Record Dispersion Explained: Options Mechanics — Full Breakdown & Transcript

[00:00] This really has been the story of the summer, though, right? Large moves under the surface. The indexes are pinned here. You know, from your view, thinking about the risk map moving forward, does it start to worry you if we're looking at a period where volatility could be rising around the corner

[00:15] that maybe all these little bets that you think are moving idiosyncratically asynchronously, well, they actually could start to move asynchronously, rather, which would become the problem. How do you adjust your time horizon around this particular information?

[00:28] Yeah, I mean, I think it remains important to, I don't know, just keep your hedges in place. As you said, put hedges are very cheap, especially right now. And, you know, as I've harped on a number of times over the last few weeks,

[00:41] and in much less eloquent terms than Jim, it does feel like we are in this holding pattern. I'd be interested to hear your input as well, Jim, but I've been saying this just feels exactly like October of last year to March of this year.

[00:53] We test the same level over and over. It was 7,000 in that window. It's 7,600 this time. but we just don't seem to have enough momentum to really break through the surface. As it pertains to your question specifically, Chris, if we are expecting ball expansion in the coming weeks, I do think that that would worry me,

[01:09] maybe not even due to the asynchronous nature of things, but we are in, I mean, today is sort of a perfect example of what happens if we're in the perfect environment where a ball is completely compressed or it feels like we're ripping higher and higher.

[01:23] And I must say, I feel very strongly that we come right back down tomorrow. The momentum just doesn seem to be there doesn seem to be sustained enough for us to put in additional legs to the upside We seeing the capital rotation happen now The macro environment continues to weaken or trust continues to deteriorate in the news in this administration

[01:39] I do think that that paints something of a scary picture. It's something that everybody should certainly be prepared for. There's obviously no such thing as infinite growth, but in this administration, It's tough to feel like we can have even continuous growth for more than a, you know,

[01:54] two-month insane rally to the new level before we stagnate or to hold these. Chris, I want to add something here. So the dispersion you're talking about is a feature. It's not a bug.

[02:06] When you have index law compression, the index itself is pinned, and you have plenty of implied volatility, you know, structured products are just selling volatile dealers. that compression of the index level, by definition,

[02:20] and most people don't understand this, it's very important, it forces, because there's idiosyncratic risk, right? Some new news comes out, talent tears up. If the index can't move, let's just say we lock the index

[02:33] because of index law compression. By definition, that means something else has to go down. And so what you've seen, if you go look through 2017 and you look at 100 years of history, correlation is in a very tight gap.

[02:45] But starting in 2017, you see correlation break out to record and just keep going. At first people are like, oh, this is a one-time thing. This summer for example is the highest dispersion we ever ever seen in 125 years of history Right yeah That is not a coincidence People try and have a fundamental perspective They always start with fundamentals So they say oh it because all these crazy macro changes are happening

[03:10] and that's driving different outcomes for different stuff. No. That's not the reason. The reason is because compression is happening at the index level, and that force is actually higher realizable at the single-list constituent level.

[03:25] by definition, by arbitrage constraints, if I hold the index in place, you're going to have higher correlation. You're going to have higher volatility, the constituents.

[03:39] This is counterintuitive for most. Most are like, well, the ball's compressed. Look at what's happening. This is crazy. It's not crazy. It's actually because the ball is compressed. And to such an extent, we worked in May.

[03:55] vocally, aggressively talking about how expect the biggest dispersion ever this summer because of the law of compression before it happened. And not just that, we said expect the crazy move in momentum to turn,

[04:11] and that to be the primary entity that gets hurt in this flotation or urgency this summer. People are like, how did you call that? It's not because of macro. It's not because of anything really changed at the momentum, at the memory level or whatever.

[04:25] people will put a narrative on it but it because all the call positioning in that momentum area had record call positioning record implied vols It had just run 50 The bar at which that would have to keep running in order to make those calls

[04:44] you know, work for those customers, was not likely to be there. And guess what? All the dealers are short those calls and long stock or things that look like stock against it. And as the index compresses, right, and it has the opposite positioning, short put, long call for dealers at the index level, that part started to get selling pressure.

[05:09] We know this is also the driving force because as you went into June OPEX, as you went into July OPEX, you start to see the greatest weakness in those areas, right, and the greatest relative ball pinning at the index level.

[05:24] So you, you know, we were able to really map out what was the likely probability of these outcomes, just as a function of the summer flows and the positioning in the market. And now these things can reflexively start to have bigger effects, right?

[05:37] Because what happens if momentum keeps going, right? Then it can, as well, becomes uncompressed with the index. Now it can cause greater stress and greater issues. But my point here is the dispersion that you're talking about,

[05:51] the kind of scratching of head, why are these things moving in such a crazy way while the index doesn't move, are actually a feature of the whole ball compression.