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Latent Illiquidity: One Important Reason To Own Optionality

Photographer: Michael Nagle/Bloomberg

On Wednesday afternoon this week (the cash market was closed) I saw something that I have not seen in a while… at 3PM, when electronic futures opened (after the closure for the day of mourning for President George H.W. Bush), the S&P 500 futures market dropped almost 50 points. That was interesting and not totally out of the ordinary for 2018, but what was really spooky was that no one could seem to get any orders in to buy or sell.  There are many theories of why there was an oversupply of selling. One primary explanation could be that given the recent announcement of the market closure, many algorithms that are programmed to transact a certain amount every hour were not adjusted, so they flooded the market at the open to “catch-up”, and likely tripped various circuit breakers.

Orders, even in the E-mini futures contracts, were rejected for a few seconds (which seemed more like an eternity). Due to their presumed readily accessible liquidity, it is important to note that E-mini futures are typically the instrument of choice for delta hedgers of options on the S&P 500 index options and their related instruments in the ETF space.

I did a deep dive into the “Velocity Logic” algorithm of the CME and found that market participants should consider getting this particular circuit breaker on their radar screens.  The video shows how the market can shut down if not only a price band is breached, but also if more new orders come in that move the price beyond a certain point in a given amount of time.

Why does this concern me?  Some of you remember 1987 – the act of everyone trying to delta hedge under the “portfolio insurance” program which resulted in a meltdown. Today, the delta hedging algorithms are still there and might even be larger due to the “short volatility ecosystem” that I have written about in the Financial Analysts Journal with Larry Harris of USC (FAJ Paper).  Most everyone counts on being able to use delta hedging of E-minis to hedge their deltas, and most algos do this on autopilot.  Many of these strategies are now in mutual funds and even ETFs so the rules have to be followed by prospectus.

The potential problem is pretty clear, isn’t it? If everyone tries to do it all at the same time, the market can keep opening and shutting down and the price adjusts down (or “up”).  Not a pretty picture if no one is able to hedge and the “negative gamma”, or the rate of change of the delta of the options rises a lot (note that the delta itself is a function of the reference underlying price, so if the reference price moves the delta changes).  According to our own observations and also confirmed by brokers and banks, the liquidity of the E-mini futures contract is already tracking the lowest since the 2008 crisis.

This is probably not something to panic about yet because the most likely outcome is that the market will adjust itself for the lower liquidity, and leverage by smart participants will be limited by risk management discipline.  But just in case the estimates of liquidity needs by market participants are off by an order of magnitude, the argument for owning (or at least considering owning) explicit optionality resonates quite loudly.  If this happens (and I hope not), the XIV debacle of February will likely look like a walk in the park.  That was mostly retail, and we just don’t know what happens when all the “smart money” institutional investors  try to exit at the same time because they cannot hedge themselves.  I wonder how many people who count on being able to continuously delta hedge know about all the circuit breakers that can potentially bring trading to a screeching halt.

I am Founder and Chief Investment Officer of LongTail Alpha, LLC, an investment management firm that focuses exclusively on extracting value from the “tails”, or the end portions of distribution curves represented by bell-shaped lines in a graph. As a portfolio manager and t…


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