another XIV brewing in crypto?
long shot bets against MSTR
Friends,
If you don’t know what MicroStrategy (MSTR) then congrats, you have won life. Close this tab and go back to sliding down rainbows and swimming with otters.
For those who remain you likely know that Saylor has been financing his BTC purchases from sale of convertible bonds.
I have nothing to add to that conversation but I have a trade idea. It’s gonna take some background to build up to it.
First, there are 2 required reads. They aren’t long and they’re excellent. The best combination. I will highlight some key points from them.
Convert of Doom: Microstrategy and the dark arts of 'volatility arbitrage' (6 min read)
by Alexander Campbell
This post explains how Saylor is effectively arbitraging the MSTR’s volatility by issuing convert that pay zero interest. This works because a convert is just a bond with an embedded call option. By delta hedging the implied vol in the embedded option, dealers or investors can earn a return if the realized vol exceeds the implied vol. The expected return presumably compares favorably or at least similarly to if MSTR just issued interest-bearing debt but Saylor, is effectively transmuting volatility into interest payments.
[In general, when a convert is first issued it’s common for both the stock and vol to decline as dealers hedge both the delta and often the implied vol by selling long-dated options to offset some of the vega they’ve bought at a discount.]
Campbell is both educational and insightful showing how:
1) the Merton model can be used to understand why MSTR is so much more volatile than BTC — the MSTR’s premium to NAV is positively correlated to BTC!
(In Battle Scars As A Call Option, I explained how one of my most painful trades occurred when I was long UNG vol when it went premium to NAV. In that case, the sizeable premium was inversely correlated with the price of gas. The exact opposite scenario of MSTR’s juiced vol today!)
2) this is a regulatory arbitrage.
Quoting Campbell:
Result: Retail buys MSTR shares at 150% premium while sophisticated investors arbitrage vol differentials and MSTR books the diff between all these trades as profitable transactions.
Here's the irony: We require hedge funds to register with the SEC, spend $50-500k annually on compliance, and limit themselves to accredited investors with millions in the bank. Yet retail investors can freely buy MSTR shares through Robinhood.
And therein lies all the difference. There’s nothing wrong with what MSTR is doing, but it’s a good example of the law of unintended consequences.
Regulators block retail from 'risky' hedge funds while inadvertently pushing them into something potentially more dangerous.
By restricting crypto access for years, regulators left retail investors few options. Bitcoin futures required $300k contracts with 50-100% margin. ETFs were obscure or nonexistent. So people bought MSTR instead - a far more complex and potentially risky vehicle.
In trying to protect retail investors, the SEC has inadvertently funneled them into a potentially much riskier product.
Which brings us to the next required reading:
Moonshot or Shooting Star? A Volatile Mix of MicroStrategy, 2x Leveraged ETFs and Bitcoin (7 min read)
by Elm Wealth
Oh how I love the existence of levered ETFs on concentrated ideas. This post echoes a very real possibility of XIV’s “volmageddon”.
Something we’ve discussed ad nauseum in this letter is volatility drag and how geometric returns diverge much lower from arithmetic returns as we increase volatility. The divergence is proportional to variance or volatility squared.
The article links to a neat calculator which offers hands-on lesson in volatility drag.
💡Learn more💡
And linking these to options which is where we are heading:
Exponents are good, wholesome fun. And this post was certainly that, inspiring the the trade idea we’re building towards.
The long quote below (emphasis mine) cuts to the heart of the matter.
Now let’s use some data to look at the probability of going bust just from a single really bad day. The price of a 2x leveraged ETF should go to zero if the price of the stock underlying the ETF goes down by 50% or more in a single day. The probability of such an event is a function of the variability of the MSTR stock price. If we assume the volatility of MSTR will be about 90% (or 5.6% per day), then we could think of a 50% decline in the stock price in one day as being a roughly 9x daily volatility move. A natural question is how often do stocks with very elevated variability, like MSTR, experience days when they decline by 9x their daily variability in returns?
We looked at about 1500 US stocks over the past 50 years, chosen so that at some point they were within the top 1000 stocks by market-cap. We found that the annual probability of such stocks experiencing a one-day price decline of 9x daily volatility was about 6%.
[Kris: The fatness of the tails should swipe you like a dragon. In Mediocristan, 9 standard dev moves don’t happen.]
This isn’t quite the final answer though, as we need the probability of a stock dropping by that much some time during the day, rather than just close-to-close. The usual estimate for the probability of touching a level over some time interval is to simply double the probability of being below that level at the end.
[The explanation of this is the same logic we’ve discussed whereby we estimate the probability of a one-touch by doubling the delta. Here’s Elm Wealth explaining:
To see why this is true in a simple random walk without drift, note that for every path that finishes below the level at the end of the period, there is another path where it hit the level and then followed a path that was a mirror of the path that finished below the level. So, for every path that finished below the relevant level (here a 50% drop), there’s another path that touched the level but then reflected and wound up above the level at the end.]
So, assuming MSTR volatility of 90% per annum, the probability of a down 50% intra-day move occurring at least once over the next year is about 12%.
If we use the MSTR volatility implied by the options market of 160%, then down 50% is only 5x daily volatility. The same data as above yields a close-to-close annual probability of about 30%, which we estimate as about a 60% probability of an intra-day drop that would send the ETF to 0.
There are a number of alternative perspectives one could take in trying to estimate this probability: for instance, trying to estimate the probability of a large one-day drop in Bitcoin and how that might impact the MSTR premium to BTC. For example, a 25% one day drop in BTC and a 33% collapse of the MSTR premium would imply a 50% drop in the MSTR share price.
[Kris: This hints at the MSTR premium vs BTC correlation Campbell wrote about]
A more complex analysis might try to estimate whether it is possible for these leveraged ETFs to become large enough that their daily rebalancing trades could themselves drive the price down 50% in one day. For example, imagine that MSTR rapidly triples in price due to some combination of BTC rally and an increase in MSTR’s premium to the BTC it owns, and the assets in the MSTR leveraged ETFs go from $5 billion to $30 billion. The market capitalization of MSTR could be about $270 billion and the leveraged ETFs would be owning $60 billion, or 22%, of MSTR stock outstanding.
Now imagine for some reason, MSTR stock drops 15% during the day – which, given MSTR volatility, would not be unusual. The leveraged ETFs would need to sell $9 billion of MSTR stock at the closing price. Recently, MSTR daily average trading volume at the close of the day has been about $2 billion, so this would be quite an impactful amount of MSTR to sell at the end of the day. For every 1% the price declines further than the 15%, the ETFs will need to sell another $500 million of MSTR, and if that pushes the price down by another 1%…well, you can see this doesn’t have a happy ending for owners of the leveraged ETF or MSTR.
[Kris: see The Gamma of Levered ETFs]
Bottom line, we think there’s a pretty decent probability – somewhere in the range of 15% to 50% – that these 2x leveraged MSTR ETFs are effectively wiped out in any given year if they are not voluntarily deleveraged or otherwise de-risked sooner.
Towards a trade idea
The 2x ETF is MSTU and the 2x inverse ETF is MSTZ. Unless these are delevered, if MSTR [falls/rises] by 50% in one day [MSTU/MSTZ] goes to zero.
I’m going to walk you through my stream of consciousness as I reached the end of the article.
1) I’ll accept Elm Wealth’s logic , my first question is…um, are there options listed on the levered ETFs?!
Checkmark✔️
MSTZ is thin but MSTU has over 350k contracts of OI.