...Wall Street loves to make convexity sound complex (I suppose it’s so they can charge higher fees?). We speak Greek (calling it “gamma”), employ physics as a metaphor (analogizing to it “acceleration”), and use mathematical definitions (since it is the second derivative of the asset’s price change).
Pish, posh. An investment is convex if the payoff is unbalanced for equally opposite outcomes. So if there’s the potential to earn a profit of two on a bet versus a maximum loss of one, the bet is positively convex. If you can lose three versus making two, it is negatively convex. That’s it. The rocket scientists are called upon to help (fairly) price the cost (value) of such possible outcomes. This is why the expansion of derivative trading in the 1990’s resulted in a hiring spree of physics PhD’s...."Pish. Posh." is a technical term only used by market professionals* for those situations where one has decided to go full Alinsky rule #5....
....and the second part.
TL;dr? Mr. Bassman knows stuff.
From Harley Bassman, The Convexity Maven:
July 21, 2020
“Long Live the King”
One would think a few summer months in the Hamptons might allow my nerves to dial back from a disquieting complex of National traumas;not limited to a bewildering pandemic, a constrained economy, and smoldering civic unrest–but that is not to be the case.Instead, our political class is engaged in endless bickering, even on topics for which they should generally agree. Perhaps for August they should take advice from Notorious RBG (Justice Ruth Bader Ginsburg):
“In every good marriage, it helps to be a little deaf.”
So, if a Sidecar and charcuterie plate at the local beach pub are off the menu, let me offer up a short-term trading notion to profit from political avarice.
Elections have consequences, which is why it is so strange that less than 56% of our eligible population votes despite a wider majority who believe the country is on the wrong track.
As a further irony-the 18 to 24-year-oldcohort is so agitated they are willing to risk their health in large public gatherings, yet has the lowest voter participation rate at barely 44%.
Notwithstanding the above, the markets have no such cognitive dissonance as they usually remain keenly focused upon elections.The -adenantheraline-below is the Implied Volatility for options on a blend of G-10 Foreign Currencies centered before and after a general election.
Surely it is no surprise that option prices tend to start rising about six weeks prior, which this year will occur on September 22nd. While COVID presently dominates the news, the consequence of this election will soon come into focus.....MUCH MORE (6 page PDF)
Ideally, one might purchase a forward starting option to avoid the time decay (theta) over the summer. The trouble here is that despite the existence of such exotic derivatives, one cannot lock in the strike price until the start date, which defeats the purpose if one is trying to hedge a portfolio at current levels. The easier path is to construct a forward starting option by hand. Here, one might sell a three-month option to buy to five-month option as a way to own the time slice between October and December.
The complication here is that the term (expiration) surface is usually steeply sloped for equity options, such that longer-dated options sport a much higher Implied Volatility than shorter-dated expiries.
Anomalously, as a result of extremely high Realized Volatility combined with a general fear that the market is balancing on the inflection point of a classic bear market rally, the Term Surface is presently inverted with the September and October VIX futures trading near 31 and 33 respectively while the December VIX future is near 29....
