prior to the beginning of 2022 the new yorkbased volatility arbitrage fund the ambrus group postulated a change in the market microstructure in a video the firm’s leadership said markets were fragile and traditional portfolio constructions such as 6040 were suboptimal “it’s a bit scary to think that there are people that manage hundreds of millions using dogmatic approaches when it comes to protecting a portfolio from a disaster” cochief investment officer kris sidial said in the video using derivatives colloquially referred to as volatility investors could “potentially outperform the market” and limit losses after last speaking with ambrus in mid2021 benzinga checked in with sidial this month to reflect on his market perspectives as well as discuss opportunities and threats in 2023 if you’re new to the game 6040 is a portfolio construction wherein 60 of the holdings are in stocks and 40 of the holdings are in bonds the mix is supposed to perform well in most volatile markets history would suggest however 6040 endured one of its worst stretches last year despite this ambrus managed to end positively using volatility an area of the markets it is committed to educating investors about via its publicly available research “that does not mean all volatility funds ended the same way” sidial said in a nod to his team’s unique method of leveraging options’ multidimensionality to note ambrus’ methods are limiting though by adding to its assets under management the firm can run the risk of eating away its own alpha or ability to outperform “therefore we want to stay as a smaller to mediumsized firm” sidial explained adding that at ambrus “quality matters more than quantity” and it’s better to run “just a few topnotch funds in terms of pure alpha rather than scaling too far and potentially underperforming” also read was fed chair jerome powell the big bad wolf of 2022 will his reputation turn in 2023 as noted 2022 was a difficult year for some equity volatility funds competing with ambrus “it was a surprise that owning volatility underperformed broadly speaking a high spotvol beta had us thinking volatility was coming to life we thought there would be more followthrough” in short volatility’s sensitivity to underlying prices was low and sidial cast blame in part on commodity trading advisors and strong volatility supply “one of the reasons was the attraction to ctas” who hedged against inflation and rising rates with commodity exposure “second traders looked at 2022 as an opportunity to sell volatility the consensus trade that a slow grind down would be the case was right basically investors expected the market to fall some sold their equities and bought volatility proactively when the decline happened investors opted to monetize and sell volatility a heightened cboe volatility index or vix as well as inflated measures like the puttocall ratio likely the result of stock loan desks replacing their short stock with deepinthemoney puts due to higher interest rates masked the pressure options prices were under though volatility prices can move towards the extremes clustering and meanreverting current trends may eventually become exhausted naive measures like the vvix which is the volatility of the vix or the volatility of the sp 500s volatility are printing at levels last seen in 2017 this would suggest “we can get cheap exposure to convexity while a lot of people are worried” “even if inflation continues the rate at which it rises won’t be the same due to this cta exposures likely will not perform as well as they did in 2022 and that’s why you may see more opportunities in the volatility space” the major risks to markets in 2023 exchanges are enabling traders to express their opinions across more options that expire over shorter and longertime horizons options trading in certain cashsettled products is available nearly 24 hours now as well on the other side of the growing sp 500 and vix complexes is a small concentrated group of market makers taking on far more exposure to risk this and the private market investors’ liquidity issues are concerns that may lead to volatility outperforming “during moments of market stress the market makers are unable to keep up with the demands of frenetic investors if you think of gamestop corp gme which we discussed before there was this reflexive dynamic that happened when investors rushed into the stock one way” “that same dynamic can happen on the way down” market makers will mark up options prices during stressful events which can pressure markets as the price of options rises option deltas or their exposure to direction rise and this prompts bearish vanna hedging flows as they are called sidial said additionally private market investors raising cash to meet capital calls may prompt sales of the more liquid public markets “there are large pension plans in the us and their marktomarket or marktomodel private deals are getting marked down to source liquidity they may have to sell some of their holdings in the public equity markets” at the end of the day markets are dynamic and you have to take what they give you not having a process and “crab investing” may result in investors missing out on opportunities therefore “having an outlook and process to express that outlook” like ambrus which doesn’t “put trades on a whim or take macro bets” is optimal “it’s not as easy as saying ‘buy volatility because it’s cheap or sell it because it is expensive’” as a validation sidial pointed to 2017 when volatility was at some of its lowest levels back then the correct trade was to sell volatility because volatility can be bimodal” therefore if you sold volatility you made money due to its clustering “if you’re trading volatility let there be an underlying catalyst for doing so” he suggested now read tesla will have a knockdown 2023 but this vehicle alone has potential to restart delivery growth analyst