decision problem, one faces a choice between two scenarios: 1) A small probability of losing all of your money all at once at an undisclosed time in the future, or 2) A high probability of gradually losing small amounts over an indefinitely long period of time, keeping in mind that persistent small losses over an indefinite time period could lead to large cumulative losses.

From this perspective, one can see why Canaccord's take of pervasive trader "paralysis" amid a background or pervasive bearishness has merit.

So what are traders to do? Kocic may have just the right trade for you. Read on below for the full excerpt, as well as what the DB strategist believes is the right trade for this environment:

* * *

The swarm effect: What to do when choices become difficult?

Markets are calm, but they are not content. Although nominally things do not look bad, there is no joy when it comes to the state of the US economy. Despite tapering of Fed purchases, rate hikes and announcement of balance sheet unwind, financial conditions have not tightened. This triggers flashbacks of the troubling aftermath of the 2004-2007 tightening cycle. Then, why is vol so low? This question continues to puzzle market players and inspire its commentators. We know there will be tears at the end, but can we be certain that if we internalize this message and “do the right thing” along the way, there won’t be tears in the meantime? The current mode of market functioning is really not so much about complacency as a result of willful blindness or ignorance as it is about difficult choices and high costs associated with those choices. More than eight years of monetary stimulus and forced status quo have created a situation where change has become impossible. To facilitate a change that would improve market conditions, there have to be multiple concessions to those forces against which change is directed. This has set in place the swarm effect: You can say no, but it is inconsequential. The resulting calm of the markets we have been  experiencing lately has a special quality to it, like the calm one sees in people who have been talked into believing that they have found their peace.

Safety third (after looking good and having fun)

The stakes are high, but what is one to do when nothing can be done? It is instructive to take a trip down memory lane once more, back to the early days of QE, around 2009 (it feels more distant than just eight years ago). Shortly after the Fed started its purchasing program, a select number of macro players, mostly non-rates specialists, came up with a theme that would keep most of the rates vol desks busy for over a year. The trade was high strike payers as a macro hedge against (“inevitable”) sell off in rates due to inflationary effects of excessive liquidity injection. The new macro theme was a welcoming development for the business that had lost its main customer and the street was happy to provide liquidity in times of stressed supply and strict risk management. For about a year, there was near euphoria about high strike payers. Everyone wanted to have a position. A typical structure, which the street saw a lot of, was 5Y30Y payers struck at 6%. With forwards around 4.50%, this was at the time a 150bp OTM, with premium trading in the 700bp range. Vol, although off of its all-time highs, was still elevated, about twice as high as today, and the skew about three times wider. But what had been conceived as a conceptually meaningful hedge in terms of delta, became a (troubling) vega and time decay exposure, that eventually drifted away from the strike, resulting in massive MTM losses. Currently, these strikes on 5Y30Y trade around 80c.

When it comes to trading options, there are many more considerations to take into account besides delta. Being long convexity means that your prospects are inversely correlated with the fate of the market. You will monetize only in an adverse scenario, when the rest of the market posts losses – your profits have negative correlation to the profits of the market. This is the main feature of an insurance policy - and a reason convexity carries a premium relative to other assets. By selling vol, your prospects are positively correlated with everyone else’s. Those assets generally trade at a discount -- you get paid to sell convexity. At the end, it is all about the decision whether to aligning your prospects with or against everyone else’s.

At the moment, investors face a difficult choice. On one side, you are tempted to join the crowd. After all, the Fed is the “guarantor” so, despite the downsides, embracing the carry trade might not be a totally unsafe option (and you get rewarded for that). For most people who operate over a short time horizon, this is the only option. However, it is well known that collective IQ is always considerably lower than the average IQ (the evidence is purely empirical, but supporting examples are convincing). So, there is some wisdom in not joining the crowds (2008 financial crisis is a good example). If you can endure time decay and negative carry and are looking over a long time horizon, why not go against the consensus?

Framed as a financial decision problem, one faces a choice between two scenarios: 1) A small probability of losing all of your money all at once at an undisclosed time in the future, or 2) A high probability of  gradually losing small amounts over an indefinitely long period of time, keeping in mind that persistent small losses over an indefinite time period could lead to large cumulative losses.

The trade: Straddle/strangle switches

Assuming we have understood the problem correctly, the key question in our minds is: Can we find a compromise between these two difficult choices? We believe that straddle/strangle switches are a logical way to proceed.

As a consequence of vol selling, the market is locally long gamma. This reinforces the local equilibrium, but positioning is different outside of the 25bp move on each side. At this point, we are sellers of gamma locally and are buyers of tails. We would strike 1X2 straddle/strangle switches so as to reduce local gamma exposure, and limit the downside, but adjust the strikes to keep the upside outside of the 50bp range. As a result, we have a high-leverage trade with limited downside, but the same upside as the 50bp wide strangle. We recommend:

  • Sell $100mn 3M10Y straddles vs. buy $200mn 3M10Y 24bp wide strangles, offer 38c

This is a long gamma position (2K). A 1X2 switch with a flat gamma profile is at struck 50bp wide (it trades at positive takeout), while a costless structure is 32bp wide (it is long gamma, around +1.6K). For comparison, a naked 24bp wide strangle costs 120c. The maximum downside on the trade is loss of premium plus additional 12bp running in case we either rally or sell off 12bp relative to forwards, a total of 147c, which is comparable to the maximum loss on the strangles. By changing the “bottom” profile of the strangles, we have managed to change the risk profile in such a way that we improved the time decay and payoff profile, without substantially changing the downside. This change of the “bottom” profile boils down to a change of P&L distribution across different scenarios. The straddle/strangle switch makes money either if nothing happens or if we break out of the range. It loses money in case of limited repricing on both sides that remains in the range. A long strangle position monetizes only outside of the range, while anything within amounts to equal losses.

Both trades have a similar time decay (in absolute terms), but the switch has about three times more leverage. 1M carry on both trades is around -40c, although it has less gamma exposure than naked strangle.