What implications do record valuations and the growth of derivatives markets have on the future of policy, the economy and financial markets?
In answering that, Benzinga chatted with the founder and senior managing partner at Kai Volatility Advisors, Cem Karsan.
About: Karsan graduated from Rice University in 1999, prior to procuring an MBA with an emphasis in analytical finance and management from Northwestern University’s Kellogg School of Management.
Closely after, Karsan pursued an interest in markets and probability at the Royal Bank of Canada RY Dominion Securities’ Derivatives Arbitrage Group as a volatility trader.
“Buying and selling stocks, based on valuation, was a little flat for me,” he told Benzinga with a chuckle. “The option space appealed to me more [due] to its multi-dimensionality and problem-solving.”
In 2002, Karsan joined John Mulheren at Bear Wagner Specialists, where he aided in the firm’s expansion in derivatives arbitrage.
After managing a sizable team of employees and utilizing a significant portion of Wagner’s tradable capital during the tech-and-telecom bust, Karsan founded Precision Capital Management, a firm that constituted up to 13% of Cboe Global Markets' CBOE S&P 500 index options volume from 2007 to 2010 during the depths of the financial crisis.
“There’s no better place to learn about capital markets than trading in the pit,” he added.
“Smelling, hearing what supply and demand feel like, and … experiencing the competitive forces of having to get something before somebody else does is powerful.”
In realizing one could no longer discount the impact of derivatives markets, Karsan later merged his knowledge of volatility trading and modeling on broad asset management at Aegea Capital Management and then, Kai Volatility Advisors.
It is this idea that “most of the edge is flowing into the primary markets themselves — the underlying — or the volatility of the product and using that” to trade directionally, he said.
Implications Of A Fed Taper: Funds holding long equity positions will hedge positions in the interest of lower volatility returns, selling call options to finance downside put protection.
As a result of this, market makers, or those who warehouse this risk, are long upside and short downside protection — a carry trade. This exposure is obviously hedged. But, as volatility ebbs and time passes, the unwinding of these hedges brings in positive flows that can lead to lengthy sprints.
“A lot of the processes that enforce these bubbles are embedded in the volatility market,” Karsan explained. “There’s this constant structural positioning that naturally drives markets higher as long as volatility is compressed, or there’s a supply of volatility.”
Graphic: SqueezeMetrics details the implications of customer activity in the options market, on the underlying’s order book.
Given the monetary frameworks in place and max liquidity, Karsan believes markets are positioned to rally and further diverge from fundamentals.
“I use this analogy of a jet,” he explained, referencing the three factors that are known to impact an options exposure to directional risk or delta: the change in the underlying price (gamma), implied volatility (vanna), and time (charm).
“As volatility is compressed, those jets will keep firing because … the hedging vanna and charm flows, and whatnot will push the markets higher.
“At the end of the day, though, the higher you go, the further off the ground you are and the more tail risk.”
Even the slightest reduction in the Federal Reserve’s balance sheet — the removal of liquidity – has the potential to prick the bubble, prompting a cascading reaction that exacerbates underlying price movements.
In other words, the response by customers, as well as the dynamics of dealers’ risk exposure to direction and volatility, can cause violent crash dynamics to transpire, further cutting into liquidity and aiding in an unraveling.
“It’s not a coincidence that the mid-February to mid-March 2020 downturn literally started the day after February expiration and ended the day of March quarterly expiration. These derivatives are incredibly embedded in how the tail reacts and there’s not enough liquidity, given the leverage, if the Fed were to taper.”
To prepare for such an event, aside from modeling very fat-tailed distributions, participants could sell local, at-the-money structures to fund convexity or out-of-the-money structures.
The Shift To Fiscal: Over the last 40 years, or so, monetary policy was the go-to for supporting the economy, sending money to capital and thereby promoting deflation.
As a result, corporations were able to take the long view, competing on eyeballs and growth.
“That creates a disinterest and unimportance to cash flows,” Karsan said in reference to policy allowing for innovations like Tesla Inc TSLA and Amazon Inc AMZN. “There’s no need for cash creation if you can create more cash in the future by not creating it now.”
When liquidity is removed, as policymakers look to fiscal policy to address inequality, for instance, corporations may have to worry about making money again.
As a result, many great ideas won’t make it.
“We’ve seen this throughout history,” Karsan said in reference to this thesis playing out over the next decade.
“These cycles are a lot shorter than the monetary supply-side cycles but they tend to be very bad for multiples and great for economic growth.
“That’s ultimately how we grow out of these valuations.”
Digital Dollar: Blockchain is a revolutionary technology.
“The broad association is that its current use for cryptocurrency is tied up in the liquidity bubble that exists across all assets,” he said in a discussion on digital currencies that have no sponsor.
“I don’t see there being a clear window where cryptocurrency is not subject to constraints and I think it’s highly likely that we move towards a digital dollar.
“I see it happening relatively quick.”
Kai Volatility: “Kai means ocean and it is also my son’s name.”
Karsan said his new venture is ahead of the game when it comes to measuring and understanding the effects of flows. Going forward, Kai Volatility will expand the depth and breadth of its flow-based product portfolio, applying proprietary models around directional trading.
“The lessons I’ve learned from being a market maker have informed my understanding of the machine and … producing alpha,” he ended. “We launched new products focused on measuring flows and using those to have better information.”
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