The Era Of Complacency Is Ending

Authored by James Rickards via DailyReckoning.com,

Physicists say a “subcritical” system that’s waiting to “go critical” is in a “phase transition.” A system that is subcritical actually appears stable, but it is capable of wild instability based on a small change in initial conditions.

The critical state is when the process spins out of control, like a nuclear reactor melting down or a nuclear bomb exploding. The phase transition is just the passage from one state to another, as a system goes from subcritical to critical.

The signs are everywhere that the stock market is in a subcritical state with the potential to go critical and meltdown at any moment. The signs as elevated price-to-earnings (P/E) ratios, complacency, and seasonality — crashes have a habit of happening around this time of year.

The problem with a market meltdown is that it’s difficult to contain. It can spread rapidly. Likewise, there’s no guarantee that a stock market meltdown will be contained to stocks.

Panic can quickly spread to bonds, emerging markets, and currencies in a general liquidity crisis as happened in 2008.

For almost a year, one of the most profitable trading strategies has been to sell volatility. That’s about to change…

Since the election of Donald Trump stocks have been a one-way bet. They almost always go up, and have hit record highs day after day. The strategy of selling volatility has been so profitable that promoters tout it to investors as a source of “steady, low-risk income.”

Nothing could be further from the truth.

Yes, sellers of volatility have made steady profits the past year. But the strategy is extremely risky and you could lose all of your profits in a single bad day.

Think of this strategy as betting your life’s savings on red at a roulette table. If the wheel comes up red, you double your money. But if you keep playing eventually the wheel will come up black and you’ll lose everything.

That’s what it’s like to sell volatility. It feels good for a while, but eventually a black swan appears like the black number on the roulette wheel, and the sellers get wiped out. I focus on the shocks and unexpected events that others don’t see.

The chart below shows a 20-year history of volatility spikes. You can observe long periods of relatively low volatility such as 2004 to 2007, and 2013 to mid-2015, but these are inevitably followed by volatility super-spikes.

During these super-spikes the sellers of volatility are crushed, sometimes to the point of bankruptcy because they can’t cover their bets.

The period from mid-2015 to late 2016 saw some brief volatility spikes associated with the Chinese devaluation (August and December 2015), Brexit (June 23, 2016) and the election of Donald Trump (Nov. 8, 2016). But, none of these spikes reached the super-spike levels of 2008 – 2012.

In short, we have been on a volatility holiday. Volatility is historically low and has remained so for an unusually long period of time. The sellers of volatility have been collecting “steady income,” yet this is really just a winning streak at the volatility casino.

The wheel of fortune is about to turn and luck is about to run out for the sellers.

Here are the key volatility drivers we have considered:

The North Korean nuclear crisis is simply not going away. In fact, it seems to be getting worse. It appears North Korea has successfully tested a hydrogen bomb last weekend.

This is a major development.

An atomic weapon has to hit the target to destroy it. A hydrogen bomb just has to come close. This means than North Korea can pose an existential threat to U.S. cities even if its missile guidance systems are not quite perfected. Close is good enough.

A hydrogen bomb also gives North Korea the ability to unleash an electromagnetic pulse (EMP). In this scenario, the hydrogen bomb does not even strike the earth; it is detonated near the edge of space. The resulting electromagnetic wave from the release of energy could knock out the entire U.S. power grid.

Trump will not allow that to happen, and you can expect a U.S. attack, maybe early next year.

Another ticking time bomb for a volatility spike is Washington, DC dysfunction, and the potential double train wreck coming on Sept. 29. That’s the day the U.S. Treasury is estimated to run out of cash. It’s also the last day of the U.S. fiscal year; (technically the last day is Sept. 30, but that’s a Saturday this year so Sept. 29 is the last business day).

If these two legislative fixes are not done by Sept. 29, we’re facing both a government shutdown, and the potential for a default on the U.S. debt. Time is short and my estimate is that one or both of these pieces of legislation will not be completed in time. This will certainly trigger a volatility spike and produce huge profits for investors who make the right moves now.

Even if the budget CR and debt ceiling get fixed under Trump’s new deal with Chuck Schumer and Nancy Pelosi, that simply postpones the day of reckoning until December 15. That’s only three months away and will be here before you know it. Markets tend to discount the future so a train wreck on December 15 will start to show up in market prices today.

Congress has to pass two major pieces of legislation. One is a debt ceiling increase so the Treasury does not run out of money. The other is a continuing resolution so the government does not shut down.

Both bills could be stymied by conservatives who want to tie the legislation to issues such as funding for Trump’s wall, sanctuary cities, funding for Planned Parenthood, funding to bailout Obamacare and other hot button issues.

If the conservatives don’t get what they want, they won’t vote for the legislation. If conservatives do get what they want, moderates will bolt and not support the bills. Democrats are watching Republican infighting with glee and see no reason to help with their votes.

If these two legislative fixes are not done by Sept. 29, we’re facing both a government shutdown, and the potential for a default on the U.S. debt. Time is short and my estimate is that one or both of these pieces of legislation will not be completed in time. This will certainly trigger a volatility spike and produce huge profits for investors who make the right moves now.

Other sources of volatility include a planned “Day of Rage” on Nov. 4 when alt-left and antifa activists plan major demonstrations in U.S. cities from coast-to-coast. Antifa are neo-fascists posing as antifascists; hence the name “antifa.” Based on past antifa actions in UC Berkeley and Middlebury College violence cannot be ruled out. This could be unsettling to markets and be another source of volatility.

Finally, another monster hurricane could be bearing down on U.S. shores, just after Hurricane Harvey devastated Houston and other parts of Texas and Louisiana.

Hurricane Katrina struck at the very end of August in 2005 and Superstorm Sandy hit the Jersey Shore in October 2012. Both did enormous damage and unsettled markets for a time. Now we’re facing two major hurricanes almost at once.

Other wild cards include domestic terror and cyber attacks.

Finally, we are entering an historically volatile time of year. Many of the greatest stock market crashes of all time have occurred in September or October including the Black Thursday (Oct. 24, 1929) and Black Tuesday (Oct. 29, 1929) crashes that started the Great Depression, and the Black Monday (Oct. 19, 1987) crash, in which the stock market fell 22.61% in a single day. From today’s levels, a 22.61% drop would mean a loss of 4,900 Dow points in a single day.

Don’t rule it out.

None of these scenarios are far-fetched or even unlikely. The war with North Korea is coming. Washington, DC dysfunction is a fact of life and we’ve had several government shutdowns in recent years. Social unrest is spreading and in the headlines every day. Hurricanes and terror attacks happen with some frequency.

It has been nine years since the last financial panic so a new one tomorrow should come as no surprise.

In short, the catalysts for a volatility spike are all in place. We could even get a record super-spike in volatility if several of these catalysts converge.

The “risk on / risk off” dynamic that has dominated most markets since 2013 is coming to an end. From now on it may just be “risk off” without much relief. The illusion of low volatility, ample liquidity, and ever rising stock prices is over.

The safe havens will be the euro, cash, gold and low-debt emerging markets such as Russia. The areas to avoid are U.S. stocks, China, South Korea and heavily indebted emerging markets.

It looks like a volatile and bumpy fall ahead.

Liberal Media Continues To Turn Against 'AntiFa': "This Is Food For The Adversary"

Yesterday, the Washington Post surprised readers by turning against black-clad “Antifa” protesters who violently assaulted no fewer than five conservative demonstrators at a rally in Berkeley, Calif. on Sunday. Previously, the US capital’s paper of record and its mainstream media cohorts had focused their scorn on violence committed by conservative protesters, particularly in the aftermath of the tragic car-attack in Charlottesville, Va. earlier this month.

But as it turns out, WaPo was ahead of the curve. Because today, both the Los Angeles Times AND The Atlantic published similarly scathing attacks on the black-clad demonstrators, portraying members of Antifa as brutal thugs who routinely gang up on overmatched supporters of President Donald Trump at events like Sunday’s anti-Marxist rally in Berkeley. Violent confrontations instigated by AntiFa have also occurred at rallies and events stretching from Portland, Ore. to Washington D.C. However, before this week, accounts like these were mostly confined to “conservative” media like the Daily Caller and Washington Times.

The LATimes" report focuses on how Antifa has alienated other leftist groups, who object to its violent tactics. One of the individuals quoted in the story, Todd Gitlin, founder of Students for a Democratic Society, one of the original anti-Vietnam War groups, blamed Antifa for sullying the left’s reputation and accused them of being “food for the adversary.”

…first, the headline…

…now, the story...

“But as the protest got underway, some of those in masks would resort to mob violence, attacking a small showing of supporters of President Trump and others they accused, sometimes inaccurately, of being white supremacists or Nazis.

The graphic videos of those attacks have spurred soul-searching within the leftist activist movement in the Bay Area and beyond. Emotions remain raw in the wake of this month’s white supremacist rally in Charlottesville, Va., which left one woman dead and dozens injured.”

...

‘This is food for the adversary,’ said sociologist Todd Gitlin, a founder of Students for a Democratic Society, which organized the first national protests against the Vietnam War. He pointed out that violent acts committed by a few will almost always hijack the narrative of the entire protest, and that it is happening now should be no surprise.”

The Atlantic continued with a more comprehensive accounting of Antifa’s sins, beginning with the protester who famously punched Richard Spencer in the face on inauguration day…

“In Washington, D.C., the response to that question centers on how members of Congress can oppose Trump’s agenda, on how Democrats can retake the House of Representatives, and on how and when to push for impeachment. But in the country at large, some militant leftists are offering a very different answer. On Inauguration Day, a masked activist punched the white-supremacist leader Richard Spencer. In February, protesters violently disrupted UC Berkeley’s plans to host a speech by Milo Yiannopoulos, a former Breitbart.com editor. In March, protesters pushed and shoved the controversial conservative political scientist Charles Murray when he spoke at Middlebury College, in Vermont.”

...responses sometimes spill blood. Since antifa is heavily composed of anarchists, its activists place little faith in the state, which they consider complicit in fascism and racism. They prefer direct action: They pressure venues to deny white supremacists space to meet. They pressure employers to fire them and landlords to evict them. And when people they deem racists and fascists manage to assemble, antifa’s partisans try to break up their gatherings, including by force.

Such tactics have elicited substantial support from the mainstream left.

...

Antifa believes it is pursuing the opposite of authoritarianism. Many of its activists oppose the very notion of a centralized state. But in the name of protecting the vulnerable, antifascists have granted themselves the authority to decide which Americans may publicly assemble and which may not. That authority rests on no democratic foundation. Unlike the politicians they revile, the men and women of antifa cannot be voted out of office. Generally, they don’t even disclose their names.

...

Revulsion, fear, and rage are understandable. But one thing is clear. The people preventing Republicans from safely assembling on the streets of Portland may consider themselves fierce opponents of the authoritarianism growing on the American right. In truth, however, they are its unlikeliest allies.

Antifa has until now effectively enjoyed immunity from criticism in the mainstream press.

But the first inklings of a sea-change in public opinion emerged over the weekend, when one local reporter shared his story about being harassed and attacked by members of Antifa at Sunday’s rally. His remarks appear to have struck a chord...

KTVU anchor Frank Somerville, a well-known Bay Area TV personality, took to Facebook this weekend to share what happened to him when he took a day trip to Berkeley on Sunday. Somerville – hardly a conservative – explained how the Antifa protesters threatened to destroy his phone and needlessly demeaned and attacked him for the simple act of trying to document a rally taking place on public property.

In response, Somerville declared that he “experienced hate first hand today... It came from these people dressed in all black at a protest in Berkeley.”

“Ironically they were all chanting about NO hate.

Some had shields and gloves. Some had helmets. Some had gas masks.”

Anyone who’s been paying attention has been presented with many examples of Antifa’s violent thuggery. Now, it’s almost encouraging to hear that the MSM at least has enough sense not to fall on its sword protecting a bunch of violent, embittered hoodlums.

Like they say, three’s a trend…
 

Volatility Makes A Comeback

Authored by James Rickards via The Daily Reckoning,

Volatility has languished near all-time lows for months on end. That’s about to change.

For almost a year, one of the most profitable trading strategies has been to sell volatility. Since the election of Donald Trump stocks have been a one-way bet. They almost always go up, and have hit record highs day after day. The strategy of selling volatility has been so profitable that promoters tout it to investors as a source of “steady, low-risk income.”

Nothing could be further from the truth.

Yes, sellers of volatility have made steady profits the past year. But the strategy is extremely risky and you could lose all of your profits in a single bad day.

Think of this strategy as betting your life’s savings on red at a roulette table. If the wheel comes up red, you double your money. But if you keep playing eventually the wheel will come up black and you’ll lose everything.

That’s what it’s like to sell volatility. It feels good for a while, but eventually a black swan appears like the black number on the roulette wheel, and the sellers get wiped out.

I focus on the shocks and unexpected events that others don’t see.

Right now looks like one of those highly favorable windows when the purchase of volatility is the right move. You could collect huge winnings as the short sellers scramble to cover their bets before they are wiped out completely.

Your correspondent (left) on the floor of the New York Stock Exchange with television anchor Lelde Smits, and Stephen “Sarge” Guilfoyle during a recent visit. Sarge is the director of NYSE floor operations and one of the savviest traders on the floor. He told me, “Jim, there’s no liquidity here; it left a long time ago. When markets turn, they won’t get any support from the floor.”

The chart below shows a 20-year history of volatility spikes. You can observe long periods of relatively low volatility such as 2004 to 2007, and 2013 to mid-2015, but these are inevitably followed by volatility super-spikes.

During these super-spikes the sellers of volatility are crushed, sometimes to the point of bankruptcy because they can’t cover their bets.

The period from mid-2015 to late 2016 saw some brief volatility spikes associated with the Chinese devaluation (August and December 2015), Brexit (June 23, 2016) and the election of Donald Trump (Nov. 8, 2016). But, none of these spikes reached the super-spike levels of 2008 – 2012.

In short, we have been on a volatility holiday. Volatility is historically low and has remained so for an unusually long period of time. The sellers of volatility have been collecting “steady income,” yet this is really just a winning streak at the volatility casino.

The wheel of fortune is about to turn and luck is about to run out for the sellers. It will soon be time for the buyers of volatility to collect their winnings, big time.

Here are the key volatility drivers we have considered:

Many analysts assume that the North Korean situation is less critical today because the rhetoric has recently toned down, and the North Korean dictator, Kim Jong Un, said that he would delay his plan to fire missiles at the U.S. Territory of Guam.

But, that’s false comfort. Kim’s statement of restraint on Guam was conditional on “good behavior” by the U.S. That was a reference to a previously planned joint military exercise of U.S. and South Korean forces running from Aug. 21 – 31, 2017. Kim’s idea of good behavior was if the U.S. called off the exercise.

That wasn’t happening.

The military exercise started as planned late Sunday. Now all bets are off. Kim could fire a missile at Guam, which the U.S. has already said it will shoot down.

Kim could also test a submarine-launched ballistic missile (SLBM) that could evade U.S. anti-missile defenses or be fired at close range at the U.S. west coast. Kim might test a new nuclear weapon; perhaps a miniaturized warhead that would be the right size to place in the warhead of his ICBM that can strike Los Angeles.

One or more of these provocations seems highly likely. The U.S. response will be firm and potentially aggressive. This would put the North Korean crisis back on the front burner, and send volatility soaring.

Another ticking time bomb for a volatility spike is Washington, DC dysfunction, and the potential double train wreck coming on Sept. 29. That’s the day the U.S. Treasury is estimated to run out of cash. It’s also the last day of the U.S. fiscal year; (technically the last day is Sept. 30, but that’s a Saturday this year so Sept. 29 is the last business day).

Congress has to pass two major pieces of legislation. One is a debt ceiling increase so the Treasury does not run out of money. The other is a continuing resolution so the government does not shut down.

Both bills could be stymied by conservatives who want to tie the legislation to issues such as funding for Trump’s wall, sanctuary cities, funding for planned parenthood, funding to bailout Obamacare and other hot button issues.

If the conservatives don’t get what they want, they won’t vote for the legislation. If conservatives do get what they want, moderates will bolt and not support the bills. Democrats are watching Republican infighting with glee and see no reason to help with their votes. The White House has already said that a “good” government shutdown may be desirable to help crystallize the policy debate.

If these two legislative fixes are not done by Sept. 29, we’re facing both a government shutdown, and the potential for a default on the U.S. debt. Time is short and my estimate is that one or both of these pieces of legislation will not be completed in time. This will certainly trigger a volatility spike and produce huge profits for investors who make the right moves now.

Other sources of volatility include a planned “Day of Rage” on Nov. 4 when alt-left and antifa activists plan major demonstrations in U.S. cities from coast-to-coast. Antifa are neo-fascists posing as antifascists; hence the name “antifa.” Based on past antifa actions in UC Berkeley and Middlebury College violence cannot be ruled out. This could be unsettling to markets and be another source of volatility.

Then there are the wild cards including a natural disaster such as a hurricane, which can threaten the U.S. eastern seaboard or Gulf coast this time of year. In fact, a potential Category 3 hurricane is bearing down on Texas’ Gulf coast right now. It could dump up to 30 inches of rain and cause great destruction in the area.

Hurricane Katrina struck at the very end of August in 2005 and Superstorm Sandy hit the Jersey Shore in October 2012. Both did enormous damage and unsettled markets for a time.

Other wild cards include domestic terror and cyber attacks.

Finally, we are entering an historically volatile time of year. Many of the greatest stock market crashes of all time have occurred in September or October including the Black Thursday (Oct. 24, 1929) and Black Tuesday (Oct. 29, 1929) crashes that started the Great Depression, and the Black Monday (Oct. 19, 1987) crash, in which the stock market fell 22.61% in a single day. From today’s levels, a 22.61% drop would mean a loss of 4,900 Dow points in a single day.

Don’t rule it out.

None of these scenarios are far-fetched or even unlikely. The war with North Korea is coming. Washington, DC dysfunction is a fact of life and we’ve had several government shutdowns in recent years. Social unrest is spreading and in the headlines every day. Hurricanes and terror attacks happen with some frequency.

It has been nine years since the last financial panic so a new one tomorrow should come as no surprise.

In short, the catalysts for a volatility spike are all in place. We could even get a record super-spike in volatility if several of these catalysts converge.

Investors who prepare now for this coming wave of market shocks stand to realize huge gains when volatility roars back to life after sleepwalking for months.

America Is On Its Way To Divorce Court

Authored by Marc Thiessen via PennLive.com,

There is a place for contempt in our public discourse.

We should have contempt for a regime in North Korea that brutalized a young American student named Otto Warmbier. We should have contempt for a regime in Syria that uses poison gas to massacre innocent men, women and children. We should have contempt for Islamic State terrorists who behead Americans, burn people alive in cages and systematically rape Yazidi girls.

But we should not have contempt for each other.

Yet, we do. Our politics today is descending into a bitter spiral of contempt. And we saw the consequences in the attempted assassination of Republican members of Congress on a baseball field in Alexandria, Virginia, last week.

Back when Rep. Gabrielle Giffords, D-Ariz., was shot in 2011, many on the left were quick to blame conservative political rhetoric - falsely it turned out. But the attack on Rep. Steve Scalise, R-La., and his colleagues was politically motivated. The assassin volunteered for Sen. Bernie Sanders, I-Vt., called President Trump a "traitor" on social media and, according to witnesses, asked if the players were Republicans before opening fire.

No one is responsible except the would-be assassin. But his actions should serve as a wake-up call that the demonization of our fellow Americans who disagree with us has gone too far. The culture of contempt permeating our politics has now had near-fatal consequences. We need to put on the brakes and learn how to distinguish once again between our opponents and our enemies.

Case in point: A few weeks before the Alexandria shooting, Hillary Clinton gave a commencement speech at Wellesley College where she declared that Trump"s budget is "an attack of unimaginable cruelty on the most vulnerable among us, the youngest, the oldest, the poorest." No, it is not. Using nerve agent on the innocent is "an attack of unimaginable cruelty." Putting a hapless college student into a coma is an "attack of unimaginable cruelty." Reducing the growth of government spending is not.

Think for a moment what Clinton was saying: It"s not simply that Democrats and Republicans have an honest disagreement about how best to help the most vulnerable among us. In Clinton"s telling, Republicans are waging war on the vulnerable. That is toxic.

No doubt, Trump has contributed mightily to our descent into the culture of contempt. (For example, the media is not the "enemy of the American people," Mr. President). But since Trump"s election, the scope and scale of political contempt on the left have reached unprecedented heights. Just a few months ago, when President Barack Obama was in office, it would have been unimaginable for a comedian to proudly pose for a photo holding up the president"s bloody, severed head.

Worst of all, we are in the process of cementing these attitudes in the next generation. On college campuses, students are being taught that it is acceptable to treat with contempt those with different ideas. We saw this phenomenon on display when Charles Murray - a distinguished conservative scholar - was shouted down and assaulted at Middlebury College in a riot that sent a professor to the hospital. Not a single student suffered any real consequences. Similar incidents are taking place on campuses across the country. Young Americans are learning that people they disagree with are not to be listened to respectfully and debated; they are to be silenced and driven out of the public square.

This is not to suggest that there is no role for righteous anger in political discourse. Conservatives felt anger about many of Obama"s policies, and liberals have every right to be angry about Trump"s policies they find objectionable. And they have every right to fight like hell to stop them.

But it wasn"t so long ago that, despite bitter differences over policies, Republicans and Democrats still found ways to work together. President Bill Clinton and Republicans in Congress worked together to pass NAFTA and welfare reform. George W. Bush and congressional Democrats cooperated to pass tax cuts and education reform. Today, that kind of cooperation is unimaginable.

And the reason is simple: When anger transforms into contempt, permanent damage takes place. As American Enterprise Institute President Arthur C. Brooks points out, a marriage can recover from anger. But when couples become contemptuous of each other, they will almost certainly end up in divorce court. That is where our country is headed today.

Liberals need to understand: When they show contempt for Trump, they are expressing contempt for the millions of Americans who voted for him - including millions who twice voted for Obama. These Americans felt that the establishments of both parties were ignoring them and wanted to send Washington a message. The response they are receiving could not be clearer: We have contempt for the man you elected, and we have contempt for all of you who put him into office. They will never forget it.

We need to pull back from this spiral of contempt before it is too late. North Korea is our enemy. Our fellow Americans who disagree with us are not. It"s time we learn the difference - before someone gets killed.

Meet The Man Behind The Market's Relentless Ramp

In an ironic twist of fate, it appears the catalyst for many of the biggest and most incomprehensible market ramps of the last few years is a fund called "Catalyst." With around $4 billion under management (before the latest collapse), the levered options fund is run by Edward Walczak who "uses options to create a better risk/return profile."

The Catalyst Hedged Futures Strategy Fund is an open-end fund incorporated in the USA. The objective is capital appreciation and capital preservation in all market conditions. The Fund invests primarily in long and short call and put options on S&P 500 Index futures contracts and in cash and cash equivalents, including high-quality short-term (3 months or less) fixed-income securities. 

A "great/lucky" year in 2008 and solid returns since...

Until recently...

• 1 Week -14.07%


• 1 Month -12.61%


• 3 Months -16.96%


• YTD -13.56%


• 1 Year -10.11%


• 3 Year -1.08%

Things have not gone well since the election...

As we noted previously, the melt-up in the S&P is the result of "a purported / murky melt-down over the past week in a large trade by a multi-billion Dollar (open-ended) futures fund which sells vol on S&P.  Without going into specifics, there is market speculation that the entity is effectively short upwards of ~$17B of SPX (deltas to buy) through selling February expiry upside 1x5 (or 1x4) call spreads."

And here is the man that runs the show...

As FuturesMag.com detailed previously, Edward Walczak began his trading career after 25 years in business operations and supply chain management. It was Walczak’s experience running Chicago-based candy manufacturer Brach’s commodity hedging operation in the late 1990s that got him deeply involved in the markets.

At one point, Walczak’s boss asked him about position limits and he had no idea what he was talking about, Walczak says. “You only get embarrassed once and I spent a week with my trader [learning] the business and became intrigued by it.” Walczak is a math guy with degrees in Physics and Economics from Middlebury College and an MBA from Harvard, so naturally he was drawn to options. By 2005 he was making more money trading than in his day job, so he began trading proprietary money full-time and set up a commodity pool for friends and family. In 2006 his proprietary trading returned 52.68% and in 2007 he added customer accounts to the Madison, Wis. based Harbor Financial LLC.

Fortunate breaks come in all forms. For Walczak his biggest break may have been a painful February 2007  drawdown in his mainly option writing S&P 500 program. The drawdown was not fatal, 17.93% for the month, and the program was positive for the year, but it made Walczak rethink his overall approach. “Back in ’07, VIX was trading around 10 and all of a sudden the S&Ps dropped 50 handles in a day,” Walczak says. “A 50-point drop at the time was a big deal but historically was not that bizarre. It could have been a lot worse and I could have been wiped out, so I had to do something different.” He spent the next year researching. “How do I cover these other risks that are out there and how [do I] use options to have a better risk/return profile?” he asked himself.

He began a study of volatility and decided to move away from pure premium collection. “If you are strictly a premium collector, you have a couple of issues. If you collect $2, then $2 is the best you can make if everything goes right. Second, if that is the only way you can make money, then you often are tempted into doing a collection trade when the edge is not with you,” Walczak says.

What he discovered was a volatility trading strategy that could exploit rising volatility. “A simple example is you sell a front-month option and buy a back-month option. If you do that at a credit, you have the opportunity for the front-month option to decay in value or go away entirely and the back-month option still has value,” he says. “The secret sauce for us is in the placement. If you are correct with where you place these things, then you get the best of both worlds. You don’t just have residual value in that long option, the long option actually could explode in value while the short option goes away.”

The February 2007 wakeup call came enough in advance of 2008 for Walczak to complete his adjustments and earn 50% in 2008, a year that completely wiped out a number of option writers. “We found that rather than trying to trend-follow price to the downside, it is better with options to trend-follow volatility to the upside,” Walczak says. “Usually those are two conditions that go hand in hand.”

While the volatility trading strategy helped diversify the program and turn 2008 from a potential disaster to a home run, Walczak still was having problems in sharply uptrending markets. “Those really caused us a lot of problems with the techniques we were using, so I spent a lot of time [on that] and in 2010, we [began] to do some trend-following price wise.”

They still were using only options and found they could exploit trends more safely this way. The strategy uses a wide variety of ratio spreads, butterflies and offset butterflies. “It is basically 1 x 2s, 1 x 3s, 1 x 2 x 1s, where you are buying one, selling two, buying one,” he says. “That allows us to put trades on for little or no cost, so if the market tanks we are not long the market. We don’t lose money, the trade just goes away.” Walczak says, “It is not that we changed so much as we evolved: Premium collection, to premium collection plus volatility trading, to premium collection plus volatility trading plus upside trend-following price-wise.”

Walczak uses all three approaches but emphasizes the one appropriate to market conditions. “I can construct a spread that gives me the exposure I want. It is not a make-it-up-as-you-go-along [approach], we have established position templates for different types of market environments. If I want to go long volatility, I don’t scratch my head and say, ‘What do I do now?’ We go into our tool box and pull out the long volatility spread and do some analysis around where to put that on.” It is a combination of a discretionary and systematic approach that has produced solid returns in different market environments. Harbor has had no losing years and has produced a compound annual return of 22.07% with a 1.22 Sharpe ratio, and Walczak is still making improvements.

*  *  *

So major leverage on billions of AUM and a look at the unprecedented ramps in US equity markets over the last few years shows that perhaps Walczak and his fund did not fully figure out the "problems in sharply uptrending markets."

The Bullard Bounce?

The Brexit Bounce?

The Trump Bounce?

Of course, Walczak"s strategy is not alone and if not the catalyst it is these levered options strategies that are the reflexive forced buyer that appears to be driving such self-reinforcing and seemingly incredible moves in stock markets as volatility has collapsed and the cost if funding massively levered strategies is de minimus. In a different world of considerably lower leverage, LTCM nearly blew up the world; in the new normal of as-much-leverage-as-you-can-eat, even a mid-sized fund"s positions can be the butterfly that flaps its wings and become the forced "ax" in world equity markets... even if it doesn"t know it.

Just how much of the last 150 S&P points are due to the liquidation of "Catalyst" (and strategies like it)?

As RBC"s Charlie McElligott warned:

This equities upside short-gamma grab has taken out a ton of ‘bid on the downside’ in equities index, in the case that we were to see any sell-off post a Trump speech disappointment.  This lack of cover-demand on a vacuum-move could see sloppiness develop, as it seems that the data and Fed itself are no longer dictating the market story at this stage - whether stocks, fixed-income or vol.  “Policy” is now firmly “in the driver’s seat,” and that is where I see the least degree of confidence in the market.

I’m worried that this stock ‘melt-up’ move is extraordinarily mechanical right now - almost entirely the aforementioned forced-covering, not high conviction induced-buying - and may be sending a “false signal” which is potentially dragging-in new buying on the breakout to new highs.

As he concludes: "This could lead to a scenario where a market can “collapse under their own weight."

Indeed, because if one removes the forced buying from the "blowing up fund", there is certainly a long way down.