Variance swap delta hedging using only words found in Dr Seuss from ScottJo34110219

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https://threadreaderapp.com/thread/1238864479888248832.html (tweets now deleted or author disabled account/made private)
 
Scott
@ScottJo34110219
2 hours ago, 33 tweets, 5 min read 
   My Authors
Ok here we go, as promised. Variance swap delta hedging using only words found in Dr Seuss.  1/n 

Here's the Bossu paper again for those who do words & numbers together. Thanks again to @nextSignals: docs.sbossu.com/bossu-strasser…  2/n 

Now this isn't going to be obvious. It's also not easy for me to explain without a whiteboard. I saw there's a nice short version by @theta124 out there that complements this one.  3/n 

As a bonus, small conspiracy theory for those who make it to the end. Yeah, I'm Tyler Durden akshually  4/n 

Off topic - never ever work for a company without whiteboards scattered around. It means they are all morons with no interest in problem solving. Especially if they have a pool table.  5/n 

Anyway: variance swaps! Every day, take the closing SPX return, square it. At the end, add them up. That's all. Quadratic, y=x^2, x is the daily return, every day, added. Easy.  6/n 

If I buy the variance swap, I get that number, and I pay a fixed 'strike' price. If I sell the variance swap, I pay the number and receive the strike. That's all there is to it  7/n 

The strike is set from the SPX options market (read Bossu). Usually SPX realises a bit less than that, the difference has a name 'variance risk premium' or VRP.  8/n 

So, every day, if you sell a variance swap you wake up at 5am praying for the market not to move, stare at the screen all day with your rosary beads in hand.  9/n 

If the market is flat every day on the close, x=0 every day, you pay sum( x^2 ) = 0 and receive the strike. Woohoo! you are rich you guru, collect your CFA level 9  10/n 

There they are, staring at an upside down parabola y=-x^2. Move 1% they owe 1. Move 2%, owe 4. Move 3%, owe 9. Move 10%, lose your job. Hence beads.  11/n 

Every day, there they are, staring at the SPX. DON’T FKING MOVE. PLS. And in return for their faith, they usually win, they 'harvest' the VRP. Allah Akkbar, the rosaries worked!  12/n 

The trader at the dealer is long the variance swap, her parabola is the usual way up, y=x^2, and she usually loses the VRP. Say she reports to an MD. Now you may not have met many of them, but I promise you 'usually lose' isn't a dealer MD's favourite setup.  13/n 

So the dealer will hedge - she will sell options and delta hedge those options. Thus selling 'realized vol', against being long the same vol in the variance swap  14/n 

Choose the right set of options and you can perfectly hedge the variance swap. Bossu has all the maths you need here, though Neuberger is the one true king.  15/n 

So now the dealer is hedged: long from the client and hedged with a matched short option portfolio - any profit on the customer trade is locked in. Dealer MD - super happy!  16/n 

Here's the sneaky bit. That parabola y=x^2 resets to zero every day. As soon as the market closes, the guy with the rosaries starts counting from zero again at 4pm EST every day.  17/n 

The dealer is hedged - she doesn’t care about x - big or small move. But the dealer has 2 sides to her book. A variance swap that resets daily and an option portfolio that’s just options, no discrete resets in that  18/n 

Say the market moves down 6%. (You never know, it could happen). On the dealers y=x^2 parabola, you're waaay left x<<0. The slope (dy/dx=2x) is steeply negative  19/n 

On the options book, remember she's completely hedged for all x, so that slope must be opposite -steeply positive, i.e. she's short put options  20/n 

Then at 4PM - BAM! The parabola in the variance swap resets. One side of her book is now flat slope, zero delta, x=0 ready for the next day. The option side is still steeply sloped….  21/n 

Translation - she can tell she has enormous long delta risk, suddenly appearing at 4pm. Fuck. No, really, fuck. The MD thought we were hedged. FUCK.  22/n 

So down 6% at 4PM BAM the parabola resets and she covers, selling hundreds of e-minis. Phew. DOWN x MEANS SELLING x  23/n 

Next day, up 6%, (could happen) waaaaay right on the parabola, positive slope, her hedge is negative slope ie.. short the market. At 4PM BAM she covers, buying hundreds of e-minis. Phew. - UP x MEANS BUYING x  24/n 

Every dealer is doing this. Every dealer knows every dealer is doing this. So…. ask yourself what happens? That's right! Some guys go early! Yeah baby!  25/n 

The result is fast blow off spikes or crashes near 4pm if the market has moved a long way - down if down, up if up. Moves are exaggerated on the close by variance swap delta hedging. (There is a fairly new thing called BTIC that does the same thing)  26/n 

Recognise this the last 2 weeks? Well, now you know. No conspiracy, just market structure and hedging. During the financial crisis, this became equity market lore - moves get exaggerated on the close.  27/n 

And… relax. Stretch. Breathe. We're done. OK so here's the weird thing. Orangehead was supposed to talk at 3pm Friday. He delayed, apparently not for a quick #COVID19 test  28/n 

He starts late and keeps going THROUGH THE CLOSE. Now nobody, nobody sane, wants too much exposure going into the weekend. Everyone is balancing books, but he's still talking.  29/n 

So half way through, abotut 3.45, the general thought was "OK it seems there's a deal, we'll likely see a bill in congress tonight". You might not want to be long SPX but you certainly don’t want to be too short  30/n 

So, that means marginal buying and we're up 5-6%. And then uh-oh, positive feedback loop: bit of early variance hedging, more marginal buying, more hedging, more buying, more, more more and woah here we are 2700+.  31/n 

That's variance swap delta hedging in action. Moves are reinforced at 4pm. And maybe, maybe, that lesson from 2008 stuck in someone's head at the WH. Delay, keep talking, you can push it up. END.  32/n 

Postscript: please DYOR. And good luck out there. 
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