Peak6 Investments and the Baking Soda Index

“For every action in nature there is an equal and opposite reaction.” – Sir Isaac Newton

 

The performance – or, health – of complex systems is difficult to measure. Typically, you need deviations from norms across numerous sensors – the analytics – converging to signal whether a complex system is functioning properly or not. Add the inevitability of change, and the task becomes exponentially more challenging as continuity of measurement over time decays…

And then, there’s the stuff that’s difficult to measure, if it’s measured at all. The intangibles. The slippage factors that don’t come into play until they do. Like, a global pandemic – or when a frustrated segment of the population spills out into the streets in cities – big and small – across the landscape…

The indicators most commonly used to signal the health of our complex markets may no longer serve their stated purposes. For instance, does the VIX still measure fear? Aside from today’s notable spike, the equity markets appeared to have returned to normal volatility levels a mere ~70 days after the initial shock; a rate of calming that has been at least 3 times faster than the GFC (see below).

And yet, heightened levels of fear, anger, pain and anxiety in the global economy are obvious to anyone, and by just about any other headline indicator not associated with equity markets. Which means: Today, indicators like VIX measure something other than fear…

Arguably, this is a fact that has existed since the GFC, which began almost 12 years ago.

Now, I don’t have first hand knowledge of the following reference – I heard it from a friend – but, if a cocaine dealer wanted to bump his profit margins and/or get high on his own supply, he might step on his inventory with baking soda. Furthermore, in this entirely hypothetical example, the dealer might inadvertently continue this practice until his customers revolted, as Newton would have predicted…

So, if you’re following the hint, this is exactly what the Fed has done: Injected “high-grade cocaine” into the capital markets by stepping on the “moneyness” of money, thus continuing to destroy traditionally free market mechanisms; any sense of risk management; and, ultimately converting the VIX into something that might better be labeled as the “Baking Soda Index”…

The signals of the hollowing out of markets are numerous, though occasionally subtle – and not in the common headlines. Take, for example, some of our recently updated modeling on Peak6 Investments, the successful option-focused prop firm (with apologies to our friends and former O’Connor colleagues for the juxtaposition with Scarface):

Since 1997, Peak6 has been managing what might be called a quantamentally-oriented option trading strategy at its core. Beyond that, what makes this core strategy pertinent to this discussion is its limited exposure to ETFs (and therefore, ETF options, as well). So, it has a unique level of exposure to the available inventory of single names…

With US equity markets exhibiting increasing concentration to a subset of a declining roster of individual stocks (coupled with long periods of muted volatility), strategies like that of Peak6 experience a decline in applicable trading inventory over the past 4-5 years. The exhibit, below, highlights a 35% decline in 13F position count from the most recent peak (5,035 positions as of Q3 2015) to the most recent trough (3,293 positions as of Q4 2019).

In parallel with this, average position concentration – as measured by top 10 13F positions as a percentage of total 13F gross value – has nearly tripled (to 14.8%) relative to that of the prior historical period (5.6%), see below:

Now, you might argue that we are drawing an action-reaction line where it doesn’t exist. And, you could argue that even if that connection did exist, it’s Just one blinking light. But then you remember the comment from the top about numerous sensors and complex systems. And then, you leaf through the digital pages of our Feed and take note of our fixation with capacity and scaling across numerous examples, and the idea that technology creates winner-take-all market dynamics, thus reinforcing the incumbencies of the incumbents; the increasing concentrations of markets, players, and positions:  All of which, in part, representing incremental reactions to the manufacturing of monetary baking soda…

We don’t know when this framework will result in revolt/reset. The data to feed that divining rod does not exist anywhere. We will continue to assimilate clues and improved proxies in search of better timing…

Until next time…

By | 2020-06-12T01:38:20+00:00 June 12th, 2020|Alphacution Feed|

About the Author:

Paul Rowady is the Director of Research for Alphacution Research Conservatory, a research and strategic advisory platform uniquely focused on modeling and benchmarking the impacts of technology on global financial markets and the businesses of trading, asset management and banking. He is a 30-year veteran of the proprietary, quantitative and derivatives trading arenas. Contact: feedback@alphacution.com; Follow: @alphacution.