The first factor driving high returns is sometimes called by practitioners “going short on volatility.” Sometimes it is called “negative skewness.” In plain English, this means that some investors opt for a strategy of betting against big, unexpected moves in market prices. Most of the time investors will do well by this strategy, since big, unexpected moves are outliers by definition. Traders will earn above-average returns in good times. In bad times they won’t suffer fully when catastrophic returns come in, as sooner or later is bound to happen, because the downside of these bets is partly socialized onto the Treasury, the Federal Reserve and, of course, the taxpayers and the unemployed.
America’s mortgages are structured so that the lender-investor is going short on volatility. If interest rates do not move much, the lender does well. If home prices do not move much, the lender does well. But if interest rates rise, the lender is stuck with a below-market asset. And if home prices fall, the lender gets stuck with a house with a value below the amount of the loan.
Tyler is saying that for the typical financial market player, going short on volatility is a great personal strategy. When it works, you get a nice salary and bonus. When it fails, someone else–a shareholder, a taxpayer–bears much of the cost.
If you know your Nassim Taleb, you will recognize going short volatility as “fragile,” with the opposite strategy as “anti-fragile.”
I wonder if stock market investment is one of those fragile strategies nowadays. You can make money year after year going long the market–until it stops.
Anyway, Tyler argues that the changes in the income distribution of recent decades
a) have been focused at the top 1 percent, not between the 99th percentile and the lowest percentile
b) been driven by finance
c) and within finance have been driven by these short-volatility, fragile strategies.
He is pessimistic about regulators’ ability to stop the short-volatility strategies. I think he is wise in that regard.
“pessimistic about regulators’ ability to stop the short-volatility strategies”
After 5 seconds I thought “I wonder if you could give some tax preference to profits from shorting.” It is not that I think that’s a great idea, it is have the regulators ever produced an idea?
(I don’t think it’s an ability thing)
Shorting vol doesn’t necessarily involve shorting an particular assets. For example you can buy a high yield bond. In general it’s non-trivial to identify short vol positions ex ante.
+1 for this post
Good post. More precisely, the strategy that you (we) all are decrying is going short, out-of-the-money puts. Going short volatility by selling at the money straddles (short both puts and calls) exposes the seller to frequent days of reckoning (in other words you are not simply rolling over small profits until it blows up). Going short volatility by selling out of the money calls is more like what you are decrying, but is not done as much because no one wants to sell insurance against the “progressive arc of market prices”. Of course, to be really “juicy”, these strategies can’t be delta-hedged, so the seller is selling short realized (not implied) volatility. If you delta-hedge any one of these strategies, like responsible risk managers who sell insurance do, then your risk is mostly to changes in implied volatility.– much less likely to be abused to game career comp.
I’m moderately smart but need a glossary for this reply.
Taleb I can understand.
Maybe I just need to ponder. It’s always hard to tell about this stuff–“Am I really dumbest person in the room, or no one else will say they don’t get it.”
Don’t worry, you’re not missing much.
I think it’s broader than that. The more regulation, the more regulatory arbitrage. Big connected firms actually do *better* when there is a lot of regulation because the competition (small firms) get wiped out. The small ones cannot pay for all the regulation compliance costs or lobbying. So this particular strategy is an example.
Also, I don’t know what to make of antifragile. Taleb’s strategies empirically are money losers. Mark Broadie of Columbia gave a nice talk (youtube) explaining that options are in fact correctly priced and antifragile strategies would just bankrupt you. (My words not his)