Kurv Your Enthusiasm - Episode 05
Volatility Part II: Extracting the Volatility Premia. Trade and Budget Dual Deficit.
In this episode of Kurv Your Enthusiasm, hosts Howard Chan and Dominique Tersin discuss various aspects of investing, focusing on market updates, economic indicators, trade and budget dual deficit challenges faced by the US. They delve into the complexities of volatility in investment portfolios, exploring strategies for trading volatility and its implications for portfolio management. The conversation highlights the importance of understanding market dynamics and the potential for volatility to act as a diversifier in investment strategies.
Chapters
00:00 Introduction to Kurv Your Enthusiasm
01:17 Market Update
05:48 Analyzing Trump's Policies
09:35 The Dual Deficit: Trade and Budget Challenges
24:30 Volatility Redux
31:46 Extracting Volatility Premia
40:44 Covered Call: Embedded Volatility Premia
Howard Chan (00:13)
Welcome to the fifth episode of Kurv Your Enthusiasm. We are your hosts, Howard Chan.
Dominique Tersin (00:18)
Dominique Tersin.
Howard Chan (00:20)
This podcast is a discussion of everything relating to investing and everything adjacent to it. It is important to remind the listener that the trades we discuss on the show are not meant to be financial advice. We are recording this on April 1st. No joke. On the agenda today, we will go through our market update since we last recorded two weeks ago. Then we're going to revisit the last topic.
on our last podcast, which is sort of my unifying theory about what the Trump administration is doing in terms of their policies, maybe a little bit of analysis on how well they're doing. And then we go into the second part of discussion on volatility and how you can use it in your portfolio. And in particular, we're going to talk about what the trades or how you can use this particular risk premia.
to generate returns in your portfolio. All right, well, Dom, give us a market update.
Dominique Tersin (01:17)
Sure. over the past two weeks, had continuous trade tensions. we had 25% extra tariffs on autos non-manufactured in the US. We had shifting economic expectations with some analysts starting to increase their probability of recessions.
And on top of that, we had rather sticky inflation numbers, basically too high for the Fed to cut quickly if there would be a recession. So that's kind of a stagflation theme, which actually was still present when we did the last podcast.
And that can explain why the risk assets suffered for the past two weeks. We can see S&P is down, today and yesterday, it's little bit better, but down 1 % in the past two weeks. And it's actually the worst quarter since 2022. The NASDAQ is down 3%. And there was some rotation again.
out of the tech sectors and the large names into the rest, although the pace has abated recently. flight to safety, it's still visible through the VIX that has increased again, 23. It's on the high level of the range. Usually the range is around 14 to 23.
So we are at 23. And so we can see on the flight to safety, Bonds did OK this past week. 10 years is down. It's not much, but still. And the fed fund futures in December, so the expectation of fed fund rates for December is also down by 10 basis points. I believe it's pricing around three cuts.
this year with the one starting probably in June. the probability is around two thirds. On top of that, on the flight to safety, we have the usual on our podcast. It's gold is +3%. Again, it's the ultimate hedge, it seems. a gloomy picture.
from the markets and also from the macro indicators, the bias of the markets being more on the start of a clear cool down of the economy.
Howard Chan (03:55)
You forgot to mention tomorrow is April 2nd, it's liberation day, where apparently a lot of reciprocal tariffs are going to go live. You think they chose April 2nd because they didn't want to do it on April 1st and everybody thinks it's a joke?
Dominique Tersin (03:57)
That's true.
I think so. think so, Yeah, no, marketing is important.
Howard Chan (04:18)
Yeah. So, we're recording this on April 1st and this episode will probably be out on April 2nd. So we're not responsible for what's going to happen in the market today when you're listening to this and we'll have an update in two weeks to assess what has actually happened. I, I think what you are describing is something that we have been really talking about since we started this podcast, which is that, inflation.
is still well maintained, rather high for historical standard, at least over the last 15 years. And we have now continuously gotten, I would say, progressively worse and worse news in terms of economic activity. And then, of course, there's increased uncertainties from US trade policy. the probability of a recession is increasing.
And one of the concerns and maybe from a risk management perspective is that the market hasn't really priced in this increased probability of a recession. And so that's something.
Dominique Tersin (05:22)
Recently Goldman put it at 35%.
Howard Chan (05:29)
Yeah, I think it may be higher. so as prudent investment managers, we want to be sure that we don't underestimate the underpricing of this recession and then be able to protect the portfolio in case there is a downturn in the economic cycle. And that said, we do want to continuously to try to rationalize what is the Trump administration's policy and what is their aim. I think that's important to try to understand. I started doing that and explaining that at least for our base case last episode. And I think I did a pretty horrible job of describing our model. So I'm going to try to do a second take. And I'm trying to maybe.
go from a broader theme to very specific items. And then we'll give a little bit of an assessment of how they're going about their goals. since I would say the 60s and the 70s when the Chinese market started opening up after Nixon, we've seen essentially an increasing trade
imbalance through the world. It's essentially that China will make products for the world
China is producing goods, not necessarily to maximize profit, but instead to gain market share. And so as I mentioned last time, we've seen that they've done this with solar panels and EVs. And this is essentially destroying manufacturing sectors in both Europe and the US. We've seen further evidence of this is actually there's a recent report that big companies like Volkswagen's are cutting hundreds and thousands of jobs because they're not producing as many cars anymore, largely because China is actually making inroads on selling their really cheap EVs to the rest of the world, crowding out German auto manufacturers. if you were an administration who's trying to combat this, you want to reverse the trade deficit. One way is to reduce trade with China, but that's not sufficient because
The cycle continues because when China has a trade surplus, they use some of that to subsidize their internal industries so that they don't have to be profit seeking. The government can support some of the profit making and then all they have to do internationally is to try to get market share. So some of that trade surplus is used to subsidize internal production, but also to get
foreign assets. China has about a trillion dollars of trade surplus of which the US only accounts about a third of that trade. if US were just to put tariffs on, that wouldn't be sufficient because there's another 60%, of trade surplus that China can
source elsewhere from the world. The EU accounts for about 250 billion of that trade surplus. And then India is the next largest at 100 billion. So between the US and EU, it accounts for about 60 % of the trade surplus that China has.
I think, what happens is the US government is trying to put tariffs to reduce trade with China, but they can't do it alone. They actually have to also somehow convince other region to increase trade tariffs to reduce their trade with China as well. And we've seen them doing this with Canada and Mexico. I don't know if we necessarily need to be
pushing everybody to do this because obviously Europe has a big trade deficit also with China. So it is actually in their interest to protect some of their industry.
I think this is the reversal of the globalization trend that we've seen in the last 40, 50 years, that again, we're going into regional trading zones so that not one single country can dominate and have such a huge trade surplus.
And for those who are on the podcast, I'm pulling up
an infographic from USAFACTS. This is from Steve Ballmer the former CEO of Microsoft. He put together some of these data graphics that I think are very useful. the Trump administration is also trying to address the second deficit that we have, which is the budget deficit. And roughly the problem is this, is that currently the debt to GDP
of the US is roughly around 100. So one to one in terms of debt and economic growth. However, the numerator and the denominator are not growing at the same pace. US debt is growing roughly at about 7%, 6 to 7 % per year, while US GDP is growing maximum at 3 % a year.
So which means that the debt is growing faster than our GDP by about 3 % every year. And so we are actually in the time of essentially we're issuing more debt just to pay the interest on our debt. And that is not sustainable. And so in order to balance our budget deficit, we need to essentially either cut spending or increase revenue. Because if you look at the
graphic right now, the US government is taking in roughly $5 trillion from taxes and everything. And then we're spending $6.8 trillion. So that means that we have to finance a budget deficit about $1.8 trillion every year. So
that makes sense that you're looking for different ways in terms of cutting the budget, the US spending, right? And just to briefly talk about the US budget, the top five items that is being spent in the US is social security, which makes up about 22% of the spending.
Health services, which is about 13.5% of the spending. Interest payment is 13% of our spending. Medicare is about 13% of the spending and defense is about 13% of the spending. So these top five items make up about 75% of the US budget.
the Trump administration is trying to look at different ways in which to decrease spending. I guess the obvious criticism is the places that they have cut, USAID, Department of Veterans Affairs, Department of Education, those are not
really the large budget items. For instance, the Department of Veteran Affairs is only 5% of the budget. Department of Education is only 4% of the budget. Agriculture is the next big one, which is at 3% of the budget. And USAID is somewhere even below that. So it's hard to see where they could find a $1.8 trillion savings in cutting those things. The things that needs to be cut or
managed is a lot of the social programs, social security, health services, interest payment, they're working on that Medicare. And those are really, really hard questions and hard decisions to make. And they have, at least in the past, publicly said that they are not going to make any changes to those. The one part is on the top five spend is the defense budget, which is 13% of the U.S. budget. They are
making some headways on that particular front by essentially making US allies pay a little bit more. So that, think that part, I think makes sense to me, but really, if you're going to try to balance this budget, you're going to have to do one of two things, which is one, you have to cut a lot of the social programs, which is highly unpopular. So I don't know how successful that would be. Or the second thing is you have to raise taxes to make up for that $1.8 trillion deficit, which...
Dominique Tersin (14:16)
Or at least not
decrease taxes because it's expected to decrease taxes I believe.
Howard Chan (14:23)
Yeah, those are hard decisions. we're, just trying to rationalize essentially what the policies are trying to do. We are still gauging whether how effective it is. We're kind of less than a hundred days in, but this is the challenge I think for any government that's trying to really rebalance the dual deficit, the trade deficit, as well as the budget deficit. So, Dom, what do you think about that?
Dominique Tersin (14:51)
I agree. You know, in China, increasing market shares, rather than profits, it makes sense. mean, you just have to look at the Chinese stock market since 15, 20 years. It doesn't that much. I agree. At some point, you have to decrease the twin deficits, so the foreign and domestic deficits, trade and budget.
And the thing on the revenue side, in a way, with tariffs, you can increase the revenue. That's, think, one of the arguments of the Trump Administration The question is how much? I don't know. But total imports, I think it's, I'm reading, 3.3 trillion. So 20% is...
Howard Chan (15:23)
Yes.
Dominique Tersin (15:37)
600 billion which is a third of the budget deficit.
Howard Chan (15:42)
Do you know how much the U.S. pay in interest payments on their debt? About $660 billion. So the tariffs will offset our interest payments.
Dominique Tersin (15:50)
Yeah
It's a start. But I don't think they will reach 600 billion in tariff. don't think so. But in a way, I was looking at some charts and it seems that the US has the lowest tariffs in the world or one of the lowest. So if it increases from 2% to 6-8% in average, it will put them on what they had like 30-40 years ago. It's not completely crazy, I think.
Howard Chan (16:33)
And you know, there's, for and against kind of column, right? And definitely tariff will be a revenue generator for the US government. I think the open question that I have is that it took 40 years for us to go to this globalized, arrangement. I think it'd be very hard for us to reverse and to have regional trading zones.
Howard Chan (16:57)
In one or two years, maybe 10 to 15 years. So you're not going to get all of this revenue all at once. There's some time to get it. And at the same time, your debt is growing 3% faster than your GDP.
Dominique Tersin (16:59)
Yeah, it would be interesting to see if in four years, whoever takes over would have the same policy. But you know you mentioned get something on the assets. So when a country exports to another country, it can take its currency back to its own country or leave it.
Howard Chan (17:20)
Yeah, I mean, I
Dominique Tersin (17:39)
to the importing country and to have assets there. That's usually what most people do. And that's why you have, think China has $800 billion of treasuries, $300 billion of corporate debt. And I'm seeing out of the $1.3 trillion of equities and bonds that foreigners have, China has a good chunk. So as more trade deficit accumulates, that's more assets.
that you don't own anymore, right? Or you have to create them to sell them to the foreigners. So yeah, at one point it might be difficult to do.
Howard Chan (18:11)
Well, I have two comments on that, right? So in the last episode, I posited that part of what the treasury is trying to do by inducing a weaker economy is to drive the 10 year treasury rates lower. And therefore, if we refinance our treasuries, then it would lower our interest burden. But the problem is that we have a lot of debt that were issued during a very low rate environment. So I think the average interest rate on our US debt is about like three, three to three and a half percent. If we refinance now, even at a given rate, the rate right now in a 10 year treasury is about four, four and a half, right? So if we refinance, we're actually increasing our interest burden. So. we would really have to drive rate very low in order to get that benefit of extending maturities or refinancing at a lower rate, which have been talked about this theory about this Mar Largo Accord but that seems to be difficult at this moment, right? And then the second thing is, we have seen, as you mentioned, gold have reached an all time high.
And that's partially because a lot of central banks are basically storing gold instead of buying treasuries, right? So there is a question of, yes, China is a large holder of US treasuries in the past, but going into the future, as we issue more debt, who is going to buy these treasuries?
the people who are purchasing it has changed. About 10 years ago, it's largely institutional, central bank, and now more more debt is actually being owned by private entities in the US. So there's only so much that can hold in the US market.
Dominique Tersin (20:28)
And one solution to the debt is to inflate it. In a way, tariffs helps.
Howard Chan (20:34)
Yes. So that is true. You there's two ways in which you can solve that problem. One is you can grow out of it. That would require your GDP to grow at a faster rate than growing your debt, which is not the scenario that we have. And maybe one theory is that if you give a tax cut, that will induce growth and increase the GDP.
so we can somehow have real growth grow faster than debt accumulation. The other way to solve this is to actually increase inflation so that your debt is not worth as much as it was when you issued it. That is hard because we just came out of a highly inflationary period and governments changed because of high inflation. that
is something that maybe a lot of politicians are afraid of going back, right, to do. Tariff will help because it is by its nature inflationary you would just to be on par with the growth of debt, you have to increase inflation another 3%.
Right now, inflation is about 3%. So that means inflation has to be at about 6%. That's going to be pretty hard if you have an annual inflation rate of 6 % for any country. Exactly. And I think that's a good reason why gold keeps climbing higher. Yeah.
Dominique Tersin (21:59)
Gold.
Howard Chan (22:06)
So it's difficult. this framework makes sense to me in terms of what the administration is doing. The question is really about efficacy. If you are trying to decrease trade deficit, you actually want to have trade with your allies because if you're trying to bring back manufacturing jobs in whatever form they have, though there's some questions about how many manufacturing jobs you can actually onshore again, you want to create products that is being purchased domestically and you want to actually export those products. You need to have friends who wants to trade with you on those products, right? So I think over time, there will be deals that will...
have to be put in place where we have mutual trade agreements, the easiest would be the neighbors to the north and south of the US, Canada and Mexico. And then the next would be to the eurozone. So I think long term we'll see maybe a cool down of the tariff wars, because if it's true that we want to change the trade deficit in the US, we have to be exporting more.
Right, not net positive, but at least exporting more and you have to trade with people. And people tend not to want to trade with you if you are threatening them with things. And with the budget deficit, that's a really hard question in terms of implementation because the cuts will have to come from
from things that are very unpopular. That's to decrease spending. And then the thing that's not really being talked about, which is equally difficult, is you have to increase revenue. And I think for most of the world, increasing taxes is not popular. So it will be to be seen how much pain
can a population take before the government change to go in a different direction.
Dominique Tersin (24:15)
Coming from France, you have a lot of room.
Howard Chan (24:19)
I think that's why people are moving out of France.
Dominique Tersin (24:24)
Yeah.
Exactly.
Howard Chan (24:30)
but never fear. we are going through a period of change which has increased volatility, which leads us to really the second part of this podcast, the part two of our discussion of volatility, which is how do you take advantage to generate returns? just to,
do a quick recap on what we talked about, in the first episode on volatility is that volatility using it properly could be a diversifier in your portfolio. It is negatively correlated with an equity markets, especially in a moment where equity markets may be a little bit soft and correcting. This could potentially generate returns in your portfolio.
we talked about that generally there is a volatility premium to be harvested. That the implied volatility, which is the market pricing of what volatility will be in the future, generally is higher than the volatility that's actually realized in your portfolio. And that difference is the premia that you can harvest.
The way I think about volatility and this premia, I'll give you an example, which is I think about it as like an insurance company, implied volatility is sort of the insurance policy that an insurance company have to write or to provide to the market. And the realized volatility is the claim that actually happens in the market. And we know
insurance companies make a lot of money. And the reason is because the premium that they take in on their insurance policy usually is higher than the claims that they get from people. And this comes from a couple of reasons. One is that the insurance company needs to make money, but oftentimes when they write policies, they are pricing in risk that seldom happens
when your claims is lower than what the premium you have to pay to the insurance company, that's where the profit comes in. And that's where the volatility premia comes in. We also talked about that volatility really exists in almost every single asset class. It is
Howard Chan (26:54)
most famously known as the VIX, which is a measure of equity volatility, but you also have volatility in single names, which oftentimes are much higher than an index because the index has a built-in diversification which lowers volatility. And so maybe we'll stop there with the recap. And what we want to do today,
is really talk about how you can use volatility in your portfolio to generate returns. And we do use this volatility premia to generate returns in all of the strategies that Kurv offers to investors, but in different ways. We're going to cover two different ways in which volatility can be beneficial. One is a pure play on volatility, and we'll go through the mechanics in very detail.
hopefully not too boring. And then the second way is to have volatility to be embedded in another risk premium. So volatility with equities or volatility with fixed income or volatility with currency. So those two different types we'll discuss today. So I'll hand it over to you, Dom. Let's maybe do a deep dive on how you can do a pure volatility trade in your portfolio.
Dominique Tersin (27:50)
Just also to recap last time, there are two types of volatility. it's the realized volatility or historical volatility that happened. That's when your stock is up 1.3 % today. That's known. It's realized. And you have the future volatility that is expected by the market to be in the next x amount of days. And it's important because the way you do the trade, you will trade different volatility. So the pure volatility, which is what volatility will be in three months time, that will be like a VIX future. You have other volatility futures, but the VIX is the most well known.
on the volatility of the S&P500. a kind of funky average of the volatility of each single name in the S&P500. And as I said, you have correlation and diversification at play here.
But it's a good indication of uncertainty in the market. And you can trade this for futures on the CBOE. And you have also options on that.
Howard Chan (29:37)
I have to describe it by the way.
Dominique Tersin (29:37)
You have
the volatility. So right now the VIX is around 20, 22 or 23 percent, something like that. And 23% is how much the stocks are expected to move.
on a daily basis, but annualized numbers. It's a bit complicated, but in a way, if you have, let's say, 16% volatility, it will mean that your expected move will be a 1 % per day. So 23% VIX will be like 1.5% per day move. And that's what VIX is today. And this is pricing in the option markets.
And you can play the future, which is in June, and it's expected to be 22.5%. So 1% lower than today. So if you think the volatility will be higher than what is currently priced in the market, you will buy the June contract at 22. If it's above that, you will win. If it's below that, you will move.
Howard Chan (30:53)
what you're showing is essentially there's a pricing of volatility over time, right? What is the volatility that the market is pricing over the next weeks, next month, next quarter?
Dominique Tersin (31:07)
Yeah, so the VIX
contracts are... the VIX is a 30-day volatility window. So it's what the options market will price, volatility, on 30-day options. Okay, so that's why you have every month a future on the VIX. And you can trade this
volatility up to January 26th. But you have to be careful because the spot volatility might not be the same as the future volatility that is pricing the market. You have to take that into account.
Howard Chan (31:46)
how do you extract that premium on the pure play volatility, which is the difference between implied volatility versus realized volatility? another way to say it is how do you extract this premium that's between the market's pricing of volatility
going in 30 days and then the realized volatility that you actually experience in the portfolio.
Dominique Tersin (32:11)
Okay, so this is a much more complicated trade, but it's possible to do it. It's what market makers do every day to price your options.
So to price an option,
you need to take into account the move of your stock that will happen on a daily basis or even intraday if you want to until the end of the expiry of the option. And you need to do that on a market neutral basis because to extract your premium it needs to be
out of other elements. needs to be pure. It needs to be away from any moves your stock will have.
Dominique Tersin (32:56)
Your P/L should not be dependent on the stock movements.
Yeah, it should be only dependent on the movement of your underlying. And how they do it? is by what we call the market neutral hedging or delta hedging. It means that when they take or when you take a position in an option,
This option will have already embedded in it a sensitivity to the stock. And you need to erase that through doing the opposite trade on the stock. So you are market neutral. But the cool thing with option is this sensitivity moves around as the stock goes up or down. So every day you have to adjust.
your stock positions to whatever the market neutral should be on the options. So when you are short on options, it's not great because you have to buy high and sell low. When you are long the option, have to buy low and sell high, which is better. But by doing that every day,
until the end of the day of the option, until the expiry, you calculate how much you made or lost through your market neutral hedging and the sum of that should at least be the price of the option if you sold it.
Howard Chan (34:33)
last time I asked you whether it's better to short volatility versus long volatility. And you said it was short volatility. in this case, does it matter? Because you mentioned that if you're short an option, you have to buy high, sell low, which is very counter to what any investor is taught.
Dominique Tersin (34:53)
Yeah, it's counter-intuitive, but in fact, well, you get first compensated by the premium. So ideally, the premium should be the same as your cost of edging every day. But sometimes there are crazy market movements where it's difficult to hedge, right? You have jump risk, for example, between one hour to the next.
an NFP, a non-farm payroll data points in the market. Or if you are on Friday and a news happens on the weekend, with a Monday, well, it's not easy to hedge. So you need to be compensated for that. That's why the volatility that is in the option market is usually higher than the realized volatility that you will see every day on your stock.
in general. And that's the volatility risk premia.
Howard Chan (35:53)
So go ahead.
So going back to my example with an insurance company, the insurance company is writing these insurance policies to get the premium that covers unimprobable events, but as well as a little margin for them to make some money. So that's why the premiums usually come out to be higher than the number of claims that they can get under the policy.
Dominique Tersin (36:20)
Yes, and usually it's same across assets. You have this premia, so it changes. The volatility premia for bond market will be different from equity. For the S&P, it will be different from single stock. You have to have a sense of it. But it's useful to know because
in a way, it's an add-on that you have on an option trade if you are short the option.
Howard Chan (36:53)
So, so Dom, let's walk through the mechanics of the trade, right? So in this scenario, I am writing a out of money call such that it has a 0.2 Delta, So what do you do to extract
this pure volatility premia and going through the process that you've mentioned.
Dominique Tersin (37:20)
So first, if you short the call, you expect the volatility at which you sold the call to be higher than what the realized will be. That's the trade.
Howard Chan (37:33)
And when you sell the call, you receive a premium from selling that call. just to be clear, so you get money for selling that call.
Dominique Tersin (37:40)
Exactly. so once you sold it, you are exposed to the stock, right? Because it has a sensitivity of 0.2. So you are short 0.2 of the stock. So to be neutral to the market, you need to buy 0.2 of the stock, right? So you have two positions in your book, short an option.
which brings you negative 0.2 of sensitivity to the stock and long 0.2 of the stock itself.
Howard Chan (38:13)
I write $100 worth of, let's say, Tesla calls, you're saying I have to buy $20 worth of Tesla stock to be market neutral.
Dominique Tersin (38:23)
Exactly.
Now let's say the market goes up. the sensitivity of your call, a call when the market goes up, its sensitivity increases. So it goes from 0.2 to say 0.5. Since you sold the call, you're short 0.5 on your call. But on your equity,
position you are only long 0.2. So you have to buy 0.3 to make the two neutral rates and you buy it at a higher price. That's not great, is it? so you will use that if it comes back to 0.2 the next day or next few days then you will have to sell your equity. The 0.3 that you bought before at a high price you'll have to sell it back
at a lower price, 0.3. Well, this is what you do every day until the end of the expiry of the option. And if you do that, you calculate the P/L that you have on your equity side. It will be an amount, maybe $4. And you compare that negative $4.
and you compare that to how much premium you receive from selling the call in the first place. It may be five, so you make money, it may be three, so you lost money. And in general,
the implied volatility that you received is higher than the realized volatility That's the volatility risk premia.
Howard Chan (40:17)
So the premium you get typically will be greater than all the buying and selling of the stock that you do to Delta hedge. And that's the purest form of volatility risk premia.
Dominique Tersin (40:28)
Yes.
Yes, that's realized volatility against the implied volatility that will be realized in your experiment.
Howard Chan (40:45)
So this, know, obviously not everybody can do this, right? Because you have to be in the markets every day. That's why maybe you delegate this to an investment manager, but there is a second trade or the second implementation is a little bit different. It's definitely not a pure volatility premia, but it's a volatility premia that is attached to say equity or single names or whatever. And that's just slightly different, but it's easier to manage.
Dominique Tersin (40:49)
Yeah. yeah.
Howard Chan (41:14)
You still benefit from it. And this is something that we do do in all of our strategies, especially we have strategies that have a single name cover calls, as well as a basket of technology names that we write cover calls. Why don't we go through that and maybe how is it different than the first version? And then what do you give up? What do you gain in the second implementation?
Dominique Tersin (41:44)
So first you will be long the equity, plus you will do the short call on top. So the equity will bring you a sensitivity of one to the stock and the point two that you sold from the short options, well in total it will be 0.8. You will receive a premium.
Howard Chan (42:05)
And just do
Sorry, and just to clarify, so this is a traditional strategy that's called a cover call strategy in which you own the underlying asset and then you write an out of the money call to get a premium.
Dominique Tersin (42:21)
Yeah, and you do get the volatility risk premium because you are selling an option. And in general, the realized is lower than the implied volatility at which you sold the option. By the way, it could be on covered call, but it could be on other strategy where you sell the options on. And then on top of that,
volatility premium that you get. Well, you do get also the time value of the option. So if the spot doesn't do anything, you get the full premium. But you also have the first risk that we talked about, the first trade, the pure volatility trade in a way. You do have it, but in between the time you traded it,
and the expiry. Because options are priced at the implied volatility, if increased the second after I sold it, then the call will be will be worth higher. So in a way, you do get it as well. And by timing the moment you sell the call or the put,
you do get this pure volatility movements as well.
Howard Chan (43:50)
So one of the interesting things about the second implementation is that volatility is mean reverting. As I mentioned last time, you're looking for spikes and then ultimately the decrease of the spike going mean reversion, right? But there's also some structural volatility behaviors that is very apparent.
And what I show here on screen is the implied volatility for two tech stocks. One is in Amazon and one is Netflix. And you can see over one year, there is a very visible spike over four times a year. And this is typically around the time of earnings. During times of earnings, uncertainty increases.
And as Dom has says, the implied volatility is calculated 30 days into the future. And as soon as the earnings is within that 30 day window, implied volatility increases. So some of these behavior in spikes of volatility is periodic and predictable. And maybe Dom, this goes even further.
when you were talking about why generally you prefer to be short volatility versus long volatility and how does this work in terms of the second implementation, which is a cover call that you can leverage to generate returns.
Dominique Tersin (45:26)
So we are looking at implied volatility on 30 day options. And you have the spike from the day that this 30 day period includes the earnings announcements.
And the thing with earnings announcement is you don't really know when exactly they happen. They can be delayed, right? So that's why the spike takes longer than usual. But you can take advantage of that because higher volatility means higher price of the options. So it means you have more caution.
against either a move of the stock or if you are a pure volatility realized against implied play you have more cushion from that. And by doing a covered call, when you do, you get both because you have the spike in pure volatility so you're selling at a higher
It's like as if the VIX had cyclicality every month or every three months, then you sell it at the high. And you do get also the volatility risk premium, which means realized is lower than implied.
Howard Chan (46:55)
And, just to be absolutely clear, you mentioned you want to be short volatility. so that generates positive return when volatility falls, right? So when you write your calls at these peaks, you get more premium. And then when volatility falls, that contract will,
Dominique Tersin (47:07)
Mm-hmm.
Howard Chan (47:17)
fall in price but because you're short volatility, that's actually a positive return in your portfolio.
Dominique Tersin (47:22)
Yes, I should add on that that
If you hold your option until the expiry, it doesn't matter how the volatility moves.
Okay, because at the end of the expiry, it's pure intrinsic value. There is no time value. It's just the price of the strike against the equity that's worth. Okay, it's if you want to sell it in between, that the new implied volatility will matter. But anyway, it's good to have the pure volatility play when the volatility is up
Howard Chan (47:56)
you can see why volatility may not be correlated or negatively correlated with other markets because it doesn't depend on a specific market going up. It just depends on a specific market going up and down. so that the increased volatility could be both upside surprise or downside surprise.
So you can see why volatility could be a additional diversifier in your portfolio
The important thing is the spikes in volatility that you are looking at. And as Dom correctly reminds me, the market does have a bias that volatilities tend to spike more when the market falls, especially current market where equity market is falls it acts as a negative, it's negatively correlated. You generate returns when equity market has negative returns.
So that could be something that you can explore and use in your portfolios to further generate returns over a long period of time.
That's it for this episode. appreciate your time listening to us. We definitely appreciate the comments that you guys have left. It helps us and guides us on the topics that we cover in future episode. Again,
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Recorded 4/1/2025.This material contains the opinions of the speakers, and such opinions are subject to change without notice. This content is not to be considered as personalized investment advice or a recommendation of any particular security, strategy or investment product.