April 2023 Update - Zero Delta Funds, LLC

Followers,

Late into 2022 and all the way through February, there was a widespread consensus that the Fed would need to continue to raise rates and keep them elevated through 2023. At every single conference we went to, this is what was being told to us. As traders, we understand this “conviction”. However, with several hikes in the rear view mirror was the short Treasury trade as asymmetric as it was a year prior? 

Obviously, not a lot of investors had bank-run and bank failures on their bingo cards to start off 2023. We believe it is also safe to say that even fewer had large bank failures with S&P500 up roughly 7.5% in Q1 2023. As these events unfolded, this crowded rates trade was unwound all at the same time, causing unprecedented moves at the front end of the curve and large subsequent losses. 

So was this a bad trade in hindsight? It doesn’t really matter if it was or wasn’t. Over long periods of time, funds will have winners and losers and be able to reflect on their successes and mistakes. However, we think it’s important to note a few things. With the markets so dependent on macroeconomic data, we think it is important to stress trade structuring and risk management in this environment. It is so difficult to know what the market will throw at you right now, and you have to stay nimble and be prepared to shift your position quickly while preserving capital. Also, if there aren’t any good trades, it is fine to just do nothing. Waiting for the asymmetric opportunities and having the firepower to pounce on them will separate funds away from the pack. Often, we see so many funds that are impatient and feel like they need to always be doing something.

We are not macro-focused, but we are a firm that is focused on asymmetric relative value relationships in volatility, with a strong focus on equity volatility. As a firm that isn’t constrained by just trading indices, we will look for themes within and between sectors to drive dispersion in the portfolio in the near term. Also, if investors think the “Fed Put” is back, this could provide an opportunity for outsized opportunities from the long vol side as investors become complacent. 

We think some of the best periods for equity vol have occurred after large, slow rallies, such as in 2007, 2017, and 2019. In each of these periods, as vol was getting taken to the woodshed, there were opportunities to capitalize on this cheap vol. In other words, traders seemed to get a good “bang for their buck” from the long vol side. After 2007 was the Global Financial Crisis. Volmageddon happened in Feb 2018, and Covid struck Q1 of 2020. In each of these periods, we were coming off unprecedented low vol environments. But in the run-up to these very volatile periods, no investor was saying “I need long vol in my portfolio.”

Over the past several months all we hear are investors saying “We don’t want short vol in our portfolio.” However in just the last month VIX went from 25 to 17. The point of this is that nobody knows. The market is going to move up and down, and sideways, and any which way it wants whenever it wants. This is exactly why relative value volatility is important in a portfolio. This strategy has the ability to take advantage of pricing dislocations from both the long and short vol side.

As we’re writing this note, the SPX 20-day historical vol is roughly 13 and the VIX is sitting at 17. We are not saying implied vol is cheap or expensive, but as the market becomes complacent, relative value volatility traders will be ready to take advantage of the opportunities that present themselves.

Best,

The Zero Delta Team