Shownotes
Recorded amid the noise and pulse of the RMC conference in Munich, this episode of U Got Options follows a market learning to see itself anew. Cem Karsan speaks with Keith DeCarlucci on the return of macro discipline through EM carry and the quiet yield of volatility. Patrick Kazley traces the fault lines of diversification, where beta, convexity, and policy now intersect. And Hari Krishnan confronts the uneasy coexistence of human intuition and machine logic in risk. Together, they chart the tension between structure and surprise - a world still trading on old instincts, but guided by new intelligence.
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Episode TimeStamps:
00:00 - Opening and introductions
01:29 - Overview of guests and themes: EM, volatility, and AI
03:10 - Keith DeCarlucci on EM FX, commodities, and volatility trades
14:13 - Relative value in equity vol and tail-hedging strategies
21:20 - Patrick Casley on portfolio construction and convexity
32:24 - Reassessing 60/40, nominal illusion, and macro correlations
39:44 - The new regime: long assets vs limited diversifiers
44:39 - Hari Krishnan on AI, options, and the future of volatility
56:06 - Upside skew, real assets, and structural market shifts
01:05:21 - Closing remarks and disclaimers
Copyright © 2025 – CMC AG – All Rights Reserved
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Transcripts
You
Intro:Welcome to U Got Options, an exciting series right here on Top Traders Unplugged, hosted by none other than Cem Karsan, one of the sharpest minds when it comes to understanding what's really driving market moves beneath the surface.
In this series, Cem brings his deep expertise and unique perspective, honed from years of experience on the trading floor to candid conversations with some of the brightest minds in the industry. Together, they unpack the shifting tides and underlying forces that move markets and the opportunities they create.
A quick reminder before we dive in, U Got Options is for informational and educational purposes only. None of the discussions you're about to hear should be considered investment advice. As always, please do your own research and consult with a professional advisor before making any investment decisions. Now, what makes this series truly special is that it's recorded right from the heart of the action on the trading floor of the Cboe.
That means you might catch a little background buzz. Phones ringing, traders shouting as Cem and his guests unpack real world insights in real time.
We wouldn't have it any other way because this is as authentic as it gets. And with that, it's time to hear from those who live and breathe this complex corner of the markets. Here is your host, Cem Karsan.
Cem:Welcome back to another episode of U Got Options from the Cboe Floor, brought to you by Kai Media and Top Traders Unplugged. Today we come to you from the RMC floor in Munich, Germany. I get to talk to three different guests that were there for the conference.
We cover some amazing things, from emerging markets to volatility surfaces, and the role of artificial intelligence. First, I talked to Keith DeCarlucci. The CIO of the Melqart Macro Fund talks about all the emerging markets and different commodity trades that you can use to diversify your portfolio.
Next, we talked to Patrick Kazley, president of One River Asset Management. He talks about how 60/40 is dead and a lot of the diversification that once used to benefit portfolios no longer works.
Last of all, we talked to my friend Hari Krishnan, author of The Second Leg Down. And he gets into the weeds and the future of AI and how that's going to change markets for the long term. Hope you enjoy this one.
Cem:Music
Hello, and welcome to another episode of U Got Options. Today from the RMC floor, we're gonna walk through a couple different 20 minute conversations to talk about what's hot, what's happening here on the floor. And so with some of the best practitioners around today we got Keith DeCarlucci Thanks for joining us, Keith.
Keith:Thank you for having me.
Cem:If you don't mind, lean us off giving the crowd a little bit of background on what you do. Exactly. And then we'll dive right in.
Keith:Sure. So, I'm the CIO of a macro fund that trades cross asset almost exclusively in derivatives. So we trade FX commodities and equities with the exception of we don't do rates like most other macro funds do.
Cem:Very cool. And no better time than the present to talk about macro. In the last 40 years it's hard to find a period where there's more going on in macro for. You mentioned you do ,FX, commodities, equity indices. Talk to me a little bit about each of those. What are some of the things you're most focused on right now and where you see some of the most opportunities?
Keith:Sure.
Keith:I think what we see is most attractive on the FX side is investing in some portfolio effectively of EM currencies.
So things like Brazil, Mexico, South Africa and Korea, those have all benefited from what has been perceived or is perceived and has been weaker data coming, coming out of the US and softening against the dollar or the dollar softening against everything.
So they have an attractive profile from the interest rate perspective on the currencies as well as the volatility perspective because most of those have a fairly high risk premium attached to them. So between the volatility and the rates, it's quite an attractive portfolio. You just have to make sure you hedge the dollar portion of it.
Cem:Yeah, absolutely. And let's talk about each of those a little bit, if you don't mind. You mentioned Brazil. What do you like about Brazil in particular?
I mean, you mentioned the rates, but talk to me a little bit more.
Keith:I mean it's going to, for that it's going to be the rates in the vault that's the highest on both sides. That's out there. I think that's alongside of what's been a fairly constructive domestic story.
And you know, once you got sort of Liberation Day out of the way, you know, the flows have been quite, quite strong. Getting to the point where it might be a Little bit stretched at this point.
But we, we've, we've switched from having, you know, options that had the volatility and the rate portion attached to it to more like just put spreads in dollar, put spreads on Brazil because it's kind of coming down towards the end of where we think it can go. But it's still pretty attractive on a daily basis.
Cem:You got to love the commodity profile of the country too given the inflationary backdrop, etc.
Cem:Which is true for South Africa as well. You mentioned we had a really good bet on this year in Australia for similar reasons there. Different type of economy. A bit more.
Yeah, but, but yeah, South Africa is interesting too. And then you mentioned Korea. Talk to me a little bit about Korea. It's a little bit different in some ways.
Keith:Yeah, I mean, Korea is a bit of a different story. First off it's not positive carry versus the dollar like everything else is, but it's, it's much more, that story is much more of a, of a flow related story.
You know, it, it had been one of the favorites of the macro community being long, long Korea and so much so that, that when it became over positioned like we were, we were the other way short Korea and then it has massively retraced so then we use that to re enter on the other side and, and it's a tiny bit technical but you know we did that by selling upside calls. So Korea, Korea upside in the, in the kind of two month area. And that's because there's, there's seven holidays coming there.
So that's just an extra little kicker.
Cem:Yeah, Korea's super interesting as a location FX aside. Just because of all the auto callables and all the structured products in the space. Historic volume compression.
Talk to me a little bit about if that plays into anything that you're doing or.
Keith: k. It took quite a big hit in:But you now have a different risk transfer happening. That used to be a lot more of hedge funds taking that risk off of banks on the auto call side.
And now what you have is you have people like Jane street just taking the auto calls directly which is a big change in the structural dynamic of that market.
But it's certainly something that we have to look at and I think obviously with all the chip related things that are in Asia that also plays into Korea.
Cem:But how much of the macro bets that you guys are putting on are a matter of being a little bit more agnostic and just finding things that are cheap or expensive relative to history. And how much of it is actually making a macro kind of bet on outcomes?
Keith:Yeah, I mean our macro strategy itself is called macro tactical and is much more trading oriented. So it's usually against positioning flows.
Oftentimes you'll see things that are where the direct direction of travel has been quite consistent such that CTA isn't systematic fully loaded on that direction and you get the last bit of people buying options in that direction on top of that. So the skew goes the opposite way that you can take the other side, get paid to take the unwind. You're not.
You don't even necessarily have to be making the bet that it's going to retrace back. It's just conditionally if it retraces it's going to be much more violent on that direction than the other kind of.
Cem:Distribution, which is what's wonderful with volume.
Keith:Obviously that is, that is the wonderful thing.
Cem:Yes, absolutely. You mentioned commodities as well. Talk to me about what you guys are doing in commodities and where you see opportunities.
Keith:Yeah, I mean I think so right now it's a good example of gold has had quite the run even in the last week to the point where people are now paying for upside calls and volatility is going up on the top side in gold. This is one of these things where it's very steeply positioned at this point.
We're the other way around on the unwind and you get paid to have the sell calls buy puts risk reversal a decent amount. It's very difficult to find any coverage people papers that aren't bullish gold at this point. Right. So usually when that happens we're the other way.
Cem:So an interesting point from the data. We've done historical analysis on different commodities.
Particularly during the last period of rising interest rates 60s and 70s, you know, 65 to 82 type period. Just to kind of study what what does best and how does it perform, what's the distribution.
A lot of people know that gold was the best performing asset from 65 to 82. Right. That's pretty common knowledge. What most people don't know is it was also the most volatile asset.
Keith:Yeah.
Cem:And so the thesis to to own long gated calls was a wonderful one. Right. Especially 300% ago.
Keith:Yeah.
Cem:And I think from a macro perspective likely will be if you believe the longer term pressures of rising interest rates, et cetera, that are out there.
But I agree with you from a short term basis it really of volatility itself is still quite cheap in gold relative to the outcomes and it can go both ways. I think that's what people have lost sight of.
Keith:Yeah, I mean as I said, we're trading oriented. I can't tell you where anything is going to be in six months time, but.
Cem:Right. And how long is that bet that you're thinking about when you talk about, you know.
Keith:So those are between one and two months.
Cem:One and two months durations.
Keith:Yeah.
Cem:Yeah. That makes a ton of sense. Especially with what's going on the next couple of months. Really interesting.
Outside of gold, any other commodities thinking about playing?
Keith:We're, we're in and out of oil a lot. And that's, that's more transparent story than gold because gold can have many different drivers.
Oil has been, you know, tends to be dominated by the CTAs and the systematic side on positioning as, as it goes one direction or another. So we, you know, have been up into the early seventies we were short. Now we're, now we're not.
But it's, it's kind of been trading, it's bit range trading for quite a while now. Quite a while with a lot of event risk at, you know, sitting alongside of it.
Cem:Totally. And here's another aside.
60s and 70s oil volume, which most people would think would have been really high was actually one of the lowest volatilities of commodities and commodity. And as far as commodities go relative to longer term history is actually lower during that period.
Which is again something, not that you would think counterintuitive. Yeah. But very much like gold was bullish. Bullish, but in a very different way. Trade in the 60s and 70s was to be long gold calls and short oil puts.
Keith:Yep.
Cem:Two very different trades.
Keith:Very different.
Cem:And I think we're starting to see that play out. We've been talking about that for a couple years. But that's an interesting longer kind of mid, mid to longer term dynamic.
Keith:Yeah, I think, I think the goal the, the oil story is, you know, as I said, it's the short term stuff is dominated by CTAs and systematic positioning.
The long term story is always going to eventually be fundamentals but it's, it's, you know, very different from 15 years ago where you could count barrels and have a position in oil. Like the counting of the barrels doesn't tell you anything about the next Two months.
Cem:Absolutely. Sometimes opposite.
Patrick:Yeah, oftentimes.
Keith:Yeah. I mean you get, I mean, if you look at any OPEC decision, it often goes the opposite direction of what the decisions are.
Cem:Yeah. And that's not a coincidence. Honestly.
People position for what they think is going to happen and then reflexively those flows tend to have opposite outcomes.
Keith:That'll be interesting to see what happens if the Fed doesn't deliver tomorrow.
Cem:Great. Yeah, exactly. With everything priced in. Yeah, it's almost priced to perfection. Right, Completely agree.
You mentioned when we were talking offline as well that, that you trade relative value. You know, when I think about opportunities in the volume space, I really think, you know, you can, can't get rid of risk. Right.
You can transform risk. It's really about finding the right opportunity at the right time. So market timing A, and then B, you know, relative value.
As we kind of discussed, what's cheap at a moment and what's expensive and those are hard bets. But if you've been in the markets for a while, if you have a good look on history and what might be happening, you can find real opportunities.
So we kind of talk macro and market timing a little bit. Let's talk relative value. Where do you see relative value opportunities in equities and other products and how do you approach that part of that?
Keith:Yeah, I mean, historically equities have been biggest part of our relative value bucket generally. You know, we don't have anything super secret in how we look at that, but we do have models and things that say, like how much is it out of line?
And where the macro part comes in is this is out of line, Is it likely to persist? If so, why? And that's how against the macro backdrop.
So for instance, we consistently right now will have, you know, short, longer dated volume and equity indices and long shorter dated volume, so one month, two month versus nine month, one year kind of spreads and collecting kind of six, seven balls in some of those, which is very attractive Carry. You just need to protect it whenever things April comes along or something or August of last year.
And it's hard to find things more attractive than that in other asset classes because it doesn't get distorted that much. You have the change in the structured market has left less supply of backend volatility which keeps it elevated along the way.
So you want to be able to try to capture that as much as you can. And that really doesn't take place in things like commodities or fx. You just roll it into macro.
Cem:And the theoretical basis for that, which I know you know But I want to tell the audience a little bit is, you know, this is a well established theoretical construct. Short term volatility historically because of mean reversion is actually higher than long term.
So if you play, you know, short term volume, it's actually better. But historically because of risk premia, longer term volume trades at a much higher implied volume.
This was actually the thesis behind long term capital management. Not to, not to say that that's. No, no, no, no, I don't. It's actually a great trade.
Cem:The key is structuring it in a risk managed way so that you don't face an outcome like long term capital. There's a reason Shoals, right. Made that that bet. And the reality is they ended up being right in the long term.
Cem:Yeah.
Cem:They were just, they just couldn't hold the trade and, and didn't know how to manage risk properly, candidly.
So the reality is theoretically it is a long term positive carry trade, incredibly positive return over the long run and has a lot of great dynamics, I'll add to that. And again, I didn't mean that as a negative at all because it is a great trade.
But it's important to understand that it's a well established trade and that there are risks to it and it's very important to manage it properly and to manage the risk on it. I would add to that an interesting point. Again, back to data.
Historically, during that 60s and 70s period, the last time we saw interest rates secular going higher. Again, not a one week, one month, one year bet even.
y higher interest rates, that: Cem:Yeah.
Cem:And one of the things we find during that period is equities are even more mean reverting than any other time in history. From 68 to 82. I don't know if you know this or not. Equities actually went nowhere.
Cem:Yeah.
Cem:In nominal terms.
Cem:Yeah.
Cem:So long term volatility was awful in terms of a hold. Right. Long term volatility was a massive sell.
But short term volatility due to all the geopolitical crises and everything that happened in between was actually higher than history. So there is actually a macro framework that would, that could say if interest rates go higher you could see increased short term volatility.
But due to the nominal illusion of equities being priced in nominal dollar terms, you could really see a lot more mean reversion. So a really compelling trade actually.
Keith:Yeah.
I mean we've been through lots of wars and lots of crises and I think we have a pretty good handle on how to hedge it largely will be long convexity in the front end as a, as a starting point to hedging as well as strips of all the way up the curve of the VIX options to protect the term structure. And I'm talking like up to the 100 strike calls in Vix.
Cem:Let's talk about the long tail part actually a little bit more. So you said you're doing a strip of long dated calls.
Cem:No, no, no.
Keith:Short shorter dated calls but higher strikes. The really teeny stuff that explodes in an April and that kind of stuff.
Cem:Yep. As you and I know the price of those don't even matter yet. At the end of the day it's.
It's the most convex moment on a distribution and when something does actually happen the price of those is you know, bid at. Offered at nothing yet. Right. Like at infinity. So I couldn't agree more.
Those are things that people try and sell to buy something else on a relative value basis. But. But more often than not don't realize that it's the ult ultimate imbalance in supply and demand on the planet. So. So yeah. Tend to outperform.
Cem:Yeah.
Cem:On those type of moves. And then what else do you do against those?
Keith: bit of April that happened or:And for that we've we use a product called variant swaps where we're long very short dated variance swaps. So one month and under duration and short some plain vanilla strip of options against it to neutralize the vol. The outright volatility exposure.
So that leaves you with a convex profile of the swap versus the linear profile of the option. So that works very well.
Cem:Yeah. And again very few people understand that in the general public.
But again a great kind of well established trade that does really give you on a relative value basis a really nice convex tail without the carry most times.
Keith:And I would add it also another thing that it does that tail strategies have a problem with is it monetizes because you re hedge every day at the close and that effectively monetizes every day everything that happens in a day. Yep. So you don't end up with like a March 20th happens and you're up 35% by year end. You're flat.
Cem:Right? No, there's a perfect match between the two strategies in terms of duration and timing. That's a. That's a great point. Yeah. Really compelling stuff.
Last question before we go.
Cem:All right.
Cem:If you have one, one opportunity that you think is particularly compelling in the next year, and we'll. We'll talk about it next year at rmc. If you're here, is there anything, anything on your mind?
Keith:I mean, we already sort of talked about it. I really think it's consistently trying to harvest the carry in the, in the term structure. The equity thing. That's been very persistent.
it's not as good as it was in: Cem:And as we mentioned, particularly in this environment, when you get that kind of match, that's really compelling. Thank you, Keith. Thank you for joining us.
Welcome back to U Got Options.
I get Patrick Kazley here today from One River, one of the bigger thinkers in the space. I've actually been looking forward to this conversation for some time. Thanks for joining me, Patrick.
Patrick:Yeah, thanks for having me. It's. It's always nice to get here in Munich and around Oktoberfest.
I. I forced a nice pun on stage yesterday about a beer stein and that was well received.
Cem:So I like that. The.
Patrick:The bubble popping up. Yes, the bubble.
Cem:That's right. So you wanna, you wanna tell everybody what that was just.
Patrick:So, yeah, it was a reference to the optimism in. Involved in equity volatility specifically, but just markets more generally.
lassic German Movie Beer Fest: Cem:Classic, yes.
Patrick:It goes back to the. So anyways, you tip the beer stein or Das Boot, it's a glass boot, and you can visibly see a bubble forming in the toe of the boot.
And that air abscess as it travels from the toe to the main funnel creates this gurgling. It overwhelms the drinker. You fail the boot chug. So you kind of try to turn it to prevent that.
And I think that's just a good metaphor for people and how they think they can see the bubble forming in markets. And there's any number of metrics one could pick to elucidate that bubble, but they think they can get out of the way.
So there's no need to preemptively hedge. I'll just react.
Cem:Yeah. Welcome to vaultoberfest. Yeah, no, I think it's clear, like valuation wise, we're, we're in some type of a bubble. Speaking of bubbles.
But, but I think there's a lot of academic research out there that, that clearly states that that trading and any period less than a decade based on fundamentals is an incredibly poor indicator.
Patrick:Yep.
Cem:I like to think of it as a risk management tool. Valuations. I've given this analogy. Or like if you're on an airplane, it's your elevation off the ground.
Patrick:Okay.
Cem:The elevation doesn't really determine which way you go. Liquidity or gas does.
Hari:Right.
Cem:At the end of the day. But once that gas stops for whatever reason, which it invariably will.
Patrick:Yep.
Cem:Then all that matters is how high off the ground you are or how you know how high that elevation is. We're full of metaphors today. But, but I do think that's a really good way to think about it. And I agree that bubbles kind of in the boot.
The question is, you know, when and how will that come? And that's, that's where risk management comes.
Patrick:Yes.
Cem:And that's why, you know, rmc, that's why we're here, all here. You know, the big question is how do you manage risk in the context of not really knowing when that bubble is coming down?
And you know, let's, let's talk about that a little bit. How does one river do that? How do you guys think about risk? Let's dive in.
Patrick:Yeah. You know, one river is we're a hedge fund but we're, we're also a, I would say allocation advisor to an extent.
So my title is President Head of solutions. So it's, we do that. We concoct solutions all the time.
So the real kind of if you were to make it into a problem set, you would probably say, how do I create one pool of capital such that I don't care if we have a right tail or left tail. And that's kind. We're in a two tailed distribution right now where people can really.
We've witnessed and seem to continue to be witnessing with this Oracle announcement, this right tail melt up. The ability for large cap stocks to gap up 30%. It's just not normal. But it could be our normal for a number of quarters or even years.
So you can't really afford to abandon beta. Certainly can't afford to abandon beta and lead against it at the same time.
The foregone compounding could be too great, especially in this benchmark aware world. Right. However, whenever the dam breaks, it's probably going to break violently. So the, the metaphor I also used on stage was sumo wrestling.
I think I've even heard you reference this one. You have deadlocked heavyweight opponents, you have bulls and bears no visible kinetic energy, loads of potential energy in the markets.
It's, it's, it's a very apt one. It's very true. So the way that we navigate that is we actually say it shouldn't matter where you are in the cycle.
How do you create one pool of capital that doesn't care? So for us, we think I try to find high average return, negatively skewed assets. You need look no further than equities.
You want it to be passively long, those in a low leverage way. And then against that you want to be actively long, positively skewed assets and you want to do that in a leveraged way and you do those together.
What's beautiful about that is you can, you can convert those equities into futures, be very capital efficient.
So $100 of equities, maybe you park $7 in margin, you have $93 to play with, you can buy Vix futures, Vix options, S& P straddles equity index straddles a host of things that are defensive. Put those together. So, you know, for us that is the, the way to do that. Your, your leverage on the Equity Markets Beta 1 and you can be very active.
And so ideally you have skill on the long ball side so you can be dynamically participating, reduce the beta drag. But even if you're not great at that, you're probably going to compound pretty well.
Cem:I, I tend to agree. I, I think the one, you know, it's always good to have a little bit of disagreement and we all have different perspectives.
I think, I think the one part of this that I want to have people think about more in this environment. You mentioned the right tail, right?
Patrick:Yep.
Cem:You know, in this environment, not only is institutional short interest or there are, the underweight is significant, which tends to happen right before in a bubble for obvious reasons, which in a supply demand basis is more likely to drive a squeeze higher, you know, if we are to go higher.
But on top of that volume is very compressed, partially because we've slid partially, you know, 40, 35, 40% off the lows, which has driven us a lot as well with all the ETFs, right.
That are issued, all the call writing, everything that we're seeing out there has also driven this volume compression, all the structured product issuance.
So you put that all together coming out of a summer into an end of year where there's a lot of re leveraging effects and all the things that we know that drive a lot of that seasonality.
And you can't help but think that going into a midterm year with historic policy coming out of not only the treasury, but likely the Federal Reserve merging, it's hard to say that the right tail is properly valued at this point given all those things.
And so instead of operating from a beta perspective and then taking in convexity on the downside, I think there's a great argument for replacing equity with out of the money calls and right tail. If you look at that distribution, you know equity markets are left skewed.
Patrick:Yep.
Cem:So you're getting a discount to get a right tail that you could argue.
Patrick:Yep.
Cem:Could actually be bigger than the left tail. Although the left hill will eventually come, at least in some medium term outcome. So agree, generally speaking, that ball.
I think we agree that volume and using that dynamism of all is, is critical in this juncture and kind of given how it's structurally compressed relative to the potential outcomes in this environment.
Patrick:Yep.
Cem:I think we both agree on that. But I think in this environment that right tail is, is really at a discount globally in a lot of assets, by the way. Not just equities, but, but yeah.
Patrick:And a lot of people, when they, when you're right in that, a lot of people also don't appreciate that when you go buy an equity future, you do pay away cash to own that future. So you're going to have a pretty discernible 4% drag on that. So the S and p is up 10, the future's up, you know, seven and a half.
Patrick:Right.
Patrick:Right. So you get that headwind as well.
For us, I think the important caveat is the client said we advise large institutions, sovereign wealth funds, they are anywhere between 85 and 95% of their risk coming from equities already.
Keith:Right.
Patrick:And so for them I would say it would be pretty silly to engage too much right tail behavior. For the typical retail investor, I'd say they're actually more underinvested than overinvested at this point in time.
So you know, for me, and I use the F1 carport, too many metaphors.
Cem:But I love David Judge's metaphor. Go ahead, let's, let's, let's hear it.
Cem:Yeah.
Patrick:You know, if you're going to embrace positive convexity, negative correlation, you, you shouldn't just put really good brakes on a car and drive at the same speed. Otherwise you're just Slowing yourself down. You need to drive faster as well.
Patrick:Yeah.
Patrick:So you could do that through additional leverage on the long legs to kind of compensate for some sort of beta drag or theta bleed. Or in your example, buy out of the money calls. Right, right. And then you, then you're convex to the right and left tail.
Cem:Absolutely. Yeah. You can do it a couple different ways. And I think you make a really good point for a lot of people.
You know, for somebody like me, that it's easy to deploy. But if you're already long equities, their tax considerations to selling there are also mandate issues. Right, but, but to your point.
And David Dredge, who we'll have on later as well, talks a lot about this. You need, you don't just need the goalies.
Cem:Right.
Cem:You need a heavy attack to pair with that. And I think particularly in this, you know, lepto Kurdic kind of fat tail environment, I think that that's critical. Let's pivot a little bit.
We talked kind of generally assets, equities. Do you guys have views on outside of equity land? Do you guys play in commodities, interest rates, fx?
Talk to me if so about how you guys look at that and how you play in the space.
Patrick:Yeah, yeah. We do high level. We're about 90% equities because our clients are about 90% equities.
But across our firm we do less convex but more defensive stuff like multi asset trend following. We have 160 markets, we trade more or less everything under the sun, credit, commodities, fx.
But the way we calibrate our trend models is to be defensive. So we're not trying to be the highest Sharpe ratio trend follower, far from it. We're actually trying to be the most complimentary to convexity.
gets more long in the tooth.:Luckily we wrote a paper in 21 so we looked pretty smart about it. To say that you should complement trend with convexity for the reason of a prolonged erosion of portfolio value.
So we think macro assets are actually best rewarded over that kind of timeframe. I call it the slow twitch muscle.
So you have the fast twitch muscle of convexity there in the concurrent drawdown, the slow twitch muscle which is there for the erosions.
So we're constantly long kind of implicit out of the money options through these kind of trend following portfolios that will really ride the wave pretty aggressively.
Cem:So I think you've heard the sumo analogy that I gave and you mentioned that earlier. I'll take one from you. I think I heard a couple of years ago, or maybe a year ago is we live in a world of nominal illusion.
Cem:Yes.
Cem: correlation breaking down in:And really it didn't exist until 40 years ago. I want to be clear about that.
Patrick:Yep.
Cem: This: sharp for a:Essentially no difference.
Patrick:And we've seen two times that since you know, over the last 20, 30 years. Correct.7 sharps.
Cem:Absolutely.
Patrick:Which is obviously not the norm.
Cem:Right. And we understand why that is. Right. Historic Federal Reserve policy, you know. And the question is can that continue into the future?
And there's a lot of big question marks about that. And I don't think we need to dive into the structural arguments of why that that may or may not be the case.
But I think you have to realize that you know, there are structural factors that, that could very well lead us back to a normalization to more long term trends. Again Looking at last 40 years interest rates top left to bottom right. And using that as your data set I think we can all agree is.
Patrick:Yeah.
Cem:Is probably not the right data set to be analyzed.
Patrick:I think sometimes the simplest charts are the best.
And we make this chart that's just a rolling 15, 10 and 20 year s and P excess of cash return and it's simplest chart but it gets us a lot of engagement. We've over the last hundred years we've been where we are now twice.
Cem:Yeah.
Patrick:Once was the tech bubble. Okay. We know the best allocation choice would have been to hide under your desk for 15 years. Embrace convexity and trend. For sure.
The other time however was in the 50s, post World War II recovery. And we spent the subsequent decade crashing through all time highs.
Cem:Yep.
Patrick:More or less incessantly. So you know it just goes to show that just because we're at all time highs, this is your right tail argument and I think you're absolutely right.
So whether your construct is levered passive beta out of the money calls, you need to find a way to not run away from beta and be defensive at the same time. Otherwise you're going to be making a short term call on long term data and that's one of the worst things you can do, that mismatch.
Cem:So I started in 98. So I started right as kind of that the tech bubble was going and I think this will bring full circle some of that right tail argument.
For the last two years into the tech bubble, the best trade by far and the easiest was to own long dated calls and equities like out of the money. Right. Those, those calls were way too cheap.
Market up, volume up didn't happen just in brief instances like we've seen more recently, but it literally happened eight out of 10 days for two years.
Patrick:Right.
Cem:So it was a great way to capture Right tail make money on the way up hedge by the way. You could sell stock against it.
Patrick:Sure.
Cem:On the way up and then eventually make money on the way down. You got a big kind of a general megaphone into, into increasing rallies, which is what tends to happen for a lot of the reasons we've just discussed.
Patrick:Right.
Cem:So I think, I think that again not to hammer on that idea, but that, that is a compelling argument. If you look to the 60s and 70s though, to your point about the 50s, yes, we did hit a lot of highs along the way starting in the 50s.
But again, nominal illusion, a lot of that was just a function of structural inflation. If you look at 68 to 80 to 14 years at the end of that, that cycle in nominal terms, we went nowhere. Yes, a lot of rallies, a lot of drops.
However, we did lose up to 50% like towards the end of that 50% was the, the max. I think it was a 13 year period. 50% in real terms decline.
Patrick:Yes, I mean that's.
Cem: ir buying power by being in a:Not nominal, it tends to be very predictive. So a lost deck in a sense isn't just nominal necessarily, it's really a question of real.
Patrick: eye watering pretty quickly.:But in fact the bond standard deviation was much more significant obviously. But the drawdown for that portfolio was the same. Right.
And I think if you revisit things like 73 and those types of the Yom Kippur type drawdown, if you shock portfolios today. With that we've raised the hypothetical. There's four quadrants of economic growth and inflation.
You say well there's inflationary growth which is intuitive and deflationary recessions are intuitive. There's deflationary growth which we've lived through. How about inflationary recessions?
And when you kind of see prices meet that marginal elasticity to their peak but they can't go any lower because people are not going to operate at negative margins. It's irrational.
Cem:Yeah. And you can't help but see some of the stagflationary pressures that would drive and so. Agreed.
That's an outcome that not many people have thought about much for 40 years. But you can't help but see that the least the probabilities of that are higher than they in the past.
Patrick:And I, and I love the, the euphemistic language that slips in. You talk about inflationary recessions and 95% of, of people I talk to come back with stagflation. I'm like no, that's stale growth and inflation.
I'm talking about a recessionary inflation which is, which is more in the 70s what we saw. Correct.
Cem:And that's exactly what you end up seeing. Six and seven.
Patrick:Yeah. You're going to see real, real growth assets lose ground. At the same time nominal prices increase.
Cem:We need a new term for that. Yeah, so what'? We'll have to come up with that.
But last thing I want to kind of touch on before we kind of wrap up here is I think an important idea that very few people are looking at in terms of risk. You know, these days we have $500 trillion. Let that sink in. $500 trillion of long assets.
That's stocks, that's bonds, that's private equity, private credit, real estate. That's globally. That's a eye watering number. And at the same time we have as non correlated assets and that's hard to define exactly.
But in that number I put precious metals, I put crypto which is arguable and then structured products and things that fall in the structured product Umbrella in that I'm including all the new ETFs, all the buffer funds, all the, you know, things that people that are all at this conference do. And then I'm adding in hedge funds. Right. Broadly. And I get. Hedge funds are again tend to be more correlated than not, but they have.
Patrick:A generally non correlated 7 correlation but low beta. Yeah, yeah, sure.
Cem:And so you start, you start putting those all together. Those assets are only about $15 trillion now.
Patrick:Yeah.
Cem:Now the caveat to that is people will be like, wait a second, precious metals are 25 trillion. How can that be? About 20 trillion of precious metals is underground in safes, untouched, not accessible broadly. So I'm really counting as five.
All of that. That 15 is up from five just three years ago.
Patrick:Okay, got it.
Cem:And the reason I say all this is they're all, they all have about doubled or tripled in the last three years. And that doubling and tripling of assets for all those is not a coincidence.
They all coming in my opinion from the same sources, which is people looking to manage risk and diversify in a world where bonds do not diversify risk.
Patrick:Yep.
Cem:So big picture, 500 trillion on one side, 5 to 15 on the other side. Where do we think we are in that? In that.
And, and so I, I want to highlight, you know, solutions like we're talking about, which is an element of that, that you can put that in the structured product hedge.
Patrick:Yes.
Cem:Kind of part is critical and I think increasingly critical. People are just early adopters are figuring that out.
Patrick:Sure.
Cem:But we've yet to other than 22 see any real reckoning there. And I think I just want to highlight that as a major risk.
Patrick:Yeah. I think every asset in a sense can be viewed as a trading pair of the dollar. Right.
And when you have dollar stability or regime stability, mean reversionary forces kick in. If something pops, it tends to come back. The dollar will rally against it. And that's another way of saying it lost value.
But when you're in a reflexive regime, which is the opposite of a mean reversionary regime, you see this tripling of non dollar assets over a very short time period and that reflexivity tends to give raised rise to more real flexivity and then there's some sort of crescendo.
Keith:Right.
Patrick:And I don't think we've seen the crescendo personally, but it's also the hardest thing to predict in markets.
Cem:A hundred percent, I think it's safe to argue, at least I think so super early given the 500 to 15 kind of trillion type reality and the fact that we've yet to really see.
Patrick:Yeah.
Cem:Any of that mean reversion yet. And like you said, it's a pendulum.
Patrick:Yep.
Cem:So once it starts to swing, it can really get going in the opposite direction.
Patrick:Yeah. So all these dollar off ramps in the exuberant price moves we've seen. I don't, I don't love forecasting asset returns and so I really don't.
But I think if you're looking to hedge real losses, equities are tempting. But real assets have to be a big part of your portfolio, certainly bigger than they've been.
I remember going back to:We had risk parity portfolios that I was, you know, helping kind of manage and, and market on behalf of aqr and nobody wanted to touch them because it was basically just levered bonds and the only other thing you were embracing was real assets. Those types of portfolios, especially anything that elevates the presence of real assets in the portfolios.
It's probably a decent allocation regime to think about in a reflexive dollar off ramp regime, which is what I really think we're entering to your point.
Cem:You know, hard to say with conviction that it's definitely going higher or that it's an incredible bet, but what I think is fair to say is it's a great diversifier at this point. And markets don't respond to fundamentals over a short period of time, but they sure do respond to supply demand.
And when you have that kind of supply demand imbalance, probably not a bad place to be allocated.
Patrick:Yeah. And you see, I mean just forward multiples at what, 24 on the S&P trailing multiples, flirting with 30.
I don't know where the cape measure is, but it's gotta be flirting with 40 now, which is basically all time highs. Everything else is 50 to 2 times its median or average.
We're clearly on borrowed time, of course, with the caveat that borrowed time can last quarters and years sometimes. And that's in a period of time that matters for investors, especially when real, when nominal costs are rising the way they are. Right.
And so it's a very tricky time to make pivots.
I do fear that people will lean a little bit too hard into the equity risk aspect, fearing the right tail and, but fail to kind of appropriately calibrate the left tail. And that's broadly what we've seen with a lot of allocation shifts of late. Not ubiquitously, but just on Average. So we'll see.
Cem:Yeah. Now there are. The key is thinking about it distributionally. Right. And I think that's what's really hard for people to do when they think about beta.
They either need to reduce their beta or improve their beta. The reality is you can maintain the allocation.
Patrick:Right.
Cem:Maybe even get leverage to the right tail while still protecting your left tail. And I think that's where we are in this cycle. And wonderful talk to somebody who gets that. Patrick, thanks for hopping on.
Patrick:Yeah, thanks for having me. Appreciate it.
Cem:Welcome back to another episode of you Got Options here at the RMC floor. Third conversation for today. We got no other than Hari Krishnan. I remember almost nine years ago reading his the Second Leg Down. Incredible book.
Written a bit since then as well. But no better person to talk about tail hedging, market dynamics and where we're going than Hari. Welcome, buddy. Good to see you.
Hari:It's great to see you and couldn't be happier than to be in Munich and to be chatting with you. Yeah, we got to go get a.
Cem:Beer together after this.
Hari:Oh, at least one, certainly.
Cem:So one of the things that actually just there was a session on was AI. AI and options trading. Kind of the effects it's having where things are going. And I know you have some opinions on that. I do too.
And I think they're all kind of, you know, really speculating about current circumstances, how fast this is moving and the effects it's going to have. But I'd love to dive in for the next 20 minutes and kind of focus primarily on that, if that sounds.
Hari:Yeah, yeah, sure.
Cem:So couple things. Just to give you a sense of how fast AI is moving broadly in the demographic of high school, sorry, college educated men.
In the US specifically, unemployment has gone from four and a half, 4.7% to almost nine and a half percent in the last year and a half.
Specifically, nothing has happened to the four and a half percent unemployment rate for college graduated women and for high school or non college graduated men and women, also four and a half percent. Very few people can understand fully why that is.
I think it's pretty clear if you look at the data and where it's happening, that that's happening specifically to those working in fields that are using, you know, technical expertise, not nursing jobs, not service jobs, not teaching jobs. Really, really. Programming, accounting, legal, you know, across the board there so massive wave and it's happening way quicker than people realize.
I certainly here in the derivative space, I think it's, it's so important and we're Seeing a lot of quick changes as a function of, you know, options being relatively complex.
You know, people like you and me have, have studied or worked for decades, right to kind of fully understand these things and, and to rise kind of to the, the middle top or the top or whatever of our fields and, and be able to kind of discuss these and understand these, these products. But their growth is, is tremendous as people look for more non correlation and understand them more and there's more network effects.
My view is that AI is really going to help the broader audience move more away from a two dimensional stock bond commodity investing type exposure to really access more the distribution of each product to be more precise with their positioning and adoption. What I feel like, and again, I know you drink the Kool Aid as well, a superior way to position, a more precise way and flexible way to position.
So I really see it as a coming revolution, not just for AI, but for options, structured products, anything that involves dimensionality and democratizing it in a sense.
I know that's probably going to sound like a little bit of wishful thinking or the question is about timing, but tell me what you think about that, how you see it. I know you have a little bit different view, but would love to hear your thoughts.
Hari:Well, I have a strong view, it might be incorrect, but again I don't have a crystal ball.
If you think of machine learning, there's kind of a wide variety of fields where it's applied, always getting wider and in some areas it's been conspicuously successful autonomous driving, if you are able to control for the impact of mistakes all the way down to finance.
Finance is actually kind of the frontier or financial returns predictions is the final frontier in some sense of machine learning because the signal to noise ratio is very low and so teasing more out of the data is immensely powerful. Now you know as well as I do that if you trade just futures, forget about the options for a second.
If you can be right 52% of the time and trade a lot, your Sharp can be immense. Even getting to that is tricky in lower frequency contexts using machine learning. So it's a challenge.
And one of the big challenges is as you build a machine learning model, you're always playing a trade off between something called model variance and bias. So in finance what that means is you don't want a model to be too biased in the sense that you don't want it to always be long or always short.
You want it to change its positions dynamically. Conversely, you don't want a model to be too unstable.
So if you input a slightly different data set, you don't want the model to do something totally different.
The trouble is that for markets which tend to go up, like the S and P, at least in recent years, model variance is a big issue and models simply want to be long a lot of the time. So I know there's a passive revolution. I know that there are lots of other factors driving.
I know that liquidity measures and so on are indicators of ramping up equity markets.
But I think the technical models that are increasingly used, maybe we're under the ML guys, have that, as you put it earlier, momentum aspect to them. Momentum and long bias to them. So fighting that bias is a real challenge.
Cem:Yeah.
Hari:And options allow you to do that.
Cem:How much of that is just a function of the data set?
Hari:Right.
Cem:I mean, obviously any intelligence of any kind when only given a certain amount of information will have, you know, poor outcomes if they don't have the full picture.
And I how much of the argument that it's not good is that we just haven't had enough data points or that the tails in particular are underrepresented. And what if we were to take a much wider lens and at least drive enough simulations to create a broader data set? I don't know, just love to.
Hari:Well, tail risk, which is a topic close to your heart and my heart and Dave Dredge's, who will come on at some point, that is one of the areas which is hardest to apply machine learning to because machine learning tries to tease out fine structure in a mass of data. So you need tons of realizations. The stuff that occurs at the tails doesn't happen much by definition.
So machine learning models don't have much to grab onto.
And so buying the tails, which is something that I guess most respectable market makers, dealers will do just to keep going, is the defense against statistical unknowability, I guess. And so that's an area where you can combine machine learning and options.
So you could have a futures program where you do all the statistical stuff, you aggregate huge masses of data, you do cross sectional pooling, blah, blah, blah, but then at the tails you just play defense. And that's the cost of doing business.
And I get the suspicion that a lot of people in the industry who are sophisticated using these models are doing exactly that.
And you might not see it in terms of options activity at the tails, although that has increased, but more clearly in terms of very tight risk controls. So positions that have been working and no longer work just get flushed out very quickly, not only to the downside, but to the upside.
And that creates this sort of interesting situation where options add even more value.
Cem:Right.
Hari:Based on the fact that more is predictable within the narrow. Not the narrow, but within the belly of the distribution. And everything else is non modelable, at least knowing in current conditions.
Cem:Yeah. And do you think.
I think what you're implying is that those participants who are increasingly using these things are not only poorly modeling those things or can't use them well to model them, but because they can't, are reinforcing those tails.
Hari:Yeah, absolutely. I mean if you have an edge and your edge doesn't apply to outsized moves, you just get out.
Keith:Yeah.
Cem:You just cut your risk. And that obviously just forced.
Hari:And we're seeing a lot more of that.
Cem:Yeah.
Hari:And we discussed this previously as well. But short selling has become more difficult, or at least index short selling or short bias strategies have become more difficult as a result.
Because cutting risk doesn't only apply to the downside.
Keith:Right.
Hari:It applies somewhat symmetrically to up moves as well.
Cem:Yeah, absolutely.
You know, I think it's particularly relevant given that, you know, the last 40 years have been really, up until just a couple years ago in 22 maybe have been fairly one note. I mean, if you. There have been short periods of volatility, but volatility has come and gone quite quickly. We haven't seen also a.
Until 22, a major breakdown in any way with correlation. There have been ways to manage risk and to handle things, which is quite unique honestly to longer history.
I mean, if you look at hundreds of years of market history, not just in the U.S. but also outside of the U.S. you know, the last 40 years is a bit of anomaly in the context of the bigger picture and.
Hari:It explains a lot of the dynamics we're seeing now. So we see a rich VIX term structure. Why?
Because I think there have been more instances of the VIX popping from a low teens level in recent years than we saw previously.
Cem:Absolutely.
Hari:And so people are playing defense there and that is not contiguous and it's not consonant with what's going on in S and P options.
So there are lots of dislocations where VIX might be rich, but S and P offers value either on the upside, perhaps, or even on the downside in certain spreads. And that's created a lot of interesting situations that may not be resolvable.
They're not really arbitrages because the players who could do the arbs.
Hari:Are not.
Hari:Positioned in such a way to do those particular ones.
Cem: an, I Think I always find the: Hari:That's right, yeah.
Cem: Options were created in: Hari:88, yeah, that's a great comment. And it is historically true. I wonder if there is an analog today with the call skew for the.
Cem:S and P. That's right where I was taking this. Absolutely.
Hari:Well, you kind of tipped me off, so I'm going to give you credit for that.
Cem:No, absolutely.
I mean, I think we've started to see a significant compression of vols on the upside that as a result of not seeing any structural inflation of any meaningful lasting time due to a very stable monetary policy and regime and a broad geopolitical regime really for the last 30, 40 years. It's interesting that we're seeing those things that stability of policy change dramatically but without a reaction.
And I really do think it'll take an event to do that.
Hari:And that's a great point because if you go back only to the 80s, let's say, and you try and look at S and P earnings multiples as a function of inflation, you see something that looks a bit like a bell curve. So high inflation is bad for equities, low to negative inflation is bad for equities, and there's a sweet spot of 2%, I'd say.
And it all fits beautifully together with the Fed's recent thesis and so on. But that could all change. That's not a written in stone fact at all.
Even as it is, it's statistically noisy and so high inflation could actually be quite good nominally for equities.
Cem:Agreed. It all depends on what kind of inflation.
Cem:Right.
Cem:And we're also talking about devaluation.
Hari:That's great.
Cem:Right.
Especially in a regime, by the way, when 10% of all the top 10% of all earners constitute more than 50% of all consumption in the United States, that could be something that where the wealth effect is more important than ever and if you drive liquidity to the top with lower interest rates and there's.
Hari:A double whammy there, because if the top 10% are generally older, which they are, and it was previously assumed that older people consume less, the effect is even more dramatic than that.
Cem: I started in the business in:Probably the only other than briefly in 07 outside of the US really the only time I really saw that for a continuous long period of time and again it was almost two years of market up volat which most people don't fully appreciate. So I've kind of been wondering if and when that would ever come back again.
And I can't help but feel that slightly different circumstances, some things run like Federal Reserve policy and whatnot, which we can get into.
But really the amount of short interest, the amount of retail involvement, obviously the power of narrative, you know, all bubbles are built on a very believable idea that this time is different and where you're let off with AI. Like I can't think of a more powerful driver of that narrative.
So in the face of that narrative, retail involvement, very aggressive coming monetary policy likely, given that the administration is taking over the Federal Reserve, you know, all the ingredients are there again.
Hari:Well, I'd like to make a cheap comment about that. This time it's different.
I'm actually quite sympathetic to young people because if they didn't believe this time is different, what hopefully they might think that we're going to get old, we're going to get old and sick and then we're not going to do very well.
Cem:Oh yeah.
Hari:So they have to feel this time is different. It just doesn't really apply to financial cycles which outlive all of us. So. Yeah.
Cem:And by the way, it could be different. We were talking about tails. Right. Like, you know, the reality is there may not be enough data.
It's possible, but that possibility is what drives the exuberance and the drive to some extent.
Hari:Well, I think one of the most interesting case studies will be what happens to the cryptovol surface over time. That is a very nascent surface. It used to be flat and high. Yeah. What contours will it take?
Cem:Yeah, let's talk about that a little bit because I don't play as much in crypto vault.
Hari:Nor do I. Yeah. So speaking a little bit out of.
Cem:Field, I definitely think, by the way, and this is a little tangential what we're talking about, but that there is a massive right tail convexity as we've seen in crypto, but also extending not just to crypto. And now again we've seen it recently in precious metals. We talked in the Gulf. Yep.
But across any asset that is really perceived as any type of a diversifier. You Know, people don't realize the growth that we're seeing in structured products, which I often, often talk about.
And when I in structured products, I mean also the ETFs and the buffers and all the things. Right.
Cem:Yeah, they're all very related.
Cem:That's gone from 500 billion to 2 trillion in just three years, which is pretty amazing. Hedge fund assets broadly have gone from 2 trillion to 4 trillion in about three years. Gold has tripled in three years.
Crypto has tripled in three years. What I don't think many people have connected is all those things are connected.
Hari:Absolutely.
I mean, even if you take the hedge funds piece, if the bulk of the flows are going into the pod shops and the pod shops have very tight limits, risk limits in each pot, what are you going to do other than chase a winning strategy and bail out if it, or get bailed out if things go against you?
Cem:Right.
Hari:You have to do that. You can't be a long term player. That's where the opportunities lie for some of us.
Cem:Absolutely. But all of that's, you know, you have 500 trillion on one side and now you have up from 5,015,000,000,000 of diversified assets.
ext of just a warning shot in: Hari:I mean it was a mild decline. I mean it was significant in terms of distance, but not in terms of speed, right?
Cem:That's exactly right. So I mean, I can't help but feel like, you know, talk about right tail events, we're already seeing it in those assets right now.
And that's before the liquidity push coming from an activist Federal Reserve likely coming and an active administration.
So you can't help but wonder, you know, how fat should that right tail be and how much of that can not just continue in those assets, but even translate across all assets going forward and all the time in the context of structurally compressed volume on that tail. You know, it's the harder part, honestly is, is owning the left tail because it's expensive. Everybody needs it.
Everybody's long assets, everybody needs it. The cheap part is the right convexity. And because of that structural imbalance of long assets for short assets, we have compression on the call side.
But again, I think that is, that's exactly at the moment. Right? Yeah, it's the place to play. Anyway, we kind of moved off of the AI piece a little bit.
But I do think that AI also could potentially play a role in that.
Hari:Well, we do a lot. Well, just to summarize, the AI piece from my Perspective. We do a ton of AI or machine learning.
I won't glamorize it in various guises, but it's always dedicated to median return outcomes. So the options, the need for options never goes away.
Cem:Right.
Hari:You have to look at median return outcomes because these are pre leveraged numbers and you don't want to be glued too much onto rare events.
Cem:Right.
Hari:Because machine learning requires very repeatable patterns that occur many, many, many times. Fine structure cannot be found from a sample set of tests.
Cem:Yeah, no, I agree with that. The question, I guess, ultimately is how durable is that weakness in the models?
And you know, like you said before, I don't know that our edge, our views, the contextual thinking that you need outside of an AI model will go away in a year or two.
But I think it's safe to say with stronger models, better data, that you could, in theory, also start modeling more complex things like that, which are actually more valuable. You know, in the sense that it's. It's hard for most people to access that, maybe even you and me at times.
Hari:I think it's hard for me as well. But it's. Of course there'll be windows of opportunity in these spaces.
Cem:Yeah.
Hari:The reflexivity of markets, though, will always.
Cem:Create something new that is not going away that we hope that we can agree on. Awesome conversations, always. Thank you, Hart.
Hari:Thank you, sir.
Cem:Always a pleasure.
Hari:You got it.
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