Logica Capital's commentary for the month ended November 2023.
Summary
Markets surged in November toward all-time highs. The S&P 500 posted its 9th largest monthly gain since 1990, and demonstrated remarkable market breadth, with nearly all sectors showing a positive return with the exception of Energy. Implied Volatility (IV) behaved about as expected given the S&P 500’s powerful month, with the VIX index recording its lowest close since before the pandemic on November 24. Logica’s strategies withstood this IV decline headwind with a relatively solid month.
1) Returns are net of fees and represent the returns of Logica Absolute Return Fund, LP and Logica Tail Risk Fund, LP, respectively. Past performance is not indicative of future results.
2) Naïve Straddle Return: a 1.5 month out, S&P 500 at-the-money put and call bought on the final trading day of prior month and sold on the final trading day of current month. This return on premium is divided by a factor of 6 to be comparable to Logica’s typical AUM-to-premium ratio. For illustration purposes only.
3) Naïve Ratio Straddle Return: a 1.5 month out, S&P 500 at-the-money put and at-the-money call (divided by 2) bought on the final trading day of prior month and sold on the final trading day of current month. This return on premium is divided by a factor of 6 to be comparable to Logica’s typical AUM-to-premium ratio. For illustration purposes only.
4) S&P 500. The index measures the performance of the large-cap segment of the U.S. market. Considered to be a proxy of the U.S. equity market, the index is composed of 500+ constituent companies.
5) The Nasdaq-100 is a stock market index made up of 101 equity securities issued by 100 of the largest non-financial companies listed on the Nasdaq stock exchange.
6) The Dow Jones Industrial Average is a stock market index of 30 prominent companies listed on stock exchanges in the United States.
7) The Russell 2000 Index is a small-cap U.S. stock market index that makes up the smallest 2,000 stocks in the Russell 3000 Index.
The Portfolio: Looking Inside - Commentary & Portfolio Return Attribution
8) For illustration purposes only. Attribution returns are composed of daily returns, gross of fees
"There are only two tragedies in life: one is not getting what we want, and the other is getting it" - Oscar Wilde
Our portfolio attribution unfolded roughly as expected, with upside Calls contributing nicely with the rally, and downside Puts, as expected, contributing negatively. With that larger backdrop, there were few surprises. That said, it is worth discussing the zero contribution from our Fast-Scalping Call module, which some might find counter-intuitive. This provides an opportunity to explain November’s outcome as well as share more detail about our models for better understanding of future outcomes.
In simple terms, by its very nature, scalping thrives on market “jitter” rather than aggressive trending; that is, the underlying markets must oscillate enough to allow for “buy some lower” followed by “sell some of that higher”. Or said differently, if there is not enough of a pull-back in the market one seeks to scalp, there is no chance to re-load what has been sold off.
And this is what happened to Fast-Scalping in November, given the largest pull-back in the S&P was 78bps on Nov 9th. Outside of four other far tinier down moves, every other day or cumulative set of days in November were positive. Accordingly, there was not much opportunity to capture higher frequency jitters. Fast-Scalping, really, is far more suited to clustering or range bound movement, or at the very least, oscillations along a trend. Albeit our models are not as simple as looking for a pull-back of x%, as they consider multiple timeframes, as well as the corresponding behavior of the Volatility market with the underlying. But the larger point is analogous, and the results, similar enough to enable a fuller understanding. Finally, and as mentioned various times over the years, results like these demonstrate why we infuse multiple frequencies: some markets are Faster, and some Slower, and we do not believe there is edge in timing such frequency regimes.
Separately, our Sector & Single Stock Calls kept pace nicely with the S&P 500, helped by the broadening out of the market rally. The thin breadth rally that catapulted the S&P500 forward for much of 2023 was tough to watch from the sidelines, so we were pleased to see the participation widen out. This was not only a positive development on its own, but such broader participation often indicates an overall improvement in the health of the market at large.
That said, and even though we are happy to see the widening breadth, we continue to observe an extended factor divergence. It’s difficult to not expect this to create more issues sooner or later, whether by a reversion to correct the imbalance, or other effects of a continued dispersion. Accordingly, we continue to be diversified on the Call side of the book in order to minimize whipsaws related to factor rotations.
The bigger story for our strategies in November was that of our Delta/Gamma Scalping and Vega Scalping. This is a great opportunity to take a deeper look at how we manage risk/exposure in months that can get extremely “one-sided” with respect to the return of the underlying (in November’s case, the explosive melt-up of the S&P).
"The computer can’t tell you the emotional story. It can give you the exact mathematical design, but what’s missing is the eyebrows." - Frank Zappa
In the charts above, the Delta/Gamma Scalping graph indicates a predominance of positive outcomes. Throughout the month, our strategies consistently maintained an above-average Delta tilt, aligning with our models’ expectations of the S&P’s continued movement, and this approach proved rewarding. However, upon examining the subsequent Vega Scalping graph, the opposite pattern emerges. We observe several “poor” outcomes as our Vega exposure (sensitivity to change in volatility) consistently remained above average in November, a period during which implied volatility (IV) declined.
It is crucial to recognize and appreciate that this apparent contradiction is intentional and by design. The dichotomy in the results is a deliberate aspect of our strategy, where different components are designed to excel under specific market conditions. This intentional design allows our overall approach to navigate and adapt to diverse market scenarios.
One can think of Delta/Gamma versus Vega as naturally “opposing” forces, given that over the long history of markets, and in line with rational context behind it, Vega/IV is very highly negative correlated to the directional movement of its underlying (i.e. when the underlying goes up, IV usually goes down). And by rational context behind it, we mean that when markets are in a “risk on” phase, there tends to be more certainty, and therefore lower Vol, whereas when markets are breaking down, and moving toward “risk off”, the inherent uncertainty begets higher Volatility. So given this opposing nature, we have built parameters into our models that very rarely allow too much risk to be taken from either “variable”; that is, when Delta is high, Vega is also high. When delta is high, we are exposed to a sell-off in the market. But high Vega also implies that losses from the market sell-off should be offset by profits from the associated rise in Volatility. Separately, when Delta is low, Vega is also low. There are of course exceptions to these rules, but this is the general approach, which one can visualize like this:
For illustration purposes only.
Source: Logica Capital Advisers. Points represent historical daily Vega and Delta exposure for LAR from June 2021 – Present
The majority of our positioning and observations fall within the middle range, where the Delta/Gamma risk is moderate, and exposure to Vega is lower. Additionally, we can observe a deliberate aversion to the red and yellow zones. The avoided red zone signifies higher risk, characterized by potential overexposure with a significant Delta tilt and insufficient Vega protection. On the other hand, the yellow zone presents an entirely different risk profile, having an abundance of Vega with minimal Delta tilt. While advantageous during a crisis, this scenario is less favorable the majority of the time, as it leads to undesirable levels of bleed or expense.
Conversely, we show an abundance of observations in the high Vega, high Delta corner (upper right), which is a position we tend to like. It gives us the advantage of capturing market upside while also carrying a large amount of Vega/Put exposure on the books should a crisis event occur. In the simplest of terms, the market can carry its own insurance. And given the market exposure and/or directional tilt is implemented through optionality (long Calls), it will still be defensive during crisis, both providing concavity (losing less in a Call option as the underlying goes the “wrong” way) and offering positive Vega (gaining in value as IV climbs/spikes). In this way, we seek to take the most advantage of the valuable characteristics of optionality.
In summary, during November, we spent most of our time in the upper right quadrant, enabling our strategies to strongly capture market upside while also carrying high Vega exposure (had a crisis ensued, or some drastic turn in the inflationary concerns that we have all been facing, etc…). Further, this is in part helped substantially by a “normal, expected” move from IV (which we will talk about below), that more easily allows us to carry this added Vega exposure.
Finally, looking more closely at our daily movement, we see LAR track nicely with the S&P 500, and LTR holding up well with its “short” market exposure in the face of a powerful rally in the underlying. As much as we like to see LAR participate, we also enjoy seeing LTR express its asymmetry to up markets, nicely holding on to its heavy protection at a lower burden.
The Volatility Market: Looking Outside
"I skate to where the puck is going to be, not where it has been." - Wayne Gretzky
As we can see in the chart below, the VIX/IV response in November appeared right in line with expectations.
However, if we consider that VIX started the month just above 18, which is just slightly above its long-term historical median (just below 18), we might have expected even less of a VIX/IV crush than we experienced in November. In other words, when estimating the likely movement of VIX/IV, we need to consider its starting point. For instance, in an extreme scenario, when IV is at 50, it can easily change by 10 points. However, at a lower level like 15, losing 10 points down to 5 would be highly unlikely.
In prior letters, we have used the analogy of Vol being a compressing spring, wherein, as you squish it down further, it gets tougher and tougher to continue pushing it. The coiling becomes the force of resistance. Similarly, when IV gets lower, we expect less downward movement (and, of course, a whole lot more area to benefit into the right skew).
If we look at the chart below, demonstrating all occasions the VIX has come from around 18 over the last 30 years (from 1990-present) versus an average 1 month move in the S&P 500 (rolling 21 days, so agnostic to the calendar), we observe a notable turning point point at S&P +5-6% where being long IV becomes favorable. In other words, when the VIX starts at around 18 and the S&P 500 goes up 4% in the subsequent month, the VIX drops on average – as you would expect from the inverse correlation between the VIX and the S&P 500. But if the market increases more than 5-6%, the VIX ceases dropping and even starts to increase. More broadly, this highlights how volatility is truly a function of movement itself, independent of direction, even though it spends so much time negatively correlated to the S&P 500. Essentially, its reliable behavior “on average” is not its behavior at the extremes, whether left or right tail. For Logica’s strategies, given our 100% gross long volatility exposure, these kinds of extreme months are when we more easily exit the “valley” of the straddle, and have wider opportunity to benefit to the upside.
"The conditions in the pure air of the Colorado Mountains proved extremely favorable for my experiments, and the results were most gratifying to me." - Nikola Tesla
Looking elsewhere, and rather interestingly, we can see that the S&P 500 Option moneyness slope is still hanging near all-time lows.
While this may indicate that out-of-the-money (OTM) options are cheap relative to at-the-money (ATM) options, conversely, some interpret this metric to show a lack of true fear in the markets and thus an increased likelihood of calm waters/volatility suppression ahead. We continue to be prepared for that scenario, as we know it’s only a matter of time until it unwinds (or something anomalous or surprising occurs), and in the meantime, we believe we’re better positioned to take advantage of a lower realized vol environment. With IV being so much cheaper than it has been for quite a few years (generally, since Covid), and much closer to its long-term lower bound, we are far more able to benefit our trading strategies’ alpha rather than fighting the headwind of material IV decline.
