In Thursday’s paid subs post, embedding spot-vol correlation in option deltas, I buried this story but I thought worth sharing since it’s broadly suggestive of what happens when you list options on an investments touted as worth being in your asset allocation:
I started in commodity options just before the listing of electronic options markets. When I first stepped into the trading ring, many market-makers were still using paper sheets. We had spreadsheets on a tablet computer, but heard of a fledgling software called Whentech. Its founder, Dave Wender, was an options trader who saw the opportunity. I demo’d the product, and despite it being a glorified spreadsheet, it centralized a lot of busy work. It had an extensive library of option models and it was integrated with the exchange’s security master so its “sheets” were customized to the asset you wanted to trade.
I started using it right away. Since it was a small company, I was able to have lots of access to Dave with whom I’ve remained friends. I even helped with some of their calculations (weighted gamma was my most important contribution). I was a customer up until I left full-time trading. [Dave sold the company to the ICE in the early 2010s. It’s been called ICE Option Analytics or IOA for over a decade.]
The product evolved closely with the markets themselves. Its nomenclature even became the lingua franca of the floor. Everyone would refer to the daily implied move as a “breakeven” or the amount you needed the futures to move to breakeven on your gamma (most market-makers were long gamma). Breakeven was a field in the option model. Ari Pine’s twitter name is a callback to those days. Commodity traders didn’t even speak in terms of vols. They spoke of breakevens expanding and contracting.
What does this history have to do with a spot-vol correlation parameter?
This period of time, mid-aughts, was special in the oil markets. It was the decade of China’s hypergrowth. The commodity super-cycle. Exxon becoming the largest company in the world. (Today, energy’s share of the SPY is a tiny fraction of what it was 20 years ago.)
Oil options were booming along with open interest in “paper barrels” as Goldman carried on about commodities as an asset class. But what comes with financialization and passive investing?
Option selling. Especially calls.
Absent any political turmoil, resting call offers piled on the order books, vol coming in on every uptick as the futures climbed higher throughout the decade.
A little option theory goes a long way. Holding time and vol constant, what determines the price of an ATM straddle?
The underlying price itself: S
straddle = .8 * S *σ√TIf the market rallies 1%, you expect the straddle price at the new ATM strike to be 1% higher than the ATM straddle when the futures were lower. Since the “breakeven” is just the straddle / 16, you expect the breakeven to also expand by 1%.
But that’s not what was happening.
The breakevens would stay roughly the same as the market moved up and down.
If the breakevens stay the same, that means if the futures go up 1%, then the vol must be falling by 1% (ie 30 vol falling to 29.7 vol)
It dawned us. Our deltas are wrong.
If we are long vol, we need to be net long delta to actually be flat.
When your risk manager says why are you long delta and you explain “I need to lean long” to actually be flat, you can imagine the next question:
“Ok then, how many futures do you need to be extra long for this fudge factor?”
We need to bake this directly into the model because it’s getting hard to keep track of. Every asset and even every expiry within each asset seems to have different sensitivities between vol and spot. The risk report can’t be covered in asterisks detailing thumb-in-the-air trader leans.
Whentech listened. Whentech introduced a new skew model that allowed traders to specify a slope parameter that dictated the path of ATM IV. Their approach was simple and numerical…