Does "Buying the Dip" Pay Off? (w/ Danielle DiMartino-Booth & Chris Cole)

TL;DR

The herding instinct has led to a significant increase in short volatility strategies, creating confusion and potential risks in the market.

Transcript

DANIELLE DIMARTINO BOOTH: So talk about what effect this herding instinct has had on the way this generation views investing. CHRISTOPHER COLE: You and I have a very similar writing style. I love metaphors. I think visually. I think I think you do too. DANIELLE DIMARTINO BOOTH: Yours are better. CHRISTOPHER COLE: Yours are-- they're very good. But ... Read More

Key Insights

• 🍰 Short volatility strategies make up a substantial portion of the equity markets, totaling around $3 trillion.
• 🍰 Explicit short volatility strategies involve selling derivatives like options, while other strategies replicate the risk parameters of short volatility trades without directly shorting volatility.
• ❓ The decline in volatility and the increase in mean reversion have influenced various investment strategies.
• 📼 Autocorrelation, or the tendency for asset prices to move in the same direction, has decreased significantly in recent decades.
• 💢 Buying the dip has been a successful strategy in the past 10 to 20 years, particularly during the era of quantitative easing.
• 🤪 The success of buying the dip strategy in recent years does not guarantee its long-term viability, as historically, it has gone bankrupt three times in a 90-year period.
• 😮 The rise of short volatility strategies coincides with a period of reactive central bank policies and quantitative easing.

Questions & Answers

Q: What is the significance of the short volatility trade in the equity markets?

The short volatility trade, which amounts to around $3 trillion in equity markets alone, is composed of strategies that use volatility as an input for taking risk and aim to generate excess yield by selling volatility or assuming stability.

Q: What are explicit short volatility strategies?

Explicit short volatility strategies involve selling derivatives, such as options or the VIX, to profit from a decrease in volatility. However, they only form a small component of the overall short vol trade.

Q: What are some examples of strategies that replicate the risk parameters of short volatility trades?

Volatility targeting funds and risk parity are examples of strategies that replicate the risk parameters of short volatility trades. These strategies may not directly short volatility but align their risk parameters with those of short vol trades.

Q: How has the decrease in volatility and the move towards mean reversion affected investing strategies?

The decrease in volatility and the prevalence of mean reversion in asset prices have led to a wide range of strategies built on the assumption of mean reversion. However, it is important to note that mean reversion may not always be the case.

Summary & Key Takeaways

• The concept of the Ouroboros, where a snake devours its own tail, is used as a metaphor for the $3 trillion short volatility trade in equity markets.

• Short volatility strategies involve selling derivatives like options, but also include strategies that replicate the risk parameters of short volatility trades, such as volatility targeting funds and risk parity.

• The past 40 years have seen generational lows in volatility, with assets moving towards mean reversion, leading to the assumption that mean reversion is implicit in asset price behavior.