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Because I’m WFH (aka couch) today to re-charge, I’m going to do a slightly wonky markets (not econ) thread. Trigger warning: barrier options (I’m so sorry, I had to)
First, let’s start with a chart (screenshots from my phone plus bonus furball bc I didn’t have enough for a 4x4
First, let’s start with a chart (screenshots from my phone plus bonus furball bc I didn’t have enough for a 4x4
These are a bunch of different leveraged Exchange Traded Notes (ETN) and some of the ETFs that track the indexes that the notes replicate. The idea is that whatever the performance of the asset you are tracking you amplify by two or three and if the referent pays dividends, same.
So at 2x 5% becomes +10% and a 10% dividend yield can become a 20% dividend yield. A smart reader will wonder “but what if the referent goes down -51%, won’t the note end up being worth less than $0?” Yes, that is why the notes have to hedge that scenario and create a value floor
How can you create that floor? Well generally you buy an option. But options can be expensive and you really only need one that protects you under very specific conditions, namely a -50% or -33% (2x 3x respectively) decline in a day (or month for monthly rebalancing funds)
Buying and rolling a regular PUT option would be a very inefficient way to do this, costing a lot of money and negatively impacting the value of the note day-to-day.
Enter the “knock-in.” (I couldn’t think of a good knock knock joke, very niche missed opportunity)
Enter the “knock-in.” (I couldn’t think of a good knock knock joke, very niche missed opportunity)
A knock-in is a special type of exotic option where, after you enter the contract, the price of the underlying has to touch or breach a specific price before it essentially becomes a normal option. Having that additional condition makes the option a lot cheaper. Good for the ETN.
It’s a good way to buy “disaster insurance” and you’ve probably seen it lots of times, either in principal-protected equity products, structured notes, autocalls, and, if you’re an accountant or actuary, pension and annuities portfolios. Essentially “tail risk”
So, back to market mechanics:
Investor Joe buys $100 of ETN XYZ tracking index ABC 2x, rebalanced monthly. ETN is technically a liability, not a fund, so it’s issued by a bank, let’s call them Crodeet Swish. Crodeet Swish buys $200 worth of exposure to ABC and the -50% knock-in:
Investor Joe buys $100 of ETN XYZ tracking index ABC 2x, rebalanced monthly. ETN is technically a liability, not a fund, so it’s issued by a bank, let’s call them Crodeet Swish. Crodeet Swish buys $200 worth of exposure to ABC and the -50% knock-in:
As the month goes on, ABC has been declining and it’s down -25%. Joe’s XYZ ETN is down -50%. Crodeet Swish’s $200 is down to $150 but their liability to Joe is down $50 so they’re break-even (I’m not accounting for the knock-in price here just for simplicity and round numbers)
A market crash happens before the month ends, ABC index goes down 35% in a day. Joe loses the rest of his investment. Crodeet Swish’s liability is reduced by $50 and their ABC portfolio goes from $150 to $97.50. Which sucks because they bought it with Joe’s $100 + borrowing $100.
But their knock-in gets, well, knocked-in. So they have protection that covers that $2.50 shortfall. *phew*. Now comes the interesting part. Crodeet Swish tells joe they’re sorry but they will now liquidate his XYZ and he should surrender his shares of the for a residual payment
Residual payment? Where did that come from?! Remember the knock-in we didn’t account for before? Well, it’s way way up in price, so joe probably will get like $0.50-$1.00 back. But, uhm, who sold the knock in? They’re probably pretty displeased by this scenario. Not great, bob.
Enter Dealer Z (tad niche). Dealer Z is an options dealer and market maker, and they regularly sell these options, but they hedge, they’re not in the business of betting on ABC direction, just making markets. So, the knock-in goes from having effectively a zero delta to 50+ delta
Dealer Z does the rational thing and hedges as soon as they’re knocked in (IRL options pros: I know I’m simplifying but why are you even reading this) by selling $50 ABC ($200, minus a 50% loss, times 50 delta). But hey, the market is thin and crashing it just went -35% in a day
liquidity is terrible, why are they doing this? Well, they have to. Won’t it cause the price of ABC to crash further? Yes. And the faster it crashes the more Dealer Z (who is now short gamma) has to sell. This is often how those crazy moves you see near market bottoms happen.
Anyways: Crodeet Swish and Dealer Z come to an arrangement, net their positions out, and the residual gets paid to Joe. It’s over.
Postscript 1:
This is why I don’t subscribe to narratives of “capitulation” or “retail throwing in the towel” or “mass panic”. None of what happened is affective in nature, all of it is just a necessity of the structure of that market under a particular set of conditions.
This is why I don’t subscribe to narratives of “capitulation” or “retail throwing in the towel” or “mass panic”. None of what happened is affective in nature, all of it is just a necessity of the structure of that market under a particular set of conditions.
Post Script 2:
If John had bought a 3x note before Joe bought his 2x, John’s would have knocked-in first, and the hedging by Dealer Z could have caused the price to move lower and knock-in Joe’s. This is what a cascading crash or waterfall market is, in effect. It’s all mechanics
If John had bought a 3x note before Joe bought his 2x, John’s would have knocked-in first, and the hedging by Dealer Z could have caused the price to move lower and knock-in Joe’s. This is what a cascading crash or waterfall market is, in effect. It’s all mechanics
Post Script 3:
Dealer Z may not have wanted the risk, so Crodeet Swish could have had to find an alternative buyer for it by structuring it so that the premium was paid as a coupon to someone willing to take that risk. This called “tail risk recycling” see also: autocalls.
Fin.
Dealer Z may not have wanted the risk, so Crodeet Swish could have had to find an alternative buyer for it by structuring it so that the premium was paid as a coupon to someone willing to take that risk. This called “tail risk recycling” see also: autocalls.
Fin.
