The Second Leg Down: Strategies for Profiting after a Market Sell–Off

Praise for
The Second Leg Down

"The most difficult portfolio management decisions come after an unexpectedly large loss in an unsettled market. This book tackles that situation with a comprehensive, accurate and clear account of clever strategies to navigate the troubled waters with little or no sacrifice of upside. It′s well–written and entertaining. Most of the time you′re better off with the unclever idea of cutting positions to where you′re comfortable for the risk, but if you refuse to do that, this book gives you the best chance of profiting from your aggressiveness."
Aaron Brown, Chief Risk Officer, AQR Capital Management

"Investors can be fickle, only allocating to a given strategy after a stretch of strong performance. Trend following is a classic example: it is an all–weather strategy that deserves a permanent place in a well–diversified portfolio. Reality suggests that investors only want to add defensive strategies when their core (read long beta) investments are failing them. Hari P. Krishnan has written a book that accounts for investor behavior, while providing the best possible solutions when your back is against the wall. This book is essential reading as a survival kit against disaster in your portfolio."
Niels Kaastrup Larsen, Managing Director, DUNN Capital; Founder, Top Traders Unplugged Podcast

"Hari Krishnan is one of the most practical thinkers in this business. He has forgotten what I am still trying to learn! His combination of practical real–world trading experience with theoretical know–how should lead the reader down secret pathways of knowledge few have the privilege to glimpse at, nevermind have illuminated and marked out."
Jerry Haworth, CEO, 36 South Capital Advisors

"How do you survive market crises and moves as sharp as those created by the Brexit and the US election? Predicting outcomes can be an exercise in futility, as these very recent examples have shown us. By tapping into his wealth of knowledge and experience as a fund manager during the 2008 crisis, flash crashes, crises in Europe, and many other market storms, Hari shows us how to weather these events so our portfolios can come out of the other side, intact, and maybe even having made some money in the process! Not only is the book very informative, but a great read as well!"
Marc Malek, Managing Partner, Conquest Capital Group

Preface xi

Acknowledgements xiii

About the Author xv

CHAPTER 1 Introduction 1

The Airplane Ticket Trade 1

The Bull Cycle 2

The Renegades 3

Claws of the Bear 3

Zugzwang 4

The Sceptics 5

A Sad Truth 5

Common Mistakes 6

Imprecise but Effective 7

Hedging Against Implausible Scenarios 8

A Black Swan in Correlation 8

Taking Profits 8

The Good, the Bad and the Ugly 9

The Great Escape 9

Having a Plan 10

Trend Following as a Defensive Strategy 11

Taking the Offensive 12

The Pre–Conditions for Market Crises 12

Banks: The Great Multiplier 13

A Change in Risk Regime 13

CHAPTER 2 Safe Havens and the Second Leg Down 14

The Matterhorn 15

Mrs. Watanabe s No. 1 Investment Club 18

The Risk of What Others are Holding 19

The Risk of What Others are Likely to Do 22

Here We Go Again 24

Summary 28

CHAPTER 3 An Overview of Options Strategies 29

The Building Blocks: Calls and Puts 29

Why Buy a Call or Put? 34

The Black Scholes Equation and Implied Volatility 36

The Implied Volatility Skew 38

Hedging Small Moves 38

Delta Hedging: The Idealised Case 39

Practical Limits of Delta Hedging 41

Hedging Options with Other Options 43

Put and Call Spreads 43

Straddles and Strangles 44

The Deformable Sheet 46

Skew Dynamics for Risky Assets 48

The 1×2 Ratio Spread and Its Relatives 50

The Batman Trade 53

Implied Correlation and the Equity Index Skew 56

From Ratios to Butterflies 59

Calendar Spreads 65

Summary 67

CHAPTER 4 Hedging the Wings 68

Taking the Other Side of the 1×2 68

Comparing the 25 and 10 Delta Puts 69

Hedging Sovereign Bond Risk 78

Selling Put Ratio Spreads on the S&P 500 83

The Hypothetical Implied Distribution 83

Our Findings So Far 84

Back–Tests: A Cautionary Note 84

A Short Digression: Delta–Neutral or Comfortably Balanced? 87

The 665 Put 87

Implications of the Square Root Strategy 88

Futures vs Spot 89

A Dramatic Example 89

A Cross–Sectional Study 91

The New VIX: Model–Independent, Though Not Particularly Intuitive 94

The Spot VIX: Oasis or Mirage? 94

Migrating to VIX Options 98

Reflections on Figure 4.36 101

Migrating to Different Markets: The V2X 103

Risk–Regime Analysis 104

Conditional Performance of Hedging Strategies 106

Summary 109

CHAPTER 5 The Long and the Short of It 110

Short–Dated Options 110

The Physicists Weigh In 112

Buying Time 117

Long–Dated Options 119

Far from the Madding Crowd 121

R Minus D 122

The Lumberjack Plot 125

Selective Application of the Weekly Options Strategy 126

Summary 127

CHAPTER 6 Trend Following as a Portfolio Protection Strategy 128

What is Trend Following? 128

Trend Following Dogma 130

The Crisis Alpha Debate 131

An Aside: Diversifying Across Time 134

Taking Advantage of a Correction 135

The Niederhoffer Argument 135

Chasing 1–Day Moves 138

Pushing the Analogy Too Far 139

Analysing the Data Directly 141

LEGO Trend Following 142

Summary 143

CHAPTER 7 Strategies for Taking Advantage of a Market Drop 144

The Elastic Band 144

Trading Reversals 147

More Texas–Style Hedging 149

Selling Index Put Spreads 151

Breathing Some Life into the Equity Risk Premium 152

Buying VIX Puts 153

Selling VIX Upside 154

The Remarkable Second Moment 155

Summary 158

CHAPTER 8 Flash Crashes , Crises and the Limits of Prediction 159

Lord of the Fireflies 159

Cascading Sales 160

A Concrete Example 162

An Aside 162

Paths, Prints 163

The Role of the Central Bank 164

Credit Cycles at the Zero Bound 164

The Monetary Policy Palette 165

Reading the Tea Leaves 168

Summary and Conclusion 169

GLOSSARY 171

REFERENCES 173

INDEX 177

HARI P. KRISHNAN, PHD, is a fund manager at Cross–Border Capital, where he runs systematic macro and volatility strategies. Cross–Border is a London–based hedge fund with roughly US$300 million in assets. He previously managed a CTA for a London–based asset management boutique, and he was an executive director and co–head of alternative asset allocation at Morgan Stanley (Chicago and London). In addition, Dr. Krishnan has worked as an options trading strategist and as a senior economist at the Chicago Board of Trade. He received a PhD in applied math from Brown University, and he was a post–doctoral research scientist at the Columbia Earth Institute, Columbia University, before moving into finance.