Second Leg Down

HARI P. KRISHNAN, PHD, is a fund manager at Cross-Border Capital, where he runs systematic macro and volatility strat-egies. 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 bou-tique, 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 In-stitute, Columbia University, before moving into finance.

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