Download Known Unknowns and Iron Condors

Valtteri Ahti Ph.D
+358 9 4766 9773
[email protected]
Niklas Tapola
+358 9 4766 9195
[email protected]
September is flush with juicy events. A new country to bomb, the monetary supertanker known as the Fed finally begins to
steer towards normalcy, the Iron Lady of Europe is re-elected and Doctor Sleep by Stephen King, the sequel to The Shining is
finally published. What all these events have in common is that their outcomes are known with a high degree of certainty.
But if so, why is the option market exhibiting signs of nervousness? We think it shouldn’t. Embrace the premium.
The key event this month – as usual - is the FOMC meeting press
conference on the 18 Other events include smacking Bashar with a
few hundred cruise missiles and re-electing the Iron Lady of Europe
on the 22 . Still it’s a sad time and political pundits will remember this
as the time when western powers great and small came to grips with
financial realities and dictators around the world slept a bit sounder.
th.
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What these events have in common is near certainty over outcomes.
We know, having seen that US macro data has been sufficiently
robust (see Exhibit 1), that the Fed will initiate tapering. We know
Damascus will burn. We know that Angela Merkel will emerge
triumphant in the German elections.
But, but… Implied volatility – a measure of market anxiety - is flirting
with levels last seen in June (see Exhibit 2). Furthermore options
brokers fret about implied volatility behaving strangely. But how can
this be if all major outcomes are for all practical purposes known? To
quote Donald Rumsfeld – whom we here at Evil Bank naturally revere
- is there a known unknown at play? It’s harder to speculate about
unknown unknowns, but options markets are pricing a known
unknown.
Perhaps given the sheer number of events, some sort of tail event is
likelier. Frankly this line of thinking gets fuzzy if not downright
ridiculous. Sell side strategy does involve a dash of alchemy, but this is
taking thinks too far.
So the natural conclusion is to use elevated implied volatility and bet
against it. Note that this does not mean betting the house. One can be
short volatility without being short tail outcomes. For an example see
this option strategy, known as the Iron Condor.
Incidentally if one has followed the dynamic Financial Times duo of
Messieurs Authers and Mackintosh, they have come up with the
realization that the recent emerging markets stampede applies only to
those emerging markets that are net importers, i.e. countries running
current account deficits. See the link above for currency
appreciation/depreciation. In Exhibit 3 we show that the same
phenomenon applies to stock indices as well. Countries enjoying
current account surpluses have emerged () relatively unscathed.
Hence those hunting the bargain basement for contrarian moves are
best advised doing so by selecting deficit ridden countries.
Gentlemen Prefer Bonds August 2013
On a bond market gone bonkers.
Markets Overreact to Fed July 2013
In the short run markets overreact to Fed, but the secular bull run in Government bonds ends
here. The US can handle the punishment, but how will a sclerotic Europe handle dearer financing?
Economic Growth and Stock Market Returns June 2013
Stock markets overprice economic growth prospects.
Bernanke in the Rye May 2013
Discussion on what’s driving the market, with a particular focus on central banks.
A Spoonful of Inflation helps the Medicine go down May 2013
Why do we strive for 2 % inflation, why not just go for zero?
Macro Drift; a market anomaly April 2013
An asset allocation anomaly that is similar to post earnings announcement drift.
Dynamic Put Spread Overlay
Systematically writing put spreads subject to prevailing implied volatility. We did some
computations on other underlying indices.
Enhanced Momentum Modeling: Developed Countries
A follow study of enhanced momentum models – BAMM – see below. This study applies the same
methodology to countries included in the MSCI World All Country index. An unpublished study
applied BAMM to Finnish single stocks, with significant success.
Enhanced Momentum Modeling: White Paper
Adjusting momentum signals according to market beta improves both nominal and risk adjusted
returns. The paper was inspired by the “Betting against Beta” literature. Paper includes a case
study that uses STOXX 600 Europe sectors.
Global Macro Momentum and Asset Allocation
Asset allocators like to use PMIs and PMI momentum as gauges of “macroeconomic
momentum” as decision inputs. In this paper we take a look their efficacy and what sort
of measures one should use.
Macro Momentum: Country Selection
We build long only and long short portfolios of major countries using economic
momentum (3 month changes in PMI).
Pooling Leading Indicators
A long piece on a tedious subject. The idea here is that instead of picking the best
leading indicator – CB LEI, OECD, etc - one can extract the predictive power of the best
leading indicator, but reduce the number of false signals by pooling all leading
indicators. It is portfolio theory applied to leading indicators.
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Author: Valtteri Ahti
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