In this episode I speak with Harel Jacobson, an FX volatility trader.
There is a lot that makes the FX volatility market unique. For starters, the end users are more focused on hedging cash-flow and liquidity than wealth. Since the underlying is currency pairs, volatility surface arbitrage conditions become multi-dimensional. And then there is the global geopolitical event calendar to consider.
Did I mention that trades are performed, almost exclusively, OTC? So even something like price discovery, which we take for granted on listed exchanges, is non-trivial. Especially if you want to backtest a new research idea.
This is a fascinating conversation into a fairly niche, but important global market.
I hope you enjoy my conversation with Harel Jacobson.
Transcript
Corey Hoffstein 00:00
Sir, are you ready to go? Yeah. All right 321 Let’s jam. Hello and welcome everyone. I’m Corey Hoffstein. And this is flirting with models, the podcast that pulls back the curtain to discover the human factor behind the quantitative strategy.
Narrator 00:21
Corey Hoffstein Is the co founder and chief investment officer of new found research due to industry regulations. He will not discuss any of newfound researches funds on this podcast all opinions expressed by podcast participants are solely their own opinion and do not reflect the opinion of newfound research. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of newfound research may maintain positions in securities discussed in this podcast for more information is it think newfound.com.
Corey Hoffstein 00:52
If you enjoy this podcast, we’d greatly appreciate it. If you could leave us a rating or review on your favorite podcast platform and check out our sponsor this season. It’s well it’s me. People ask me all the time Cory, what do you actually do? Well, back in 2008, I co founded newfound research. We’re a quantitative investment and research firm dedicated to helping investors proactively navigate the risks of investing through more holistic diversification. Whether through the funds we manage the Exchange Traded products we power, or the total portfolio solutions we construct like the structural Alpha model portfolio series, we offer a variety of solutions to financial advisors and institutions. Check us out at www dot Tink newfound.com. And now on with the show. In this episode, I speak with Harold Jacobson and FX volatility trader, there is a lot that makes the FX volatility market unique. For starters, the end users are more focused on hedging cash flow and liquidity than they are wealth. Since the underlying of this market as currency pairs, volatility surface arbitrage conditions become multi dimensional. And then there’s the global geopolitical event calendar to consider that I mentioned that trades are performed almost exclusively OTC. So even something like price discovery, which we might take for granted on listed exchanges is non trivial, especially if you want to back test a new research idea. This is a fascinating conversation into a fairly niche, but important global market. I hope you enjoy my conversation with Harold Jacobson. Harold Jacobson, welcome to the podcast. This is going to be an episode that definitely pushes my boundaries, we’re going to be talking about FX vol markets, something I know little to nothing about other than just speaking to you. So this is going to be a fun and exciting one for me. And I hope, actually no, it will be for the listeners as well. So thank you for joining me.
Harel Jacobson 03:01
Thank you for having me. I’m super excited to be on the show.
Corey Hoffstein 03:05
So I know we originally connected via Twitter, I think you’re taking a bit of a Twitter hiatus, and you were actually writing on medium for a while taking a bit of a hiatus there as well. I don’t want to assume that all of the listeners necessarily know who you are. Maybe we can just start with your background.
Harel Jacobson 03:23
I been in the derivatives business for the last 15 years or so. I started in 2007. While I was doing my bachelor in economic. I always wanted to be in banking business. And I thought well, I should probably get some practical experience having very few opportunities in Israel, in finance, like you have many opportunities in tech. But in finance, you don’t really have anything, I decided to apply to a company named Super derivatives, super derivatives down now to highs like intercontinental exchange. But back then the leading thin tech company that specialized in derivatives pricing. I applied them and well, I didn’t know anything about derivatives and options back then. And so I came to an interview, and the guy who interviewed me started asking me questions about options calls goods, though, like, Listen, I don’t know anything about that. I’m eager to learn. I don’t know anything right now. I think that I can get the hang of it, if you’d give me the opportunity. So he hands me a book, which was John house futures options and other derivatives. And he tells me just read that, you know, he scheduled the interview. If you come and you know what you’re talking about, then I’ll hire you. So I do that. And I think that they read that cover to cover over the weekend. I was just completely fascinated and hooked on that. Obviously hired me for the next three, four months. The only thing that I did was just watching the generation of photoshoots surfaces so I QA them making sure In the dark, any funny numbers or anything, that everything comes smoothly, and I also investigated client queries about pricing, they might come and say, Well, why is my who come to option prices like 5%? Well, you know, my brother shows me or like 3%. And then I would just go and investigate that. So it gave me a lot of time to sit with the quants and the developers. And I just got completely fascinated and overwhelmed by derivatives and by derivatives pricing. But I really felt that my quantitative background is not up to par. So I didn’t have any foundations in quantitative disciplines. I was doing my economics degree, and you don’t really get anything beyond calculus, one to one or probability theory, one to one. So I really needed to get some foundations in quantitative disciplines. So I thought, well, either I dropped out of economics and start something like computer science, or mathematics or physics, or I just learned everything by myself, I decided to take the letter. And I just started teaching myself all the quantitative background that I needed to know how to read and implement papers. Think that it took me almost a year until I could really implement the paper, just after reading that I was just so excited. And I think that I went through that rabbit hole of derivatives quite quickly. And then in 2008, a friend of my boss at derivatives, asked me whether I want to join him, because he was a large PM, that the local market fixed income in Israel. So for large properties in Tel Aviv, I was more than willing to join, they asked me whether I want to be is ethics quarkchain. I was so into that. So I started in September 2008 as his quant, and then, two weeks later, I saw Lima, going under, basically. So it was quite an interesting start to my trading career. And then for the next year and a half, I moved both into the reserves and with this guy, so I think that they got the best of both worlds. And then 2010, I decided that I have had enough with pricing options and everything, and I want to go full time ethics option trader, I went to that company and started running my own ethics option, boop. And then a month after I joined. So then a flash crash of 2010. So again, super volatile markets. And I think that this form, the way I think about falls in a way, for the next nine years, I ran ethics option and they thrown rates options for that firm. And I was lucky enough to work with senior guys who were around the block for many years. And they really taught me the practical experience of trading those markets, something that you can’t really learn watching videos on YouTube or reading in textbooks, the thing that really make change for trader. And then in 2019, I decided that I really want to expand to be cross assets voted, I thought that this is what I want. And then I went to another prop firm, I joined them. And then I saw in March 2020, that not all for some data set. You think that Ethics Bowl and equity vote are the same, but apparently they are really really not the same. So it’s comparing you to Yoda to a Formula One car, the only thing that they have in common is that they have four wheels. That’s it. Besides that, everything’s completely different. And I learned that the hard way, was pretty rough patch. But the thing that I learned a lot about the blind spots of my portfolio, risk management. And I think that I took a lot from there. Then me 2021 I decided that I kind of had enough with prop trading, I’m really passionate about out called derivatives research and modeling. So I decided that I’m going to stop prop trading, and I’m going to focus on that. So I’m currently just researching derivatives and model volatility.
Corey Hoffstein 09:15
So I’m definitely going to ask you to expand upon this concept that not all falls are the same. But before we go there, I want to start with just a basic understanding of the FX vol market. What is it? Why does it exist? Who are the players and why are they operating in the market,
Harel Jacobson 09:35
we can grossly divide their FX market into the listed market, which is a fairly small segment of the FX market and that market is on the CME and you have few CTAs there, but the volumes are not really meaningful. We constantly read the commitment of trade report and then they say well don’t volume so dollar positioning is The roof, everybody’s long dollar. And that’s partially true, but that’s only because they are trend following. So if dollar moves higher than it makes sense that their position will be maximum. But I wouldn’t read too much into that, despite what people think the part that’s really moving the market is the OTC market, when you see that on Twitter that not too many retail accounts, really understand that market and know that market. And the reason is that the barriers of entry are pretty high. So to have an access to the ethics for market on the OTC market, you really need to have either ethics prime brokerage account, which is quite expensive and requires a lot of margin, all you need to have is the master agree, as a retail trader, you can’t have either one of them, unless you put a lot of margin, which further traders don’t have, basically. And I think that this market can be grossly divided into three groups. So the first group would be the sell side and the sell side with a the dealers like large swap dealers, investment banks, second tier banks, they have known dealer market makers. So that’s a small segment within that group. But I think it’s a growing one, because I just read the optiver, which is a market maker across multiple assets, started to gain more traction and is currently showing prices on multi digital platforms. So I think that in that sense, it’s a growing player in that segment, and then you have the interbank brokers like tradition and GFI that basically just broker between dealers. So that would be the sell side. On the buy side, you have the corporate and the hedgers and the real money that basically come to that market just to hedge their ethics exposure, their cash flows, and their long and short term costs, currency funding needs, they provide most of the supply and demand to the market and their volume sensitive. So in a way, they need to hedge whether or not bodies are 1015 or 20. Because they had exposure and they need to edge that way. They create a lot of those dislocations that no var managers try to offset or two options, then the other group on the buy side with the macro managers that take directional views on the FX market, they think the dollar yen is going to go to 151 60 then they will buy calls, they will do some structures to enjoy that move. And you have multi managers who are trying to use effects as part of their own books. So they diversify into effects either involved or in other types of strategy. And the last subsets of speculative account would be the relative value or the ethics for managers and they all kind of a secondary risk underwriter. So, they will try to take advantage of dislocation created by the macro managers, and by the corporates and the dealers don’t want to warehouse that risk or don’t have the capacity of just trying to take advantage of foul and they are very sensitive to vote. So that could be the ethics option mark.
Corey Hoffstein 13:12
So let’s attack this idea head on that not all vol is the same. And maybe specifically talked about what makes FX vol. So different from more traditional volatility markets, say like equity,
Harel Jacobson 13:28
I think that they’ll be doing differences. One would be the sheer amount of quoting conventions, I don’t think that people outside the ethics market understand how many conventions different conventions you have the, quote, falling effects. So if you take the most trivial thing, like six months at the money strike, or the Moneyball in whatever currency you want, though, you basically have three different strikes and vaults that correspond to the six months at the money, and you don’t have that in anywhere else. So to ask for the money vote from a dealer, you can either ask for at the money spot, which is the strike that correspond to the current spot and go, and then you have death fix at the money for, which is the strike that corresponds to the forward rate. So if you don’t have any rate differential, that would be pretty much like spa. But if we have some chunky forward like in Turkey, like South Africa, Brazil, then forward rate would be very different than the money spot. And therefore the money vol would be different than when you put them on the spot. And then you have a third Convention, which is I don’t think that you have anywhere else but effects and that would be the delta neutral at the money. So just to give some listener, some background, and I’m not going to go into that because quoting premium conventions in effects is one topic that very few really know how to do that. So basically, when you quote, premium of an option, that is essentially The cash flow. So, if you take that premium and incorporate that into the Delta, that actually changes the delta. Now, because premium is highly sensitive to the volatility level, than when you have high vol, the Delta neutral strike, which is completely different than what you are taught when you learn Black Scholes, that 50 Delta is that the money. So it basically makes the Delta neutral strike completely of where you think the money forward is and where the money spot is. So again, at the money, three different conventions, and no one understands which one is which. And then, if we go beyond that, and we look at our strikes are quoted in effects, they are never quoted in six strikes, they’ll always quoted in Delta strikes you in general steel deal for 5% out of the money option, you always ask for like a 25 Delta to to call. And I think that this basically explained a lot about what we call the stickiness of strike inequity, we are used to the idea of sticky strikes, while in effects, we are used to what is called the sticky Delta. Those are two completely different ways to look at spot for dynamic. And then another thing that makes ethics very different than equity would be the things that really drive that market. So if you think about equities, when you come to as your equity book, you come to hedge your wealth, your investment, but when you come to it in effects, basically come to either your liquidity, or your funding. So that’s really different in terms of dynamic. Now, in March 2020, we saw that fall went to the roof, and then equity will continue to be relatively high, versus the FX ball drops very quickly. And the reason for that is because Central Bank, monetary policy was pretty known like rates were at zero, no, you had no late differential. And then vols went to a very low level. Now we see the trade differentials are starting to grow. And then people are uncertain about future rate path and then they need to hedge because you know, they can’t leave your book on hedge. We can’t leave your interest rate exposure on edge and you can’t really be in a position where you don’t really know well rates is going to go when your book is completely experts. So I think those two main differences are what drive about ethics, foreign equity.
Corey Hoffstein 17:32
One of the things you learn when you sort of learn the textbook, Black Scholes implied volatility surface on equities is all about the arbitrage boundaries for different parts of the surface. When I start to think about currencies, the first thing I think about and I think the first thing many people are taught about is that textbook triangle arbitrage trade. In my head when I take these two concepts and start to merge them together, I start to think about how the arbitrage bounds in FX probably create something like an implied correlation triangle, that all these surfaces have a relation to one another. They’re never independent from one another. And they’re sort of cross surface arbitrage pounds. Curious how that multi dimensional nature of FX presents both an opportunity and a risk in the volatility space.
Harel Jacobson 18:23
If you think about currencies, a currency doesn’t have a value unless it’s related to another currency. So Euro doesn’t have a value unless it’s quoted in dollar terms, or Sterling doesn’t have a value unless it’s quoted in yen terms. So when you think about relative performance between two currency pairs, you really need to have a third currency, which is a common currency. Whenever you think about options, and gold, you need to think about the trying relationship. And then we think about how we measure realized volatility whether one currency outperforms another, we can basically think about many coalition triangles, whereas every coalition has three vols and three subset of correlations. So if we take Gitane effects, we have 10 currencies in Gitane that makes 45 currency pairs, so 10 times nine divided by two, obviously, not every single currency pair in Gitane effect out of those 45 is tradable in the market. So some currency pairs like say, policy versus Swedish kronor, no, it would not be super liquid. And most of the deals are not going to quote you that option. But assuming that there is a liquid market to all those currency pairs, you basically have 360 coalition triangles, so we are in a multi dimensional coalition world. So I think that it’s very difficult for dealers to maintain those 360 coalition triangles aligned at any given point in time. Does so Many opportunities there. But obviously, you know if something is a very high correlation, so it’s very close to one, no one would quote you correlation at one. Because there’s understand that, obviously everybody wants to show correlation at one. And by correlation, it’s minus one. So obviously, no, there will be some skewed quote to death. But if you think about it, like yours can’t maintain those coalition triangles in line. So what they do, usually, they usually widen prices on stuff that are illiquid. And on some stuff, they will not quote you. So mostly, if you trade coalition, you never want to go and do the traditional coalition trade, which is trading three vanilla trades or three bar swaps, because it’s too expensive. So as a correlation trader, what you always want to do you want to trade some relative value between two currency pairs, and basically what you want to own some idiosyncratic risks, because market risk, you can add your way and diversify your weights, but idiosyncratic risk is what you want to hone. Whereas something that has a high better risk, you want to show if it has a low idiosyncratic risk.
Corey Hoffstein 21:05
I want to talk before we get into maybe some strategy discussions again, the nature of this market that makes it unique part of it is that the vast majority of the volume is OTC. I want to know what it means to be a systematic trader in an OTC market, what are like the major challenges you face?
Harel Jacobson 21:24
Well, there are many challenges. The first challenge is the fact that dealers are not obligated show prices. So they are operating on goodwill, they will show you prices whenever the market is calm, and nothing happens and Basel. But when things turn south, like we are in oh eight and 2020, they will either widen the price significantly to a point where that’s just not tradable, or they will just completely stop quoting. So when there isn’t be dropped the flow on the Euro Swiss, most of the interbank platforms will just ask like no one would show prices for 30 minutes to one hour, no one would show anything. And we saw that many times. around Brexit we saw the same behavior. And around the US elections, showing prices is kind of on a goodwill basis. Whereas if you go to listed market, there are market makers reserves that constantly show prices and usually tight prices. The other problem when you run systematic strategy for systematic effects is that you don’t really know that positioning, mostly because that fix market is a very non transparent market. So there is a problem for you to understand the how positioning is in the market. And you don’t see anything. And I can just pick up later, a thing that it’s a huge issue in options. If you are trying to run systematic, which means that fully automated strategies, it’s very difficult. In fact, it’s mostly because you need to have some hefty investment in infrastructure, you need to have reliable sources for voting for foods for anything. If you look at something like voles or forwards, your data source can change all of a sudden, and then your delta starts to change and your entire books start to jam. And if you have an automated execution system, that can really be problematic for you as systematic effects. And then it’s a market that operates little over 24 Five, if we think about it, you need to have it constantly monitor does so many things that happened within three trading sessions between Asia to New York, you have many hours, that liquidity is just there. So if you think about what’s called the witching hour between New York and Tokyo, so many times it’s that price action there was just completely erratic, but things that I saw the dollar yen collapsing at least three times during that witching hour, the Twilight between New York and Tokyo. That’s crazy. Now if you run a position and all of a sudden you wake up in the morning and you see that you’ve just lost you need like five $6 million, just because DOLLAR YEN moves. If you operate in the OTC market, there is a huge operational risk, settlement risk that you don’t think about when you do stuff on the listed market. And then you have trade reconciliation and consolidation and settlement of trades. Most of the risks that we don’t think about when you trade equities or listed stuff.
Corey Hoffstein 24:27
You mentioned it briefly, but I want to draw it out a little bit more in these OTC Markets. It’s not necessarily just a lack of transparency on price, but also a lack of information about market positioning and flow potentially. And I’m curious about how you deal with data issues. They’re understanding what the market landscape looks like.
Harel Jacobson 24:49
For many years, I thought, well, positioning doesn’t matter. It’s just my positions that I need to worry about. Everything is pretty much priced in the market but I think since I started reading Twitter, and understanding like gamma exposure and DDoS positioning, I started really getting into that positions. And up until a few years ago, he couldn’t really understand the market positioning, because he wouldn’t have regulation like Dodd Frank and enter that requires trade reporting by corporates or by bank. So nowadays, regulation that requires you to report trades, but the problem is that they show very little, they will very little about the trade side, like what side was the client side, or anything beyond that, unless you’re willing to do the footwork and build an algorithm or model that understands the positioning, you are pretty much in the dark. And I think that investing in that positioning report or models that do that, that understand the positioning from the raw data, is extremely valuable, in the sense for now, most of the ethics option traders rely on the liquidity providers, the dealers just to tell them listen, a macro fund bought some topside in whatever currency they did, and then they will come so well, a relative value traded debt and that structure, so they will not reveal the names of those funds. But they will probably tell you this macro just buying a lot stops. It’s also a good thing that you know that.
Corey Hoffstein 26:26
Along that same theme, when I think about less transparent markets tend to think about information asymmetry. And more specifically, information asymmetry can lead to highly adversarial markets and adversarial risks. I’m curious on your take, do you find with these types of OTC markets, especially versus say, with the traditional markets, adversarial risk is much higher and something you have to actively consider and try to minimize in your portfolio.
Harel Jacobson 26:58
I don’t think that race is greater in effects, and OTC market them in the equity market. If you are a retail trader that watches the market, what information do you have that reduces death rates, I think that everybody’s in the same boat in terms of like the information that they get. So again, unless you have some sophisticated model, you still have some lack of transparency, and you don’t really know the positioning, or think that if you run a systematic strategy, that systematically made money, the only thing that you need to worry about is your risk limits. Because you might get some significant move, market is going to move and your model is going to scream, you need to increase that position because market goes against you. So you want to basically average the train, and you want to sell more or to buy more. But as long as you maintain your risk limit, don’t think that can get damaged is your mark to market. If this trade systematically made money, then yeah, I don’t think that you really need to worry about information asymmetry, or anything like that. If I had a good information about what’s driving the market, I would be able to squeeze more Alpha. But that said, I’m more worried about having my risk limits intact. So I’m not going to get stopped. Should this news continue.
Corey Hoffstein 28:18
So given you operate in these OTC Markets, it is possible for you to have completely tailor made positions. How does that opportunity affect strategy design?
Harel Jacobson 28:30
I think that one good thing about the ethics OTC market is that you can basically tailor yourself a very, very distilled exposure. If you want to be exposed to like the third order derivatives to the butterfly, you can do that. If you really want to do that. I don’t know why anyone would want to do that. But if you want to be exposed to that, you can basically with that. So I think it allows a lot of creativity. We can go wild with how to structure a trade. I think that that’s great. And I think that the fact that you are not bounded by strikes and maturities allow you to be very, very flexible on how you structure your portfolio. And I know that corporates really love to buy those exotics, those first and second generation exotics. They say that it cheapens their exposure, their hedges, you know, I think that they just like to play with exotics and barriers and triggers. I know that they do that a lot. And I recently read that macro managers made a killing on just buying those dollar cnh arcaos. That’s basically just buying the call and setting a barrier, usually around four to 5% out of the money so it cheapens their exposure because as they get into the money, they’re very gets closer. They become essentially short gamma, although they don’t really run the gamut, but it cheapens their exposure. Being able to tell your exposure is great in effects. One of The biggest stories over the last 20 years, I can talk about it later in length. The thing that that’s amazing was the Japanese yen, and what is called the euro, dashes bonds. Those were like the first structures that was sold to retail investors. And I think that they need a huge difference on our wall dynamic is priced in currencies like DOLLAR YEN.
Corey Hoffstein 30:25
But why don’t we dive into that right now and maybe talk about some of the things you’ve seen in your career that have impacted these markets and how the landscape has evolved.
Harel Jacobson 30:36
If we think about the full dynamic, like in dollar yen, a friend of mine said that the graveyards in the market are filled with people who sold for when DOLLAR YEN vol was 30. But it’s also full with people who bought for when it was low, single digit. So dollar yen is a very strange animal that no one understands. But people keep on trading that the story is that since the 1990s, interest rate in Japan was zero. So Japan was the first market to have a zero interest rate. And I think 30 years interest rate back then was zero. And I don’t think that they got it wrong. Interest rate is still zero in Japan. So adding no interest rate to gain, retail investors basically couldn’t get some yield out of government bonds. So, local dealers basically offered them yen denominated bonds, but provided yield from foreign currencies like Australia, the US dollar. So those who basically just carry traits packaged into bonds, so no long term like 2030 years costarring swaps, that will package into a bond and they had some optionality that dealers called that option. I think after two years, they could call that option in our historian Bazian spot multiplier. So those products that are called TR DC that stands for power, reverse dual currents note, they will very popular in the early 2000s. There was started being issued in 2000. And then they can so much popularity because Dalian earnings higher. So those were real issue and issue an issue and they get huge issuances back then, and then in oh seven, markets started to go down. So Ghana started to appreciate that the problem was that dealers effectively will show downside strikes. And they did not have that, as yen appreciated, dealers got into a short gamma position. And apparently, and no one thought about that, they actually got into a short gamma coalition and Vodafone. And apparently at the end of the day, they got some basis risk between short term volatility and forward and long term voting for long story short, they just got hammered complete. If you like those kinds of stories, just Google prdc on and you find so many papers and articles about how to get F in being a dealer on those markets. And apparently, those products actually starting to make combat nowadays. So I just read a week ago, that issuances of prdc is going through the roof and everybody’s piling on in because dollar Yang is moving higher. And no one remembers that in a way. Paper was just getting killed there. And we got to a point actually, in a way that the voice surfacing DOLLAR YEN just got completely broken. We all thought that butterflies can’t go negative. But apparently, when everybody’s buying them the money, they’re gonna sell downside puts and calls. So they turn the butterfly to be negative and broke the void surface model. So fun times, I would say,
Corey Hoffstein 33:51
it sounds like there is opportunity from structural flow pressure from people looking to indiscriminately hedge their cash flow or their liquidity. Maybe we can take a step back, not talk about market dynamics as much but maybe talk about your approach to the market. How are you trying to find an edge? And what do you think the nature of that edge is?
Harel Jacobson 34:15
I would say that I define my strategy or my approach is a quantitative base with a discretionary overlay. I used to be fully quantitative. And then you know, I saw the markets on time does it make sense that you’re told to sell ball on currencies that are managed, if something breaks like the Euro Swiss flow, so I tried to maintain some discretionary but think that most of my hedge comes from the fact that I understand the market players and our dealers bronzer exposure. If you need to be on a trading desk to understand that dealers run their books in a certain way that prevents them from finding those smaller Just that I find, because I used to trade mostly niche market. So I like to be a big fish in a small pond, rather than a small fish in a big pond. If you become an expert in those markets, it’s very difficult for dealers to beat you, or to take down for way from you. Now, if you think like what we saw with Xero, that they tried to beat the market with their house flipping business, and they lost money. And that’s because someone who is expert in a niche market, most times will just get you.
Corey Hoffstein 35:33
When you talk to quantitative traders in highly liquid markets, they often talk about this red queen principle that they have to keep innovating and researching just to stay in place just to stay equally competitive with their peers. Do you find the same in sort of the less liquid OTC market?
Harel Jacobson 35:54
Yes, and no, because some markets got more sophisticated over the years. So dealers finally began to understand they mispriced some of the ball so they missed some of the dynamic, they don’t see that. So gradually, vols moved higher. So whenever you bought for an I bought folding some currency pairs in the low single digits, and now they’ll price almost double digit. And that’s only because they started seeing that they slowly bleeding alpha, because no one was doing that before I did that. But as they started seeing that they are bidding up for the kind of skew the price is higher. So effectively, I improve the market. So now I need to find new edges, and find new places and new ways to find that in those markets. So I think trying to find that edge is very difficult, especially as deers get more sophisticated, and players get more sophisticated,
Corey Hoffstein 36:49
we’re do effects of all traders tend to get in trouble, what makes them blow up.
Harel Jacobson 36:54
There are many ways to blow up in effects, like any other market, but think that three main reasons that someone can get into trouble trading effects, the first problem that someone can encounter is just not knowing the market enough, not having a good understanding of the market. And that would be if you look at the strategy, and the currency, which is managed, like Swiss franc, for example, like Hong Kong dollar. I know so many people who got completely crashed in 2015. But if you bought a one month straddle, since that’s been introduced back, I think in 2012, or 2011, you would have lost 20% of your AUM, just buying options and rolling that waiting for the s&p to drop the bear. So everybody’s trying to pull a source like it’s 99 to do. But it’s very rare that you can do that. People have been talking about the Hong Kong dollar, which needs to either get depreciated, massively, or appreciated massively. And for 40 years, it has been trading between 775 and 785. So nothing happened there. So trying to run a strategy, that that’s that something will change is very difficult. So you might not blow up and go up in flames. But you will just bleed slowly but surely. And another thing that people don’t understand about markets, and then they try to run position is that they don’t understand liquidity and funding. So that’s mostly true when you run position in emerging market. Short term funding is being controlled by central bank. And if markets like Turkey, for example, which is just getting completely broken, the central bank decides that it wants to appreciate the lira, they will just drain the market from liquidity. And you will end up being on the right side of the trade. But you will lose a lot of money just because you don’t understand the dynamic. And the problem for those markets is that when everybody wants to go to the exit, the door becomes extremely small and you can’t get out of those trades, basically. So that would be the first reason that someone can get into trouble trading effects. The second reason would be you just don’t understand the products. Well, one product that used to be extremely, extremely popular. And banks used to offer that in massive amounts would be coalition swaps in early 2000s. And even after that they would go and sell those coalition’s so coalition swap basically gives you an exposure to the realized correlation versus a fixed strike. So just think about value swap. But with correlation, which is basically just three variants of on steroids. You would think that correlation can go wherever it can go, but people didn’t understand that. This is a fixing base structure. So you’re bounded by the fixing so it doesn’t really matter where the intraday coalition is, you will really bound it by the way that the fixing will correlated, which is completely different, especially in the rigged market of prior to 2012. Well, they actually prosecute people for rigging the WMF six. But the other thing that people didn’t really understand is that those will highly convex structures. So the sensitivity correlation was not linear across all coalition levels, and people just got completely killed trading them, although they will right on the direction, they will just completely killed because they didn’t understand the product. And I think that the last reason that someone would get into trouble was just not factoring in fat tails in geopolitical events. In 2016, we actually sold it twice within four to five months, that before Brexit, no one really factory deemed like a five or six standard deviations moves in the market thing Sterling, and actually got that. And then everybody said, well, Clinton is going to win the elections, there isn’t any event to be priced, and then they got Donald Trump, and then the market goes completely crazy. So I think not factoring in enough fat tails to geopolitical events is very problematic for the trade effects.
Corey Hoffstein 41:04
Well, I wanted to talk about the underlying next, I think there are many things about FX that make it unique as an underlying but to tie to your last point, FX is an asset class that one would presume is very sensitive to geopolitical event risk, as well as the release of global economic data. I’d love to know how you think about accounting that massive calendar of events of knowns and unknowns into the risk modeling that you have to do in your portfolio. A think that
Harel Jacobson 41:35
any trader who trades effects will has some way to factoring event weights, because when you look at the calendar, we have so many events. So first of all, you need to decide which event is actually worth looking and worth pricing and which one is not worth looking at pricing. Over the years, I kind of developed way to estimate the event weights out to calculate this isn’t the one day seasonality for each event. I think 10 years ago, dealers would grossly underpriced events, especially in niche markets, the easiest thing to do would be just go and buy overnight falls in those markets because they wouldn’t price any event. And then you would get Delvian said I keep cutting 50 basis points, you’d get 2%. Well, the market price, maybe half percent. So that was quite easy. But nowadays, it becomes more difficult. So I think nowadays, dealers are pretty much pricing. Correct Wait, two major events like FOMC. CPI, they will they’ll mostly accurately price. So you can basically back the implied event weight from the one thing forwards between the date of the event and the day before. And I did some research about that you couldn’t make money trading those events during the last two, three years. Because events just became meaningless. When monetary policy is zero. events don’t matter, actually, only now, when you start seeing those divergence in monetary policies, you start to see those events become more meaningful, actually, PMI says became far more important over the last three to four months than data 10 years up until now, that’s the most problematic thing to value is a geopolitical event. Those events that are not frequent, and you don’t really get recurring events like elections like was something that is not on the calendar is all of a sudden in the calendar. And you don’t really know the price that. So historically, I think that trading those geopolitical events, doesn’t produce a good alpha, mostly because it’s a dose of coin. So either the market overpriced tails or over prices for which not pricing tails correctly, you can’t really know that. And there is only one event. So you can’t really analyze that in a way.
Corey Hoffstein 43:53
When I think about FX markets. One of the other things I think about is how the different pairs may have different economic sensitivities, or may actually be influenced by dramatically different players, whether it’s central banks or those who are generating cash flow in a given economy. For example, the US dollar might serve as a flight to safety assets. Whereas the Aussie dollar the Canadian dollar or the Kiwi might be more sensitive to what’s happening in the commodity space. How does this show up in volatility surface dynamics? And again, how does it affect the way you think about portfolio construction,
Harel Jacobson 44:31
you can divide the different currencies in the market to high yielding currencies, which have high beta risk and to commodities. And in Gitane those would be the Aussie, the kiwi, the Canadian dollar, the Norwegian kroner, those would be the high yielding currencies and so they are highly sensitive to equities and China. Commodities. And then on the other end, you have the dollar The Swiss, now also the Euro because it’s a low yielding currency. And then they would be the flight to safety crisis. So obviously, when you have something that performs well, when things turn south, it would price as a call overproof. So call them dollar costs on yen cause of Swiss would be priced higher than goods on that. On the other end, if you have something that sells off when equity moves down, puts would be priced at a premium. So if you look at something like Ozzy yen, the skew there is massively negative, because it would get a double whammy effect. So everybody would buy in and everybody would sell Ozzy. And we saw again, like in 2020 2022, that it can really move. So people actually use that as a proxy on equity. Whereas like, in most days, it’s not proxy on equity. But when things turn south, it really becomes a proxy on equity. And I think we talked about the fact that Tn is actually quite complicated. For dynamic selves, short term involved, and risk is being determined by supply and demand by macro names by hedge funds, but long term, vol. and skew and convexity was just supply and demand by pension funds. And those banks that issue some yield enhancers,
Corey Hoffstein 46:20
as you’re looking to continuously innovate, where the new research ideas come from,
Harel Jacobson 46:25
I think like 15 years ago, and 10 years ago, I would say, Well, I read a lot of Wilmoth form and nuclear finance. If you know those bones, we probably do all
Corey Hoffstein 46:37
nuclear finance is one of the best kept secrets. If anyone’s made it this far into the season in this podcast, there’s some real gems on the old nuclear finance forum. I really
Harel Jacobson 46:46
liked his clutter. And every once in a while I go into Willmar, just to say that the last thread was from 2020. And now on post, I used to read a lot research by banks quant research, but like Citibank, Deutsche Bank, Goldman, they used to have this amazing quant research notes, they stopped producing those. So nowadays, a dominant read research notes or research ideas by banks, and I mostly read Twitter medium, and I listen to podcasts,
Corey Hoffstein 47:19
given the lack of transparency, and maybe the lack of obvious pricing data in this universe, how do you actually go about testing new ideas? What assumptions do you need to make about entry and exit liquidity? For example?
Harel Jacobson 47:38
I think that the problem for me when back testing strategies, the fact that I don’t know the nature of the data, I assume that the data that I use is good. But most of them do not. It’s not good. I think like a month ago, I backed us in strategy. And I said, Well, that’s amazing. And I tried to bet just a strategy that actually bought wings. And I thought that it will just lose a lot of money over the years. And apparently it made money. I was like, okay, something is not right here. You can’t buy wings in highly context, currency pairs and make money. So something is not right. So I dug into the data. And apparently, at some point, just vol, base was divided by 100. So effectively, instead of just buying at 16, voting bought at point 16. So obviously, it would make one when the market moves, besides the obvious the, which is just double check your prices every single time that you’re on the strategy. And if it doesn’t make sense, just dig into the data and find what’s wrong thing that a lot of time we just penalize my model by getting bad prices. So I just factoring normal that in a refix entry and exit points. Because I don’t know whether you know, you’re going to make money or you’re going to lose money. You don’t know whether you’re going to exit the market when you know everything is in chaos, and you can’t really get out. That’s especially true when you backtest strategies that are highly correlated to the market vol. If you buy something which is affected by convexity, and he wants to take profit. If that strategy is in profit, it kind of makes sense to assume that the market is going haywire. So you need to assume that bidders prices are wider than normal. That’s how I go about setting my transaction costs.
Corey Hoffstein 49:29
What’s an argument I often hear from people on the tail hedging side who is shoe using exotics especially OTC because they say when those exotics really hit and that convexity really kicks in the market will be in chaos and your ability to exit the exotic not just from a potential counterparty default risk, but actually getting a good market on that exotic could be really difficult. It sounds like I don’t want to put words into your mouth but the answer for you is a Recognizing proactively, that is likely the case and that you need to adjust prices. Is that right?
Harel Jacobson 50:05
It’s completely true. And I think back in a way, we ran some exposure, and we are full of oil agreements, so FTAs. And obviously in dollar year that made a killing. But the problem was the, besides the fact that two of our counterparties almost defaulted. You couldn’t get out of trades? Well, you thought the TVs. So when market is in chaos, any price makes sense. Basically, you can’t really assume that if the old model shows you that, you should have exited the trade at 20 volts, you might be exiting the trade safety involved because Mark is done worldwide.
Corey Hoffstein 50:42
The last question I’m asking everyone this season is to reflect back on their career and answer for me what was the luckiest break you had?
Harel Jacobson 50:50
I’m gonna say that first time that I went into Twitter was after I listened to your podcast with Ben iPhone. So a friend of mine said, Well, you should like listening to Corey Hoffstein And Ben iPhone podcast, because it’s a great podcast. And I loved it so much. And I said, Well, let’s give this Twitter a go. So I think that was my lucky spring. Because I found so many people that I was just blown away by the amount of knowledge, people are willing to share, and collaborate. And the only thing that I was looking like Docker, because as a prop trader, especially in Israel, that don’t have really a community of Prop traders and traders at all. And no one does what I do, I can assure you that I never had this collaboration and brainstorming with anyone. So I found Twitter. I found so many people that really helped me get better understanding of the market and improve my art on my modeling. So I think that will be my largest breaking my career.
Corey Hoffstein 51:53
Well, thank you so much for joining me today. This has been incredibly educational for me, and I certainly look forward to diving to the markets further in the future.
Harel Jacobson 52:02
Thank you