The Anatomy of a Short Vol Trade | Exploiting Geopolitical Shocks

Given markets are prone to different regimes, which often last long enough to put proponents of methods antithetical to the environment out of business — or in a psychiatric ward — it is then necessary to have a number of different approaches or frameworks to remain adaptable enough to exploit variant regimes.

What is ‘Short Vol’:
Short vol is a strategy wherein a derivatives trader sells short a put and a call option at typically equidistant strikes out-of-the-money, with the same expiries. This contract works like an insurance contract, hedging the counterparty for moves in the underlying instrument beyond the strikes (plus the premium received), up until the expiry of the options. Once a trade of this strategy is undertaken, the options seller has a short gamma profile, whilst being positively exposed to theta – the rate of decline in the price of an option through time. As time goes by, the probability a given option will move into the money decreases, and so the theoretical liability of the seller decreases accordingly.

My Experience Adapting:
Having come from a background in a long vol fund, malleability has been essential for me to revise my beliefs around shorting vol. Principally, being a reader of Taleb, I am still rather reluctant to having permanent tail-risk and so, I look to hedge such outcomes when structuring a trade to limit worst-case drawdowns to something pre-defined. Additionally, I am reluctant to enter the short vol side without having a view on future implied volatilities. To satisfy these preferences, shorting vol after a meaningful expansion in implied vols is when I feel most comfortable… Perhaps because of that elevated premium!

In 2017, this worked favourably in a couple of instances, both were geopolitical in nature, where political catalysts caused outsized realised vol due to markets overreacting — and implied followed accordingly.

The Anatomy of Geopolitical (Over)Reactions – A Behavioural Model:
Distinguishing between genuine geopolitical events where there is a digital repricing and those which are simply a liquidation or de-risking event — with a later re-risking — is no hard science. In either case though, realised vols have already expanded and implieds naturally chase in response. Thus, selling a strangle is of worthy consideration, especially in the liquid foreign exchange markets where double digit moves only tend to occur when somebody abandons a fixed currency regime (cough… SNB).

Polemic Paine (@polemicpaine) one of finance twitter’s resident gentlemen and one of its more generous contributors, pointed out a brilliant model in his post Markets. Where Physics Meets Psychology which fairly accurately depicts the mental model one must apply for such events. It is called the damped harmonic oscillation. With time, the amplitude of the oscillation decreases, just like the pitch of investor sentiment as market participants calibrate to the shock.

IMAGE 1: The Damped Harmonic Oscillation

Evidently, it seems in the examples I shall outline below, this framework held true. Behaviourally speaking, this is because the shock value decreases with each newer instalment of the same story — much like how “Grexit” was seemingly of much greater dramatic magnitude after the first Greek default, than the later n reincarnations of the same disaster.

Additionally, there’s a mechanistic reason for this process too, in that, after all the leveraged weak hands are washed out, all the positioning left is in it for the long haul. Accordingly, these less fragile participants, with longer temporal horizons inadvertently reduce the probability of high realised volatility from stop runs and news events.

Case Study 1: MXN on Trump’s Election

As a function of Trump’s rhetoric regarding the border wall, the potential renegotiation of NAFTA and other fairly protectionist views within the Donald’s policy platform; the Mexican Peso traded like a real-time referendum of speculators expectations of the election. Polling was shown to be rather inaccurate, perhaps because of the social stigma associated with admitting to being a Trump voter. This was further compounded by betting markets which had priced in a Clinton win, in a curious one-mimics-other information feedback loop. Thus, the November 8th election of Trump corresponded to an almost eleven sigma rate of change for a singular daily observation in the Mexican peso, as evidenced below.

CHART 1: USDMXN Daily Rate of Change with linear regression std dev +4 (red) +2 (red), -2 (green), -4 (green).

Further, the 30 day realised volatility of the currency leapt to a near 3 sigma deviation to historical vols.

CHART 2: USDMXN (white bars) vs USDMXN 30d realised volatility (blue) with linear regression std dev (+3, -1)

Interestingly, whilst the move was so digital in nature, implieds remained elevated whilst realised volatility managed to fall to below it’s 5 year mean (the green line above), bottoming near 11 before the end of 2016.

Suppose one had waded into the chaos and sold a 1m strangle to exploit the elevated risk premium attributed to the Mexican peso because of Trump’s election, it’d have been a rather nice period of positive theta to see out the end of the calendar year… Whilst some less than experienced commentators panic sold all of their equity holdings!

Whilst I didn’t have the vision to partake in the normalisation of the Peso after the Trump-shock, it did reinforce my earlier experience from 2016’s other major supposed political shock…

Case Study 2: GBP on Brexit

On the 23rd of June 2016 the people of Britain voted against remaining in the European Union. Meanwhile, polling — as it did later in the Trump polling debacle — suggested the Remain camp had it. Presumably, the bookies were watching this polling and thus they were completely discounting the outcome of Brexit. While the market was watching these two derivatives, instead of options pricing to gauge the likely outcome… Arguably, a less reliable process than having a pint at a pub with the locals anywhere outside of west London!

This all amounted to a rather significant political ‘shock’ with a 14 sigma daily rate of change in the cable (below) and an 11 sigma move in EURGBP.

CHART 3:  GBPUSD Daily Rate of Change with linear regression

Whilst I didn’t take action on the short vol side after Brexit, I did attempt to buy an early dip and was stopped out. Arguably, I was applying the wrong framework. I did think Brexit was a coin toss of a chance, but had misunderstood the asymmetry it represented – a worthy topic for a later essay. As we can see below, it wouldn’t have been an unreasonable approach to short vol once the July low was in place, as it was over a quarter of sideways action before the eventual re-test and break of the low.

CHART 4: GBPUSD (white bars) vs GBPUSD 30d realised volatility (blue)

Presumably, these observations are what later encouraged the framework to ‘click’ as I later wrote in my February 2017 piece The Common Law Premium – Buying the Pound Sterling:

These implied volatility levels are invariably elevated as a function of the grey swan-like impact of Brexit. Arguably, they price a measure of recency bias given the likelihood of another ~14 sigma daily move is low, which fits with my unpretentious observation that markets ascribe a greater risk premium to political uncertainty than to its antithesis.

This view justifies the perspective that both implied volatility and realised volatility will revert toward the mean as markets re-calibrate to a more certain political reality, in a market where the weak hands have been shaken out due to such high realised volatility.

Simply put, less fragile positions reduce the probability of high realised volatility. However, this is not to suggest exposure to unlimited loss structures is ever prudent. Instead, loss-limited structures, such as short put spreads; enable the ability to collect this elevated risk premium with a pre-defined and limited loss. Similarly, for those who trade esoteric structures, selling one-touch puts provides a similar return profile to put spreads as they are loss-limited, non-recourse structures.

In the piece, I was referring to GBPUSD 1m implied volatility still being in the 89th percentile of its historical distribution.

CHART 5: GBPUSD 1m Implied Vol as at February 2nd 2017

At various times this year I exploited this elevated premium, originally short puts and on a couple of occasions later, short strangles. Nevertheless, specifics aside, this gave me the experience to quickly identify another opportunity later in the year.

Case Study 3: EWZ on the Temer Revelations

On the 18th of May 2017, EWZ gapped down nearly 20% on news of recordings of Brasil’s President Michel Temer supposedly making bribes. Presumably, the angry crowds on the street and congress members demanding his impeachment contributed to a slightly over 8 sigma move in the rate of change of the EWZ index.

CHART 6: EWZ Rate of Change with linear regression

To the best of my recollection, having mulled on it over the weekend, I thought there was some counter-intuitive logic that, even if Brasil impeached its second President in a row, after Dilma Rouseff, it signaled an unwavering dedication to enforcing the rule of law and upholding the people’s will… A bullish sign!

As a result, I shorted some June and July expiry structures which contributed a collective 420bps to the portfolio over that period.

Short Vol Alert Model:

Going forward, I have developed a couple of models in TradingView which will alert statistical outlier moves in realised vol in particular markets to encourage one to assess whether they fit the framework… Indeed, deciding whether to follow a signal and the appropriate method of expression requires a lot of consideration. Nevertheless, these alerts going forward will presumably allow one to hopefully exploit the dynamic outlined herein and share these trades with the Prometheus Macro Premo Social members.

CHART 7: Statistical Short Vol Model 1

CHART 8: Statistical Short Vol Model 2


Whilst it’s difficult to know for certain if this approach is superior to continually selling vol, it strikes me as shifting the already attractive win/loss ratio of short vol a touch into one’s favour for the reasons outlined above… Further, it seemingly would reduce the probability of a black swan type event marking implied vols against you in a manner which is terminal for one’s portfolio. Meanwhile — extending the biological analogy further — it largely removes the eventual malignancy of exposure to unlimited loss from constantly shorting vol in an infinite time series.

With that said, I welcome any feedback from you all via the AMA or the comments section below.


Carl Hodson-Thomas

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Podcast | “Do What Works” | Prometheus in Discussion With Anthony Crudele

“That’s the fundamental algorithm of life, repeat what works!” – Charlie Munger

Dear readers,

A fortnight ago Anthony Crudele of the Futures Radio show was kind enough to invite me on to discuss my ideas about macro. In the podcast I try to introduce a few of the ideas which I discuss in my upcoming book Reflexive Macro: A Behavioural Approach to Global Macro Trading.

The audio is a little fuzzy from time to time, apologies, it’s likely due to the dodgy Australian internet. If I can find the time, or source somebody on Upwork to tap out the transcript, I shall post it here on the blog.

Topics include:

  1. Doxastic Openness — referring to one’s ability to revise their beliefs based upon new evidence;
  2. Evolutionary Decision Theory — on being less Lexicographic in decision making and building a comprehensive argument for action.
  3. Seeking reliable trading epistemologies — doing what works;
  4. Reflexive reasoning — how some technicals can be self-reinforcing;
  5. Position sizing — the philosophical schools of probability.

Please enjoy the podcast embedded below and feel free to hit me up in the AMA section if you have any questions or feedback.



P.S. Apologies for the close up of my head below!

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Trade Idea | A Compelling Contingent Trade

Elevator pitch: What if I told you there was a trade that would hedge your whole book to a Chinese correction AND had the idiosyncratic risks that suggests it probably may just make 7x anyway… Would that be something you’re interested in!?! 

Introduction: Forgive me for doing the Hugh Hendry to kick off, but I get a buzz out of this idea. The following piece is on FMG AU, the Western Australian miner who’s HQ I live adjacent to in Perth, Western Australia. Previously, I wrote a post on FMG here in 2012, I had been bearish iron ore for a while and the strategy worked out well. If the success of that early trade is anything to go by, then this could be a cracker. Forgive the mediocre quality of analysis, at the time I was very green and still working out my process.
I am an extremely average salesperson, but I think my grasp of logic and reason make up for it… So now that I’ve given you the sales pitch, let me indulge you with the analysis!

Hypothesis: Due to the comprehensively low volatility environment we find ourselves in, idiosyncratic opportunities are significantly mispriced. To invert the old adage, the receding tide runs all boats aground!

First Principle: Our first principle, or presupposition if you will, is that iron ore is the first derivative of China’s economy. Thus, following this logic, the companies most levered to iron ore will be the best expressions of the thesis. So the logic goes like this… If China’s economy rolls over, then iron ore will fall and FMG AU will be impacted most adversely.

Fundamental Macro Context: Presently, market participants and geopolitical analysts are parsing the words of President Xi’s speech at the 19th National Congress of the Communist Party of China, looking for hints of what the future holds for China. Some seem to think that now Xi is so well entrenched that he may be confident enough to take the risk to delever the economy. I am completely agnostic, as I have no predicitive function in that analysis. In fact I am ambivalent to the growth prospects of China.

What do concern me are the probabilities, and in the following analytical framework I hope to lay out the reasons for my conclusions as to what the risk reward proposition is, the probabilities and why this is a positive expected value trade.

Fundamental Equity Context: It’s simple, FMG is the most financially and operationally levered stock to the iron ore price. Principally, because the quality of their ore is not 62%Fe and thus, they likely have to pay penalties over and above.

As you can see in the below chart, FMG is the most financially levered to an iron ore price drop with a cost of production of USD ~ $57/t, whilst they are also the most operationally levered with a cumulative seaborne iron ore production somewhere close to 1300mt.

CHART 1: Iron Ore Miners Cost of Production & Cumulative Production

Commodity Context: Iron ore is still within the grips of a long term bear market, one which I was able to correctly anticipate back in 2010. Relief since the late 2105 bottom has been a function of Chinese stimulus, which seemed to directly flow into commodity prices by way of construction and thus steel production. Indeed, it’s only reasonable to expect the causality to flow the other way.

CHART 2: Iron Ore Weekly Price Chart

Equity Context: Since that bottom, FMG has meaningfully outpaced iron ore, as a function of its leverage.

CHART 3: FMG (blue) vs Iron Ore (orange) Normalised as at Jan 2016

Intermarket Analysis: Similarly, FMG has also outpaced its Australian peers with much lower cost profiles RIO & BHP. Both have only managed to outperform the commodity marginally.

CHART 4: FMG (blue), Iron Ore (orange), RIO (light orange), BHP (yellow) Normalised as at Jan 2016

Technical Analysis: FMG is forming a top-like pattern with $4.50 looming as the support. Classical pattern traders might call it a head and shoulders with a sloping neckline, but typically, what is the most obvious is best. Presumably, the reasoning for such a level being meaningful is that new longs will likely look to cover as new lows set in and a new trend takes force. Whilst technicals would logically seem to have unreliable claims upon reason, the other reliable method of understanding reality — experience — suggests otherwise. Thus, I hypothesise that objective and intersubjective technical methods work because humans are prone to patternicity and other type 2 errors, and so they become self-fulfilling. With respect to the below chart, support is indicated by the red horizontal range, if breached, the propensity for sustained selling is likely.

CHART 5: FMG Technical Support

Historical Mean: Further, as we look back at a monthly price chart, we can see that $4.50 is roughly the mean of the volume at price historical distribution on the left axis.

CHART 6: FMG Monthly

Bimodal Distribution: Zooming in once more to the fortnightly price chart, we can see the bimodal nature of historical prices on the left axis, which should arguably suggest that FMG is unlikely to have normally distributed price action in the future. Thus, an option seller using a model which prices options off a normal probability distribution will more than likely be misled, if the future looks anything like the past.

CHART 7: FMG Fortnightly

Implied Volatility: Which leads us to FMG’s implied volatility. Yesterday, when I clipped this chart, FMG’s implied vol was in the 6th percentile over 10 years at 30.46. Albeit, that percentile data might be slightly skewed given the single low data point in 2009 of 13.92 is wrong. Further, over the last 5 years, FMG’s implied vol is in the 3rd percentile of observations.

CHART 8: A Decade of Implied Volatility Data

Realised Volatility: Arguably, this is anomalous, and doesn’t comport with the facts presented here. But why has it happened? This opportunity exists for two different kinds of reflexive reasons: behavioural and mechanistic. Behaviourally, implied volatility tends to follow realised due to recency bias, which is the tendency to overweight recent data. Mechnistically, implied volatility tends to follow realised volatility, this is because options buyers delta hedge according to daily or weekly moves and are unwilling to buy and bid up implieds if there’s no volatility to realise. Together, they can form a self-reinforcing virtuous cycle that otherwise is referred to as reflexivity. With this in mind, it is unsurprising then, that FMG’s realised vol is particularly low, around 1 standard deviation below the mean of historical vols.

CHART 9: Realised Volatility:

Key: -1σ (green line), mean (green dotted line), 1σ 2σ 3σ (red dashed line)

Implied vs Realised: Looking at the last 40 months of data in interactive brokers, we can see that at 29.6% implied is presently significantly below the 200 day realised vol of 41.3%… Which had been as high as 67.8% in May 2016!

CHART 10: Implied (white), 30d Realised (orange), 200d Realised (purple)

Skew:  Volatility skew shows the difference between implied volatilities of options against their moneyness – how in or out of the money they are.

It can suggest a few things:

  1. Volatility Smile – shows that out-of-the-money volatility is higher than in-the-money volatility.
  2. Volatility Skew – shows that puts are cheaper than calls or vice-versa, and thus, suggests where the options market is hedging directionally.

For the December skew below, we can see that calls are priced relatively cheap vis a vis puts, which may allude to the options market’s estimate of directional risk.

CHART 11: December Skew

Volatility Timing  Model:

I made a volatility timing model to signal alerts when certain conditions are met and it is a favourable environment to get long vol. It is difficult to test its empirical reliability due to lack of options data, because I don’t yet know how to layer it onto bloomberg data… Nevertheless, it’s was what alerted me to this trade recently, so its job is done!

CHART 12: Long Vol Statistical Timing Model

Expressions: There are various ways to express this trade, here are some…

  1. Short the stock outright and keep an eye on iron ore as one’s guide.
    Sizing: I wouldn’t size much more than 250bps of one’s book.
    Stop: $5.49.
    Target: $1.50.
    Risk/Reward: ~5x.
  2. Buy 3m FMG strangle @ 105% & 95% moneyness and roll quarterly.
    Delta hedging: it’s path dependent, so hedge accordingly.
    Backtest: With a 50% win/loss ratio and a positive equity curve (without hedging), it’s arguably safe to assume that entering at these vols will suggest a higher probability of gains

  3. Buy June expiry $4 puts for $0.27
    Originally, I priced this up as a $4/$2 put spread, but cheapening it with the put leg at 2c is almost pointless… I’d rather buy it for 2c! The r/r of the put spread was up to 7x, to give some idea.

    Return Profile:

  4. Buy 9m OTM $2 puts
    Theoretically, they cost 2c!?!

And that’s my two cents!

If you made it this far, thank you for reading.

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Disclaimer: Please read the disclaimer on this site.

The Common Law Premium | Buying the Pound Sterling

Dear readers, below is a piece that went out to members and friends of Prometheus Macro Research on the 12th of February. We hope you find it informative. Note that although the trade’s horizon is multi-year, we take into account some shorter-term considerations such as positioning and sentiment, for the purposes of developing a compelling argument for action, as well as to attempt to gain an additional edge from timing.

Universally, markets tend to ascribe a greater risk premium to political uncertainty than they will to its antithesis. So, perhaps there is a subtle irony that I would develop a compelling argument for action on the long side, coincident to the announcement that the British Parliament has authorised Prime Minister May to begin the process of invoking Article 50 of the Lisbon Treaty. A consequence of the vote to leave the European Union succeeding in the referendum on the 23rd of June 2016. A vote which left the freshly minted portmanteau ‘Brexit’, indelibly imprinted upon the popular lexicon.


I’ve written before about the implications of ideology in speculative and investment decision making in Biases in Trading, where I made the case that through an evolutionary tendency toward emotional reasoning and various other fallacies and biases, people are predisposed to mistakes when making trading decisions according to their underlying political ideology. Indeed, perhaps this is why I didn’t fully exploit the fall in the Sterling whilst I was confident the ‘leave’ vote would prevail. A lesson which reminds me to focus on expected value and the potential asymmetries of political outcomes.

Politically, I leant toward Brexit, yet I didn’t appreciate that the outcome of its triumph would be so significant in the Pound over the short-term. Nevertheless, with new information and the iconoclastic tendency to question ideas that to others might be sacrosanct; I am inclined to face the other way. As the politics of Britain leaving the European Union has unravelled, it has appeared to me the emotional fervour has been distinctly in the Remain camp. Thus, I contend it is rational to diverge from the crowd amidst this cynical frenzy, and instead embrace an opportunity.


Let us consider, that to the many people around the world living in countries with a less well-entrenched rule of law – if at all – that presently the Pound represents an opportunity to buy a share in the common-law system at a steep discount. The assurance of the common law system, as well as the land rights and other liberties which come with it, is a significant factor in the robustness of the world’s most successful commercial economies. Similarly, as opposed to its counterparts in customary and religious law, common law underpins the geopolitical position of the countries who employ it, by attracting capital.


It is no surprise then, that the 16% drop in the ‘cable’ since ‘Brexit’, puts the currency in value territory against the dollar on a Purchasing Power Parity (PPP) basis; as evidenced in the chart below provided by one of our members at The Macro Trader.

CHART 1: GBPUSD PPP Valuation with 20% Bands


Given our behavioural, statistical and technical reasoning, then temporally speaking the British Pound is likely to be near a multi-year cyclical bottom.


The British Pound trade-weighted index is approximately in the 3rd percentile of observations over the past 17 years as evidenced below.


Whilst, the BOE Calculated Effective Exchange Rates UK Broad Index is presently in approximately the 4th percentile of observations since 1990.


Given these compelling statistical inferences, one must then consider the relative fundamental and technical characteristics of the Pound against various currencies.


Technically speaking, the pound looks attractive on numerous fronts. The classicists are focusing on what many regard as a potential “double-bottom” pattern, indicated in red below, although a channel may be the more likely interpretation.

CHART 4: GBPUSD Daily with 200MA in Blue

Further, on the weekly chart the cable is resting and potentially bouncing-off long-term trend support. From an elementary statistical standpoint, it is not unreasonable to anticipate a move toward the mean of the histogram on the left axis, which is why statistical extremes with support, such as these, are appealing. Particularly, considering it is currently within the 2nd percentile of observations since 1993.

CHART 5: GBP Weekly

Of course, currencies are priced relatively, thus other crosses need to be considered beyond simply the technical attractiveness vis-a-vis the dollar.


Similarly, on a daily basis, the euro-sterling appears to be a more compelling short, with a confluence of technical events occurring. Firstly, a seven-month head and shoulders pattern has the classical traders talking about a move which they measure down to the 74 handle. Further, the neckline of this chart happens to converge with both the 200-day moving average and an uptrend line that has held on the pair since it bottomed in late 2015.

CHART 6: EURGBP Daily with 200MA in Blue

Turning to the weekly, the cross doesn’t yield too much in terms of a constructive technical insight. Although, fundamentally speaking the euro seems like an ideal candidate to express this trade as the political uncertainty baton has now been passed from the United Kingdom to the European Union, whose fragility is far greater without the Brits as a member state. Indeed, this is heightened by the risks posed by the various European elections this year.



The short term chart appears to have potentially bottomed and reversed trend, given the price looks to have almost cleared the 200 day moving average. Albeit, there is little else technically compelling about the cross in the short-term charts.

CHART 8: GBPJPY Daily with 200MA in Blue

However, one constructive observation is the long term support against the Yen which has held since the mid-nineties. Perhaps one’s view of whether Abenomics will devalue the Yen would be the dominant factor in deciding the Sterling-Yen cross is the best expression.


Indeed, further consideration must be given to the regime of a given market and whether it fits with one’s strategy. In the case of sterling-yen, it is traditionally a great cross to trend follow as evidenced overleaf.

Our weekly trend-following model recently signalled a buy on the cross. As mentioned, historically this strategy works favourably, going back to the beginning of our data in mid-1975. Certainly, it is a somewhat cherry-picked, lowbrow observation and whilst it is important to avoid over-fitting to the past, one must also consider the particular characteristics of a given market.

CHART 10: GBPJPY Weekly Trend Following Model

Whilst we don’t follow this systematically, it does provide meaningful insight into the probabilities of the approach one might take on the sterling-yen cross.

CHART 11: GBPJPY Weekly Trend Following Model Performance Summary



Positioning data for spot foreign exchange transactions is not available (hopefully one day), however we can look at the futures non-commercial positioning in the Sterling as a proxy. Notably, it is presently at relatively extreme levels vis-a-vis history.­­ In fact, the levels are nearing the extremes set in 2013 when speculators and hedge funds were almost unanimously bearish, and wrong.

CHART 12: GBPUSD Weekly & COT Net Non-Commercials Speculative Positioning

As a behaviourist, one must consider that positioning is a real-time referenda on financial speculators’ sentiment, which evidenced by short positioning reaching the same extreme levels as 2013, is extremely bearish. Hence, we are inclined to take the other side.

CHART 13: GBPUSD Weekly & COT Non-Commercial Shorts Positioning

­One of our members brought to our attention that these numbers must be adjusted for Open Interest, which he has done and ranked by percentiles on his site Presently, hedge fund positioning is in the 17th percentile, having recently increased from the lowest decile.

CHART 14: GBPUSD & COT Positioning Adjusted for Open Interest


The GBPUSD volatility surface indicates market makers are more willing to write calls than puts presently. Rephrased and inverted, that means there is more demand to hedge via puts than calls. Suggesting that the market’s intersubjective probability assessment – or collective agreement of the Sterling’s future pricing – is fairly bearish. Consistent with our inferences from positioning data regarding the market’s sentiment.

CHART 15:  GBPUSD Volatility Surface

Further, this skew indicates selling downside structures to the hedgers may be of interest, so we shall turn our attention to implied volatility overleaf.


GBPUSD one month implied volatility is presently quoted in approximately the 89th percentile of the last 5 years’ data, as evidenced by the chart below.


CHART 16:  GBPUSD Implied Volatility

These implied volatility levels are invariably elevated as a function of the grey swan-like impact of Brexit. Arguably, they price a measure of recency bias given the likelihood of another ~14 sigma daily move is low, which fits with my unpretentious observation that markets ascribe a greater risk premium to political uncertainty than to its antithesis.

This view justifies the perspective that both implied volatility and realised volatility will revert toward the mean as markets re-calibrate to a more certain political reality, in a market where the weak hands have been shaken out due to such high realised volatility.

Simply put, less fragile positions reduce the probability of high realised volatility. However, this is not to suggest exposure to unlimited loss structures is ever prudent. Instead, loss-limited structures, such as short put spreads; enable the ability to collect this elevated risk premium with a pre-defined and limited loss. Similarly, for those who trade esoteric structures, selling one-touch puts provides a similar return profile to put spreads as they are loss-limited, non-recourse structures.


Long: GBPUSD & GBPJPY (trend following)


Derivatives: short gamma GBPUSD can add carry to the position

Rates: cheapen VaR by receiving LZ17

Equities: we shall follow up with our equity views when the timing is right

Given we have a multi-year time horizon on the Sterling and a fundamentally bearish bias over a similar temporal horizon on the euro, a strategic long with no stop is our chosen methodology. With the sterling-yen, trend following is our chosen strategy given its historical efficacy.

Further, whilst we don’t take unlimited-loss short gamma positions, selling the downside on GBPUSD remains an attractive proposition, particularly taking into consideration the skew and richness of the implied volatility, as well as providing the opportunity to add carry to the position.


Typically our position sizing process is one shamelessly adopted from James Leitner of Falcon Management Corporation who was kind enough to share his Kelly Criterion or optimal leverage sizing process with some of the Drobny Global Advisors members along with the presentation The Evolution of a Macro Portfolio. However, given we haven’t yet expanded upon this methodology and our variant of its application – looking at frequentist and intersubjective probabilities, and the expectations gap between them – for the purposes of keeping this piece as concise as possible we will leave this to a later date. Further, given a 100% allocation to a single currency exposure ­is everyone’s default position, sizing strategic long-term currency positions requires a somewhat different process to the one we would otherwise undertake for other asset classes. Of the various approaches one might employ, a risk-targeted approach is what we shall adopt. Accordingly, it is necessary for those who implement this trade to size according to their own risk tolerance. We shall follow up with an explanation of our sizing methodology and an introduction to our macro tracking portfolio in the coming days.

Carl Hodson-Thomas

Nb. For those of you interested in learning more about receiving our research, please visit

Prometheus Research Distribution List

Dear readers, friends and comrades; although many of you may already be on my database, I would appreciate if you can take the time to submit your information via the link below. Any double-ups will be promptly tidied up.

As you may know, I write infrequently, primarily because I want to distribute only the highest quality ideas with arguments for action that are well-reasoned and logical. Both personally, and politically, I tend to think independently; this autonomous bent often sees me well prepared cyclically.

My communications will be one of three distinct pieces and will be published as often as the opportunity set allows.

Contingencies: covering derivatives trades on the short end of the probability spectrum.

Risk & Reflexivity: elucidating an idea’s arguments for action, as well as its best expression, expected value, probabilities and sizing.

Reason & Biases: reducing fundamental and behavioural thematic arguments into a tractable process.

Depending on the criticisms and feedback, I may include follow ups with comments from subscribers & members, I’m sure this will prove fruitful as there are a number of sharp thinkers amongst the network.

The first piece to this database will be going out this week.

Please take the time to fill out your details to be included.


Ask Me Anything

Dear readers, to encourage me to interact with you more and prompt me to write more frequently, I’m adding this contact form to enable you to ask me anything that is relevant to the mandate of this blog.

Please feel free to get in touch, I look forward to your questions.

Best regards,


“Tha Squeeze” – A Gold Vol Trade Idea

If you read my last piece, you’ll be aware that gold is my favourite battleground for numerous reasons. As a disclaimer I’m already short and I also own some GCZ5P 1150 strike puts. As the title suggests, the trade outlined herein is to trade vol outright.

Last July I went to the Drobny Macro Summer School Conference in NYC. My favourite trade at the time, one that I suggested at the conference, was to buy precious metals vol below 12 vol points and it preceded to trade up throughout the rest of 2014.

2014 vol

The trade was predicated on essentially the very same reasons I outline below. This post may provide some good insight into my process. Eventually these posts will become much less thorough as I don’t need to flesh out the fundamental narratives and there becomes less need to elucidate on my thinking.

Type – Contingent: potential breakdown, potential vol expansion, potential catalyst in rates.

Fundamental Context – Gold is a story in decline, its failure to break higher has continued to impair expectations of the “believers” in a positive outlook. Meanwhile, despite the drama over the Drachma, gold has failed to stage a rally. All whilst the Fed looks ever closer to raising rates, with 6.71 months until the first rate hike indicated by markets.


A good friend tells me that “these are still doomsday prices”, expecting the mean reversion has much further to run. Further, the financialisation of commmodities markets as a result of the internet allowing every man and his dog to trade anything from home, means a huge build-up in positioning transpired through the zeroes. Coinciding with the meme that inflation was coming due to the Fed’s QE program. Gold was bid to outrageous levels and has since sold-off in similar fashion to historical bubble analogues. For further reading on the fundamentals, see Mark Dow’s blog.

Hypothesis – Gold looks set to break down and given that vol is compressed, we have the opportunity to play a mean reversion in the absolute level of vol. with the added benefit, that if the Fed raises rates during our trade horizon, it may be a catalyst for gold to collapse.

Timeframe – 4-5 months.

Trade – Buy a four month straddle on GCZ5.

LT Trend – Strongly negative
Intermediate Trend – Negative
ST Trend – Negative

GCQ5 Trends

Price Levels:
I think of price as the outcome of a contest of ideas in markets and reflective of the strength of conviction to which traders believe in a given story. With this interpretation in mind, the charts tell the story.

GC1 Price Levels

1165, 1140 and 1130 are the key support levels, yet as we can see in the below chart, the range of support may be quite wide.

Gold Price Chart

Gold is sitting right in the middle of its regression channel which has been in play since the April 2013 selloff that occurred right after gold failed to stage a meaningful rally during the events of the Cyprus bailout in March 2013. I remember thinking at the time this essentially invalidated its supposed purpose as a financial hedge.


Selling on overbought conditions proved quite fruitful since, as gold continually made lower highs. This is a strategy worth following until this regime breaks in one direction or the other. As evidenced by the below (very basic and obviously cherry-picked) backtest.


Nevertheless, even this mean reverting price behaviour has been sufficient to see large spikes in gold vol, but a breakdown of the magnitude of 2013, perhaps on the Fed raising rates, could see a significant vol spike.

Implied Vol:

“The single best predictor of future increases of volatility is low historical volatility.” – Jamie Mai, HFMW

If we think of price as the function of a contest of ideas, then the inverse of volatility is the measure of participants’ confidence in those ideas. For this reason it is a particularly valuable insight into a given market for a behaviouralist.

The low in implied vol in 2008 is obviously some bad data which skews the statistics somewhat, but even at the 9th percentile, we can be confident we are buying vol cheap.


Looking at the XAUUSD vol for confirmation, we can see that over the last 10 years only 319 observations have been below the current level.


Bollinger Band Width:
As a technical proxy for vol, we can also see that Bollinger Band Width is particularly narrow. In the same vein as the Jamie Mai quote above, as a technical indicator, BBWidth is often used for a situation called “Tha Squeeze” whereby it often tends to contract before periods of high volatility.

BBand Width

As we can see in the below skew, risk is to the downside.


To gauge whether history is on our side, let’s look at vol seasonally. Most notable is the fact that August & September have the greatest average monthly positive changes.

Gold Vol Seasonality

Certainly if the 5 year average is anything to go by, July isn’t bad timing for entry.

Seasonality 5 yr average


Directionally speaking, as mentioned, my bias is to be short gold. If your strategy is to sell breakdowns, there may well be some interesting entries in the next few days. In terms of playing vol, we can either do it via delta-hedging an option or with an option structure.

Here is an indicative structure.


Obviously it’s path dependent, but presuming there are some good moves before expiry,  delta hedging may well pay for the trade as implied vol here is only indicating a daily volatility of 0.95%. Below is the payoff chart if you hold til expiry without hedging along the way.

Straddle Payoff


Due to the length of this piece I’m leaving out my expected value and position sizing process for a later post. Don’t do a trade like this if you don’t know how to size or manage it. I’ll likely hedge moves to the topside more aggressively given my directional bias is that gold goes lower.

Gold looks like it could break down tonight, so let’s see how this trade goes.

Please read the disclaimer.


Biases in Trading: The Neuropsychological Contest of Emotion and Logic

The following piece is quite formal. Before I start sharing trades and analysis on this blog I wanted to provide an insight into my interpretation of behavioural macro trading. In which case I won’t have to unnecessarily elaborate when I work through my process in later posts. Apologies if this is TL;DR.


“Once we realize that imperfect understanding is the human condition there is no shame in being wrong, only in failing to correct our mistakes.” – George Soros

1) Logic, Emotion and their Biologies
2) Dual Process Reasoning
3) Shortcuts to Fallibility
4) Anatomy of the Gold Bug
5) Emotion Drives Cycles in Trading
6) In Closing
7) Further Reading

Logic, Emotion and their Biologies

“Reason is, and ought only to be the slave of the passions” – David Hume

Our brains are in constant disharmony, a contest between two conflicting forces. The first force is emotion. Emotion, can be both wondrous and destructive. Primarily because it is a characteristically primal, subjective and intrinsically hard-wired system that operates on an intuitive autopilot. The second force, logic, is less primal in nature due to its extrinsic abstract qualities and typically requires purposeful effort in order to reason objectively.

These two forces are asynchronous and so, remain in perpetual disunity, with one often contradicting the other,  e.g. the platitude “my head says one thing, my heart another”.

Even when we attempt to reason as objectively as possible, emotion interferes in the process, resulting in an outcome intertwined with our instinctive emotional biases. Hence, this inherent predisposition to faulty reasoning – to be a slave to our passions – our fallibility; was regarded as the manipulative function by George Soros. Nb. Not only do we manipulate reality, but also our understanding of it.

Neurologically speaking, the Neocortex, the part of the brain considered responsible for objective decision making; cannot reason without being influenced by the Amygdala, considered responsible for subjective emotional function.

The Amygdala is given priority in the brain over the Neocortex. As a result, one’s opinion tends to feel in an ill-reasoned, preconceived manner that was likely subsconsciously, and then consciously; constructed long before it was considered rationally. A curious function from an evolutionary biology perspective of our lizard brain attempting to keep us out of danger.

As information comes in, our subjective emotion is constantly undermining and contaminating our process of reason. This reflexive propensity influences all people differently.

Yet, this is only the beginning of how we fail to logically reason.

Nb. I’ve left out the discussion on hormonal effects on cognition and behaviour as it’s worth its own post entirely. Check out John Coates book linked below in Further Reading to jump start on the topic.

Dual Process Reasoning

In Thinking Fast and Slow, the eminent psychologist Daniel Kahneman separates how we process information into two systems. We have an instantaneous, intuitive and instinctive System 1, and a deliberate cognitive system, which is (hopefully) logical and rational, System 2.

System 1 is automatic, stereotypic and subconscious. It is no surprise then that it’s function is most closely associated with the Amygdala.

System 2 is the one we call upon for problem solving and strategic thinking, it requires a lot of energy via concentration. Depending on one’s familiarity with the problem at hand, System 2 takes a conscious effort to recruit, thus straining our finite capacity for logical effort.

Due to the effortful nature of System 2 and a finite capacity for abstract logic, we tend to take shortcuts. It’s hypothesised this is due to our reasoning faculties being a more recent evolutionary adaptation. Nevertheless, what we do know is the shortcuts we take. By being aware of these shortcuts and giving them a taxonomy, perhaps we can (hopefully) better recognise them in others, and, even better, give ourselves the tools to introspectively critique our own reasoning.

Shortcuts to Fallibility

Now we’ve covered the neuropsychological conditions which make us prone to failures in our reasoning, let’s look at some of the tendencies which result in the human brain drawing incorrect conclusions.

Cognitive biases are patterns in perceptual distortion that are replicable and responsible for misjudgement and illogical observation. There’s a vast array of examples for these spanning both human interaction (social biases) and judgement (memory and decision making biases). Cognitive biases arise when emotion, coupled with the rapid-fire nature of the lizard brain; result in heuristics applied outside the bounds of reason. Biases in professional trading and investing have been well documented since Keynes’ beauty contest and they are worthy of an entire tome themselves, so I only gloss over some key ones in this piece with the below examples.

Cognitive Biases
Source:  Royal Society of Account Planning

Logical fallacies are errors in logic, they can be formal violations of propositional logic or informal fallacies whose content or argument requires a leap in logic, leaving a disconnect between one’s premise and resulting conclusion. Most commonly these are inappropriate generalisations. Another great graphic with some examples below.


Reasoning by association, substitution or analogy, is an example of an inappropriate generalisation, a mistake humans often employ to shortcut the effortful process of recruiting System 2. When we find a false equivalency, we rather conveniently do not have to distill a problem to its first principles and reason out from there. Instead we are trusting the logic of the analogy; something that works well in our memory, which is typically associative, but less so in logical propositions.

An axiom is a starting point for a logical proposition, generally so evident that it is presumed true without skeptical inquiry. Axiomatic thinking is valuable when one has successfully identified a first principle, but disastrous when patently false. e.g. The Fed’s monetary policy will lead to inflation. In this false axiom, there’s a substitution between a bias about a contingent event, with an objective first principle; invariably perceiving it as given. i.e. Given A then B.

It is no surprise then, that this was likely undertaken in an attempt to reason quicker and probably done emotively and subconciously before being rationally considered by System 2. A curious commonality in these types of misjudgements is that they generally stem from an ideology, be it political, economic or religious; all are likely to incite and galvanize emotion.

“At the time, I was politically right wing and that fit with being an inflation-alarmist. The theory that the evil government was constantly debasing the currency provided for the perfect perspective for trading the inflationary markets of the mid-1970s.” – Michael Marcus, Market Wizards

Michael Marcus’ quote above is a pertinent example of one’s political ideology impacting their decision making. In investing and trading this can be both help and hindrance.

I’ve included a small survey out of curiosity to see if Michael Marcus’ observation held true in recent beliefs about the outcome of Quantitative Easing (QE). The hypothesis being: is the right more prone to an inflationist belief because of a political ideology espousing smaller government? Please check the box which best describes you. I’m Australian so forgive me if this seems a little politically insensitive.

In this way, we can ascribe a typology to ideas held by market participants and treat these ideal type generalisations as hypotheses when making investment decisions of our own. By considering sentiment and psychology and working out which story, or ideal type is the most powerful in the contest between bulls and bears, as traders we are better equipped to handle the pendular swing of sentiment and positioning in markets, such that we may have a better chance to predict and profit from the dynamic price movements and volatility in financial markets.

Giving these hypotheses the treatment of scientific falsification, we prevent ourselves from making the mistake of getting wedded to false axioms.

Anatomy of the Gold Bug

“Gold is the only commodity where the amount of supply is literally about 100 times as much as the amount physically used in any year. That is not true of any other commodity, such as wheat or copper, where total supply and annual consumption are much closer in balance, and true shortages can develop. There is never any shortage of gold. So gold’s value is entirely dependent on psychology or those fundamentals that drive psychology. Many years ago, when I was a commodity research director, I would totally ignore gold production and consumption in analyzing the market. I would base any price expectation entirely on such factors as inflation and the value of the dollar because those are the factors that drive psychology.” – Jack Schwager, Hedge Fund Market Wizards

The anatomy of the gold bug is the home-ground for behavioural macro analysis. As noted by Jack Schwager, given that gold is the only commodity whose supply is completely unrelated to the amount physically used there is no rational economically derived fundamental logic to explain the price movements in the commodity, it is simply a function of what people are willing to pay and that is determined by their expectations, which are likely biased by their political and economic ideology and emotion.

The antidote is to consider gold mechanistically; in terms of the market’s positioning, and behaviourally; in terms of sentiment, story and expectations. Sadly, this is not what happens in practice. Logic is suspended as participants are influenced by their axiomatic beliefs. The right wing guy with the house in the country who owns guns and gold and is fearful of big government and inflation, as an extension of the Michael Marcus archetype; takes it as a given that inflation will be created by the profligate government without questioning the fundamental logic of that axiom. Instead, he’s thinking about something which is contingent as though it is a given and not distilling the observation to first principles… because it was easier to skip that part.

Emotion Drives Cycles in Trading

“Faced with the choice between changing one’s mind and proving that there is no need to do so, almost everybody gets busy on the proof.” – John Kenneth Galbraith

You will come across many professional traders who will point out the disparity between paper trading and the real thing, this is because when paper trading you haven’t had the market test your nerve. That’s before accounting for the emotional difficulty one may face when it comes to changing one’s mind.

Consider the generic chart for gold below. This chart represents one of the greatest displays of emotions in trading. Indeed anyone who trades derivatives or understands the Greeks knows that it’s more complex than simply buyers and sellers. However, resistance and support keep occurring in the same ranges outlined in red for a reason, as Mark Dow smartly put it: “the behaviour behind resistance, of course, is the old I’ll-sell-it-when-it-gets-back-to-where-I-bought-it”, or vice versa.


Indeed, we can see how emotion is driving this process. For example, imagine your bias is to be bearish – you are more confident that you are correct when reality, read price, accords with your thesis, and conversely, less confident when it looks to be challenging resistance and doesn’t confirm your thesis. If you try to short gold when it makes a new low and it fails to break down, you stop out of your position as your fear response kicks in and the Amygdala or System 1, overrules the logic that justified your trade. Thus, there’s an upward force on price and the continuum of reflexive feedback between price and conviction continues.

Similarly, the bulls begin to develop confidence when the price appears to be breaking higher, and when it fails, their System 1 interferes and they hit their stops, and the process repeats. This occurs across various macro horizons. Above we can see it occurring in the course of months, but it also transpires in every timeframe, from intraday moves to the course of years. For example, take gold’s long slow march from its early 2000’s base, to its eventual sharp acceleration and blow off top. In longer term cycles, the pendular swing might be slower, and the bulls might have had the power for longer, but the process is still the same. Once the self-reinforcing positive feedback between price and participants behaviour is extinguished by the bubble bursting, the virtuous circularity becomes vicious.

GC1 lt

“Religion is a function of repetition and a passage of many many years. 10 years is effectively sufficient to create a cult, a cult of belief, in capital markets.” – Hugh Hendry

Ultimately, we can see the neuropsychological contest of emotion and logic not only occurs internally for market participants, but is also represented collectively through price action in markets, where we observe a contest of ideas represented by the participants willingness to risk capital on those ideas, reflective of their strength of conviction. The more people are convinced, the greater the emotional conviction, the stronger the idea and the more likely it is a meaningful move, or potentially, a bubble will develop. Most notably, it is often these illogical cult-like axiomatic beliefs which empower people to risk the most capital with the greatest conviction. Numerous newsletter writers on the internet, charging a $20p/m fee are incentivised to cater that, to paraphrase Kahneman: “A reliable way of making people believe in falsehoods is frequent repetition, because familiarity is not easily distinguished from truth”.

In Closing

Feedback allows us to update System 1, allowing us to develop skills, so that we are less prone to letting the Amygdala mislead us. This requires time, the effortful recruitment of System 2; and the ability to be introspective so that one is not allowing emotion to cloud their ability to remain objective. Dalio has tried to instill this within his culture at Bridgewater:

“I’ve learned that everyone makes mistakes and has weaknesses, and that one of the most important things that differentiates people is their approach to handling them. I learned that there is an incredible beauty to mistakes, because each mistake was probably a reflection of something that I was doing wrong, so if I could figure out what that was, I could learn how to be more successful.” – Ray Dalio

Ultimately, embracing mistakes and critical thinking (ex-ante and ex-post) are the only tonic to assist us with rationality. Nevertheless, it’s easier said than done, particularly in markets. Let’s see how you behave when you have your money on the line!


Further reading:
The Hour Between Dog and Wolf by John Coates
Thinking Fast & Slow by Daniel Kahneman
Behavioural Investing: A Practitioners Guide to Applying Behavioural Finance by James Montier