ZED FRANCIS: Index volatility has been swamped by a new systematized vol selling programs.

There's too many people out there that are rules over risk. We are 100% risk over rules. We think risk is the most important factor of driving any strategy you're running. And I do believe it's somewhat unique in the marketplace.

It is the definition of momentum or you can even take it to real extreme in some Ponzi scheme type. It's the last person left to go into the strategies will be one left with the bag, but-

MIKE GREEN: Mike Green. I'm here in Las Vegas at the Equity Derivatives Conference. We're going to sit down with Zed Francis of SpiderRock Advisors. Zed is running a really interesting strategy. He provides an overlay in volatility space for registered investment advisors in their individual accounts. I really want to actually spend some time talking with Zed about the differences between a dynamically allocated volatility strategy and the systematic simplistic strategies that are often presented, whether they're iron condors or call overriding, put overriding strategies. I think it's really important for people to understand the difference. And this is an interesting one, because it's one that individuals might actually be able to utilize in their own portfolios.

Let's talk first a little bit about what you're doing at SpiderRock because you run a fairly unique strategy, basically, do vol overlay strategies for registered investment advisors, correct?

ZED FRANCIS: Yes, correct. About 80% of our business right now is through the RA space and 20% institutional as we continue to grow. That balance will probably become closer to 50-50. But we do believe our unique function is providing overlays in the RA space.

MIKE GREEN: Okay. And when you're talking about providing a vol overlay, is this a yield enhancement strategy? Or is this a hedge strategy? Or can it be both?

ZED FRANCIS: It can be both. I'd start the conversation that it truly is a hedge. If we're doing an overlay, we are de-risking the portfolio, the beta of the portfolios going from one to less than one as soon as we start the overlay. So, without a doubt, step one is a de-risking function. But we do believe it's actually an alpha stream over time. So, if you stay with us through the full market cycle, we believe it actually will be an increased Sharpe ratio portfolio and potentially yield enhancement.

MIKE GREEN: So, that's an interesting thing when you talk about going through a cycle. So, basically, you are providing some insurance to the portfolio, your expectation is in this market, certainly, or through your systematic strategies, the techniques that you guys employ, that you're able to buy the volatility more cheaply in one place and potentially sell it in another to minimize the carry and the costs associated with that. Is that fair?

ZED FRANCIS: Yeah, that's absolutely right. I would bucket into two different categories. I'd say, macro portfolio hedge, which can involve all the single names within that portfolio, but it's a portfolio wide hedge, or on the other side, somebody that has a specific situation where they have a significant amount of their net worth in a single security. And that's a different type of hedge, but something we provide.

MIKE GREEN: Okay. So, let's think about that, for example. So, if I'm a high net worth individual who's recently sold a portion of my business, I've got a fairly sizable fraction of my worth, still tied up in my newly public Uber stock, right? What would you do mechanically?

ZED FRANCIS: So mechanically, it really depends on the risk tolerance along with how much of your net worth is in that single security. I would always lean towards the idea of doing more of a covered call strategy and utilizing the premium received from these covered calls in the active management process that we provide as the best means to hedge. But if that single security is 90% of your net worth, we're going to steer you towards a collar, because it's very important to actually have a floor when it's that significant portion of your overall net worth.

MIKE GREEN: Okay, so just to lay those terms out, when I'm doing a covered call, I own Uber stock, nearly public, I've sold a call against that. So, my appreciation potential for this 70% or 50% of my portfolio that is an Uber stock is somewhat limited. But in exchange for that, I'm receiving premium that allows me to effectively have extra cash, right, I get a cash flow associated with it?

ZED FRANCIS: That's exactly correct. And our management process isn't a set it and forget it, hey, this is your payoff diagram in one-year time, we're collecting 12% probably in Uber for selling a call out one year slightly out of the money. We're actively managing this. So, as Uber stock was falling since the IPO, we were rolling down these calls, continually increasing that insurance premium through time. And so, the only thing you're susceptible to is the instantaneous overnight 50% correction. And for those folks where it's such a huge portion of their overall net worth, we do want to protect them from that. And that's why we end up collaring where we not only sell that call, but we buy the put. But for folks, whether it's 50% or less of their net worth, we actually believe the best way to hedge and provide increased returns through time is the only do the covered call.

MIKE GREEN: So, effectively in that scenario. We're in either scenario, like let's say we did the collar, right. So, typically, you do something like write a 5% out of the money call and buy a 20% out of the money put.

ZED FRANCIS: Something along those lines. And once again, it's we tailored it based on that person's specific views and risk tolerances within that portfolio. In a collar situation, where we're going to provide the most value is going to be a mismatch in calendar. And so, what that means is the tenor of the call that we're selling and the put that we're buying can be different. And the main driver of that's going to be one, the shape of the volatility surface. If you have a massively upward sloping curve, meaning shorter dated options are cheaper relative to longer dated options, we may be purchasing a shorter dated put so in a longer dated call- vice versa.

Or when you have events where you get significant vol expansion, especially in single names where December, we didn't see much of a vol expansion in index, but we did and it's been a lot of technology, especially single names, then we use that vol expansion to make that collar net short Vega i.e. we're going to sell a longer dated option via the call, buy a shorter dated option via the put, our net exposure is actually, short Vega is a short optionality because of that time differential and we're going to go ahead and try to capture that pop in volatility even in a single name.

MIKE GREEN: So, just very quickly, though, you're saying that you're selling a longer dated to call, you're buying a shorter dated input. While your characteristic is that you are short Vega because of its calendar component, you benefit positively from largely the delta rewrite, right? The directional move in the stock on a shorter dated basis, right?

ZED FRANCIS: Yeah, but like I said, we're going to be somewhat hesitant to use that tool aggressively. Only for when we see the really unique circumstances, like once again, December was a situation where longer dated volatility in index didn't really move, but it did in single names. So, Apple is a simple example. One year implied volatility in Apple went from mid-20s, close to 40. And we view that as that's a significant move. Let's go ahead and rejigger that portfolio even though it's a collar in a specific security to make sure we're short optionality, short Vega.

MIKE GREEN: So, the fourth quarter was a really interesting dynamic. And I actually just sat down with Andrew Scott to talk about some of those. We saw exactly that we saw single stock vol rise very, very sharply in the fourth quarter and yet index vol failed to perform, complete opposite of what transpired in February of 2018. Why do you think that happened? What did you see?

ZED FRANCIS: So, in my view, it's actually simple. Index volatility has been swamped by a new systematized vol selling programs out there that's being perforated throughout the institutional space. And a lot of these folks that are running these quasi systematized vol selling programs, they actually don't utilize leverage. Just like something very similar to CBOE PUT, i.e. you're going to sell a front month put that's at the money. And you're going to do it again in a month's time, and you have some guardrails to try to have some active management to add value through time, but that's generically that's going on.

So, if you think about December, if you are benchmarked essentially to the S&P 500, because I think that's what most of these especially public pension plan institutions are viewing, this vol selling program is replacing within their portfolios. They used to own stocks. Now, instead of owning stocks, I think this is a better way to own socks, I'm going to do a vol selling program. So, these guys are effectively benchmarked, maybe not in writing but mentally benchmarked to the S&P 500.

So, started in December, you sell that put, market flushes through all your strikes, you actually have outperformance in comparison to the S&P 500 due to the premium you collected day one for selling that put. If you're not allowed to use leverage, you're not allowed to trade futures, the only thing you can do is reposition that put, so a new put, you're going to go ahead and transition into a seat that looks like buying futures i.e. you're going to buy back that shorter dated put that's not deep in the money and roll it to something very long dated, a year out potentially, same strike.

So, I'd say now 15% in the money put, still 15% of the money put but moving it out the calendar 12 months in this example, makes it act like you just bought futures and captured that outperformance during the drawdown event. And so, from a transition of that role, you went from a position with essentially zero short Vega because it's a deep in the money shorter dated put to selling a significant amount of Vega due to that increase of 12 months, even though it's still deep in the money.

MIKE GREEN: So, and this is part of what we saw, right? So, when somebody is selling a deep in the money put, all right- or I'm sorry, covering a short deep in the money put position. If I go to a brokerage firm and ask them to reverse this for me, they're not actually going to go buy that put, right, because that would be incredibly capital inefficient. The regulatory environment is such that they would have to reserve far more collateral if they were to do that. So, what they would actually do is that they will take the put from you and effectively go out and reverse it through put call parody buy futures, buy a call. All right.

And so, one of the things that was so fascinating about what happened in the fourth quarter was from a sentiment standpoint, many of the indicators, things like a put call ratio, began to show explosive growth of calls. And this is really just the unwind of these positions. Does that feel fair to you?

ZED FRANCIS: No, I would agree, especially when you look at the tenor of that put call parody- I mean that put call ratio in terms of what was being traded. If you split it up between three months and N and plus three months, it would have told you two very different stories, which is exactly what was going on in this process of rolling that put position.

MIKE GREEN: Well, and this is one of the things I think is so interesting, right? And so, your firm has made a tremendous amount of investments to try to understand these types of dynamics. The systematic strategies, I would actually argue are perhaps less focused on the day to day dynamics of their risk exposures, preferring to manage them relative to a model as compared to the actual factors that are underlying the market.

ZED FRANCIS: Yeah, I always portrayed it as- there's too many people out there that are rules over risk, We are 100% risk over rules. We think risk is the most important factor of driving any strategy you're running. And I do believe it's somewhat unique in the marketplace. And last Friday was a really simple prime example. I mentioned CBOE PUT index, which a lot of folks are using as a benchmark within this space, because frankly, there's not a lot of great benchmarks so they gravitate to the one with a 30 plus year track record.

MIKE GREEN: Right- and the PUT, I'm sorry, just to make sure people understand- this is the put right index, it's put out by the CBOE and it's available on most data services, you can actually see this history. And it just involves a continuous and systematic hedged position where you own- fully funded in position and when you are selling, I believe, it's 5% out of the money puts on a one month continuous basis?

ZED FRANCIS: PUT is at the money.

MIKE GREEN: At the money, okay.

ZED FRANCIS: One month out. And what I mean by slippage of rules, what I'm alluding to here is last Friday, the puts that they're selling is SPX meaning cash settle. So, the opening print is when that old position is unwound, is settled. The process of writing the new put doesn't take place the minute after cash settlement, it's a pause of an hour and then a VWAP of another half an hour to set the strike with the one hour delay, and then a VWAP of selling that put over the next half an hour. And all of this really means is there's potential slippage between when you effectively unwind the old position and put on the new position.

And last Friday was- not even extreme example, this actually happens quite often. But you had PUT, which in theory is always going to be approximately half the risk of the S&P 500 you're selling at the money put. Day one, it's a 50 delta. It's approximately should be run at a half the risk of the S&P 500. Last Friday, in one day, PUT was down 1.2%, where the S&P was down 60 basis points and had suffered twice the amount of risk. And it's purely the slippage due to the reset. Cash settlement was low, the market rallied, they sold a new put then the market fell again. So, you lost on the same 25 points of S&P 500 twice in a single day.

MIKE GREEN: Whereas you should have lost half. So, another way of saying that is the beta was four times what you would have expected?

ZED FRANCIS: No. That's exactly right. And that's why I said the issue is risk versus rules base. If you're focused on delivering that half of S&P 500 style of risk, these type of rebalancing events are not an issue to you. You're never going to get yourself in that seat, where essentially you went from a beta of one to a beta of zero back to a beta of point five, and the chop in that process over two hours led to a poor result. It can often lead to a positive result as well. So, it's a somewhat of a random walk.

But the point of it is why are you accepting this slippage? Why- and even if you were as a manager of this benchmark to this product, your information ratio that you're going to be held accountable to your investors would tell you even if you saw an opportunity in that rebalancing process, you won't take it because a 60 basis points slippage for something is probably trying to outperform 20 to 30 basis points a year. That's too much of a risk budget on any single event. So, even if you see an opportunity, folks running a strategy based on those rules won't even extract it because it's just way out of bounds in comparison to their overall annual risk budget.

MIKE GREEN: Well, it's that and then they also just don't have the authority, right? They actually don't have the authority, they would be putting their job at risk if they were to decide to trade in a manner that was not systematic.

ZED FRANCIS: And there's a myth. There's some folks that are 100% were doing the rules, there's folks that have rules with a little bit of guidelines around it to allow you to take advantage of opportunities as part of the pitch process of raising capital. But the reality is, even if you have that flexibility, you're incredibly unlikely to use it. Because the slippage is just too great in terms of what you're pitching. You're saying, all right, our fees are 20 basis points for running this, our goal is to out-earn our fees. If in a single day, you had a 60 basis points. In this case, underperformance. Maybe next time, outperformance. It is just too big of a risk that you're taking every role that nobody's going to use that event to generate any positive returns over that benchmark.

MIKE GREEN: When you see these types of slippage events, right. And you highlighted the VWAP, right, evaluated at price, right, which is basically trying to average your cost in over a period of time, right? As these strategies get larger, that slippage potentially gets larger and larger. Is that something that you're seeing? And it goes in both directions, as you said.

ZED FRANCIS: Yeah. It goes in both directions. And I think the current size in a normal market condition is not enough to influence pricing of the S&P 500. But on something like last Friday, which was quite a quiet day in terms of overall trading activity, the likelihood of influencing those types of days I think was there in the case of last week, and as the strategies build will only increase in likelihood of that potential.

MIKE GREEN: And that then creates another challenge with the systematic strategies, right? Because systematic strategies, by definition, run off of historical data set, that historical data set doesn't contemplate the change in structure that's now created by people trading around that, right? This is a colossal control theory issue or shorting just cat, you can either guess that the cat is alive or dead, or you can open it up and you lose the probability. You exchange it for a certainty, right? You can't have something be both your measure and actively trade it.

When you think about that historical framework, are people too reliant on it? Is this something that should change? And is there a way that it can be changed? Or how are you as a firm managing it differently?

ZED FRANCIS: So, one, I actually don't think people are actively trying to change it out there. And to me, my precedent for that is the fixed income industry. Fixed income industry is a benchmark world. And if you are running a long gov Treasury portfolio benchmark to Bloomberg Barclays index, your targeted outperformance is approximately 15 basis points a year. And every