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True Partner article: Icarus versus Goldilocks

Page 3: The myth versus the fairytale

Buyers beware...

The observations more concern the structure or even microstructure of the markets. We have not addressed the reasons or triggers for markets to decline to begin with. Economically and politically the world is changing more so than in the last 20 years, with many uncertainties on the near-term horizon: US-China trade tensions, Southern Europe, slowing growth (the dreaded ‘R’ word), Brexit and Iran, and from our office window, Hong Kong.

The picture we intend to sketch is not one of imminent doom. However, we do want to make the point that below the tranquil surface of the current low volatility markets risks and imbalances lurk. Unfortunately, the current configuration is increasingly digital. Future market declines might very well smother, as have the past ones, until something does pull the rug out under it. This can be reduced efficacy of central bank interventions, foreboded perhaps by the underwhelming reception of the Fed rate cut in July and Draghi’s last hurrah in September. But it can also simply be a policy error in general or for that matter maybe the President of the United States realizingthat if he continuously retracts his bravado towards China after every small down move in the S&P500, his tough image might be at stake. If the explicit and implicit safety nets were to suddenly disappear, it remains to be seen how brave the volatility selling crowd would be facing such absence. After all, contrary to popular belief assuming risk is not alchemy yielding returns. It is taking a calculated bet and if parameters of the calculation change, so will the outcome.

There-Is-No-Alternative…

So what can an investor to do in a There-Is-No-Alternative world? The problem with staying on the sidelines is opportunity costs. In most markets these costs are in the economic sense of missed opportunity, but in absolute sense in Europe given the negative interest rates.
For those who see signs of trouble near-term, these costs might be worth it, as in the above described ‘digital world’, events will likely come fast and furious. Exiting when the event hits might very well be too late. Especially given the structural aspects hampering market liquidity.

For all other investors, if there is no alternative to staying invested it would be ill advised not to have any protection. When Icarus flew towards the sun in ancient times he only had his wings. Nowadays you can protect yourself by having a parachute on your back. And the costs of one has been coming down consistently. Similarly, the price of protection in the equity markets is under pressure in the ever-continuing quest for yield. Volatility exists in both directions and as long as market movements exceed the implied price paid for such movement, the protection is worthwhile. With the S&P500 up almost 20% for 2019, this move is of muchlarger magnitude than the implied movement currently embedded in options contracts.

In a way, the prevalence of yield seekers and volatility sellers does provide subsidized insurance, which allows investors to retain exposure whilst being protected should the markets rise too close to the sun. Whether applying stand-alone options hedges or investing in volatility strategies, unless you believe the negative interest rate world is the new normal, we are of the opinion There Is No Alternative to such protections.

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About the authors

Govert Heijboer, co-CIO of True Partner Capital

Mr. Govert Heijboer, Co-CIO of True Partner, has been active as a market maker trading in the European and Asian derivatives markets as well as positional trading since 2003. Govert started as a trader/researcher at Saen Options in Amsterdam and rose to become the director of derivatives trading and a member of the executive team in 2007. In 2008 he moved to Hong Kong to set up and assume responsibility for all trading activities in the new Saen Options Hong Kong branch office. Govert holds a PhD in Management Science and an MSc in Applied Physics from the University of Twente, Netherlands. He is a founding partner and has worked on the launch of the True Partner Fund since March 2010.

Tobias Hekster, co-CIO of True Partner Capital

Mr. Tobias Hekster,Co-CIO of True Partner, has been actively trading for the past 21 years in various different roles in several markets across the globe. Starting at IMC in 1998 as a pit trader in Amsterdam, Tobias has established the off-floor arbitrage desk, headed the Chicago office in the transition from floor trading to electronic trading and set up the Asian volatility arbitrage desk in Hong Kong. Tobias holds an MSc in Economics and he teaches as an Adjunct Associate Professor at the Chinese University of Hong Kong and as an Adjunct Professor of Financial Practice at National Taiwan University.

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The full publication of this article is available as a PDF. Download it following the link below:
October 2019 Volatility Update - Icarus versus Goldilocks>>

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