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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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