A monthly open letter to the investors that read my work
Author’s Note: I am currently attempting to see if it is viable for me to host a charity live stream to raise funds for humanitarian relief in Ukraine. If this is something I can do I will send a follow-up email to subscribers with details on when the event is occurring and how to support relief efforts.
About once a month, whether it’s because I’m moving, bogged down with other work, or in this case trying to schedule interviews for the next company I’m covering on the newsletter, I’m not able to publish a coverage piece on a company. I like to take these times instead to give commentary and thoughts on what’s going on in the market, provide my point of view on trends that have been developing, and share what my plans are for the newsletter.
Again, this isn’t going to be me meticulously explaining why a single stock is doing a certain thing but taking a look at deeper mechanics happening in the markets, with a meme or two here and there. With that out of the way let’s get this show on the road and hope this investor relations team I’m reaching out to gives a response to my hail mary like Joe Burrow’s o-line never could.
Without a doubt, you know this year has had a usually volatile start in the markets. Just in Nasdaq 100 futures, the year-to-date performance was a loss of over 20% overnight on Wednesday, with the market facing steep declines so far, including the S&P 500 entering correction territory.
As we talked about in last month’s newsletter, the indexes have been hiding declines that were far more severe in single stocks, a substantial problem for individual investors that are underweight in the mega-cap names that have declined less, holding the “market” up as a result. Bet sizing matters whether you’re a large fund manager or someone playing with a small balance of their own money.
While the carnage has been immense, especially in speculative stocks, I want to focus on volatility and the psychology of hedging. I’m currently in a derivatives course for my graduate school program learning about futures among other items and the lessons seem particularly relevant with the market developments not just this year, but within the past week.
I think the VIX is a useful item in this case not just because of its standardized acceptance as a tool of measuring forward perception of volatility but also because of long-term trends in the index that I want to point out.
For a brief definition, the VIX is simply an index that measures the expectation of future volatility by measuring the prices of index options expiring in the next 23-37 days. The higher the option prices, the greater the expected volatility and the higher the index goes.
So far, the VIX is up 60% this year and closed Friday at a level of 27.57, far higher than its base level of 16 in “calm” markets during the second half of 2021. As you can see, the VIX was far higher than this on just Thursday, peaking near 38 early that morning. What has caused this whipsaw?
I think we all know the answer for volatility in general in February is the developments regarding Russia’s invasion of Ukraine. Fear over the potential outbreak of conflict which has unfortunately occurred created uncertainty among investors, leading to them buying more puts, pushing option prices and the VIX higher.
However, volatility has fallen markedly since the first shots were fired as the market has staged a dramatic two-day recovery. While some people are scratching their heads and saying on Twitter that this makes no sense, it is an observed historical phenomenon that markets tend to recover after a military conflict begins.
This is because of the same reason that the markets were going higher in March and April of 2020 despite horrendous immediate economic developments as the pandemic started. When everyone has insurance against an event, there are far fewer additional sellers for a negative event which allows the market to move higher.
In the two weeks leading up to the outbreak of the conflict, volatility was up almost 100% from its calm period levels as investors bought protection or sold in fear of the potential conflict. Since the market was increasingly hedged before the event, it was difficult for any sustained drop to last.
Although the war is far more expansive than I assume most would have predicted, market participants already being hedged against the event has allowed for a substantial recovery. As of the time of writing, S&P 500 futures are over 2% higher than they were before Putin recognized the Russian-backed areas in Eastern Ukraine as independent states that paved the way for military conflict.
Monday morning edit: Volatility is up and the market is down substantially overnight since I finished writing this. While the whole discussion about why the market may try to rebound as people had a level of hedging already done is true in markets, the market overall did not anticipate such unified and harsh economic sanctions even at the risk of harming the economies of the people making the sanctions.
The ongoing developments are very fluid and prone to change, anyone who tells you they know what is going to happen next regarding the geopolitics and crisis, in general, are almost certainly not telling the truth.
The year has certainly had a volatile start, but there are also interesting mechanics with long-term volatility that are worth looking at in my mind. In particular, I believe that the dramatic rise in the notional value of options being traded is leading to higher levels of base volatility in the market.
While the daily notional value of stocks in 2021 nearly doubled, notional option volume more than quadrupled to over $450 billion a day, passing notional stock volume for the first time. While it’s a fact that illiquid markets tend to be more volatile than liquid ones, the surge in trading of leveraged instruments like derivatives could be leading to higher volatility.
Take this normalized performance chart of the VIX from the middle of 2017 to today. While it does take time for volatility to normalize after a spike to the level we saw in 2020, the fact that the VIX’s base level remained over 20%+ higher than it was before the pandemic despite the S&P 500 being over 40% higher indicates to me that something may be up. I'm no expert in this regard, but I would love to see case studies on whether the increased derivative volume in the markets is leading to higher overall market volatility.
State of The Theta Thoughts
With the main segment of this week’s newsletter done, I want to create a “State of The Theta Thoughts” in these monthly commentaries to share my thoughts on how the newsletter is doing and what people should expect going forward.
Firstly, I want to say thank you to everyone reading this. Two months in and we’ve nearing 25,000 words written across 12 pieces (including this one). Since the last update I gave on January 24, the newsletter has more than tripled in size to over 225 subscribers and passed 5,000 article views.
To everyone that’s been reading since the start to those that subscribed in the past week, thank you from the bottom of my heart. The fact that you as investors find what I have to say worthwhile means so much and will continue to drive me in getting better. I’m still at the early stages of the learning process for this industry but hope to keep improving and learn more with each day.
Growth in the last month was largely on the back of the bear thesis I wrote on Facebook garnering significant recognition on Twitter after much of what I wrote about was validated in the company’s fourth-quarter earnings report. There was also a second influx of new subscribers after I published negatively on Black Rifle Coffee, emphasizing concerns about management and the company’s growth forecast.
To date, every company that has had a bullish/bearish stance taken on it has moved in said direction since coverage on that stock was initiated. Notably, I did not take a stance on Tenneco as the $19 price target model I put in the newsletter was more of a thought experiment. Since that piece, Tenneco’s stock has nearly doubled as it was announced that the company is being taken private at $20. A missed opportunity would be an understatement, but unless you have insider information you wouldn’t know that such an event was happening.
While I hope my “hit-rate” can remain impressive over time as I grow my analysis skills further, expecting perfection to remain is wholly unrealistic. The best stock-pickers are wrong almost half the time and I strongly anticipate that at some point the names I already have a stance on will prove me wrong, as will happen with countless future companies that I cover. There’s a dissonance between knowing this fact and the reality that in a public sphere people will expect perfection, but that is simply something I have to come to terms with.
Thank you again for finding this work important enough to keep in your inbox. I’ll see you next week with a new company worth covering. Take care.
This article is not investment advice and only represents the thoughts of Strat Becker. You can reach me by email at RealStratBeckerYT@gmail.com, on Twitter @StratBecker, or on Commonstock @Strat. This article is for subscribers of the Theta Thoughts newsletter. If this was shared with you please consider subscribing to receive free stock analysis like this every Monday.