The Second Leg Down – Strategies for Profiting after a Market Sell–Off

HARI P. KRISHNAN, PD, is a fund manager at Cross-Border Capital, where he runs systematic macro and volatility strategies. Cross-Border is a London-based hedge fund with roughly US$300 million in assets. He previously managed a CTA for a London-based asset management boutique, and he was an executive director and co-head of alternative asset allocation at Morgan Stanley (Chicago and London). In addition, Dr. Krishnan has worked as an options trading strategist and as a senior economist at the Chicago Board of Trade. He received a PhD in applied math from Brown University, and he was a post-doctoral research scientist at the Columbia Earth Institute, Columbia University, before moving into finance.

Preface xi Acknowledgements xiii About the Author xv CHAPTER 1 Introduction 1 The Airplane Ticket Trade 1 The Bull Cycle 2 The Renegades 3 Claws of the Bear 3 Zugzwang 4 The Sceptics 5 A Sad Truth 5 Common Mistakes 6 Imprecise but Effective 7 Hedging Against Implausible Scenarios 8 A Black Swan in Correlation 8 Taking Profits 8 The Good, the Bad and the Ugly 9 The Great Escape 9 Having a Plan 10 Trend Following as a Defensive Strategy 11 Taking the Offensive 12 The Pre-Conditions for Market Crises 12 Banks: The Great Multiplier 13 A Change in Risk Regime 13 CHAPTER 2 Safe Havens and the Second Leg Down 14 The Matterhorn 15 Mrs. Watanabe s No. 1 Investment Club 18 The Risk of What Others are Holding 19 The Risk of What Others are Likely to Do 22 Here We Go Again 24 Summary 28 CHAPTER 3 An Overview of Options Strategies 29 The Building Blocks: Calls and Puts 29 Why Buy a Call or Put? 34 The Black Scholes Equation and Implied Volatility 36 The Implied Volatility Skew 38 Hedging Small Moves 38 Delta Hedging: The Idealised Case 39 Practical Limits of Delta Hedging 41 Hedging Options with Other Options 43 Put and Call Spreads 43 Straddles and Strangles 44 The Deformable Sheet 46 Skew Dynamics for Risky Assets 48 The 1x2 Ratio Spread and Its Relatives 50 The Batman Trade 53 Implied Correlation and the Equity Index Skew 56 From Ratios to Butterflies 59 Calendar Spreads 65 Summary 67 CHAPTER 4 Hedging the Wings 68 Taking the Other Side of the 1x2 68 Comparing the 25 and 10 Delta Puts 69 Hedging Sovereign Bond Risk 78 Selling Put Ratio Spreads on the S&P 500 83 The Hypothetical Implied Distribution 83 Our Findings So Far 84 Back-Tests: A Cautionary Note 84 A Short Digression: Delta-Neutral or Comfortably Balanced? 87 The 665 Put 87 Implications of the Square Root Strategy 88 Futures vs Spot 89 A Dramatic Example 89 A Cross-Sectional Study 91 The New VIX: Model-Independent, Though Not Particularly Intuitive 94 The Spot VIX: Oasis or Mirage? 94 Migrating to VIX Options 98 Reflections on Figure 4.36 101 Migrating to Different Markets: The V2X 103 Risk-Regime Analysis 104 Conditional Performance of Hedging Strategies 106 Summary 109 CHAPTER 5 The Long and the Short of It 110 Short-Dated Options 110 The Physicists Weigh In 112 Buying Time 117 Long-Dated Options 119 Far from the Madding Crowd 121 R Minus D 122 The Lumberjack Plot 125 Selective Application of the Weekly Options Strategy 126 Summary 127 CHAPTER 6 Trend Following as a Portfolio Protection Strategy 128 What is Trend Following? 128 Trend Following Dogma 130 The Crisis Alpha Debate 131 An Aside: Diversifying Across Time 134 Taking Advantage of a Correction 135 The Niederhoffer Argument 135 Chasing 1-Day Moves 138 Pushing the Analogy Too Far 139 Analysing the Data Directly 141 LEGO Trend Following 142 Summary 143 CHAPTER 7 Strategies for Taking Advantage of a Market Drop 144 The Elastic Band 144 Trading Reversals 147 More Texas-Style Hedging 149 Selling Index Put Spreads 151 Breathing Some Life into the Equity Risk Premium 152 Buying VIX Puts 153 Selling VIX Upside 154 The Remarkable Second Moment 155 Summary 158 CHAPTER 8 Flash Crashes , Crises and the Limits of Prediction 159 Lord of the Fireflies 159 Cascading Sales 160 A Concrete Example 162 An Aside 162 Paths, Prints 163 The Role of the Central Bank 164 Credit Cycles at the Zero Bound 164 The Monetary Policy Palette 165 Reading the Tea Leaves 168 Summary and Conclusion 169 GLOSSARY 171 REFERENCES 173 INDEX 177