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21 questions about 50 cent

A corner of Wall Street has been gripped by the unknown identity of a trader that has been buying up Vix call options priced at 50 cents each, swelling to account for nearly 10 per cent of the listed market.

The FT has now reported that bankers with knowledge of the trades say the so-called “50 Cent” – a reference to the American rapper known for his breakthrough album Get Rich or Die Tryin’ – is the well-heeled, London fund called Ruffer, which even boasts an Earl as one of its founders.

For those now wondering who on earth 50 Cent is and what he has to do with equity derivatives, here is a twist on the rap artist’s track ‘21 Questions’.

1) Is this post actually going to be informative or has it been written solely for the purpose of a cheap pun?

Hard to tell at this stage?

2) Who is 50 Cent, the rapper?

50 Cent rose to prominence in the early 2000s, signed by Eminem and aided by Dr Dre. Dre was formerly part of the west coast group NWA, signed to Death Row Records – the same label that signed Tupac Shakur.

After his album Get Rich or Die Tryin’, 50 Cent (or “Fiddy”) founded G-Unit Records, whose members included Young Buck and Lloyd Banks, among others.

But his career took a downturn. It began with homophobic comments in the magazine Playboy, a critically unacclaimed acting spell and a host of attacks on other rappers and celebrities. It ended with a lawsuit against 50 Cent for leaking a sextape of rival Rick Ross’s ex-girlfriend, with 50 Cent eventually filing for bankruptcy.

3) Why has a London hedge fund been named after the rapper?

Ruffer has been buying up Vix call options linked to the CBOE’s Vix index. The price, or “premium”, on each contract bought has been around 50 cents.

4) Ok, so what is the Vix index?

The Vix index is a measure of implied volatility in US equity markets. It’s derived from options on the S&P500. It has been nicknamed Wall Street’s fear gauge because it is supposed to be an estimate of volatility over a one month horizon.

5) And what is a call option?

Options trades are either “calls” or “puts”, which can be thought of as the right to buy or sell the underlying index, respectively. For call options, an investor pays a “premium” (a price) to buy a contract at a “strike” price, which is effectively just a specified level of the index.

If the index rises above the strike price before the contract expires then the investor can buy at the strike level and sell at the higher market price, earning the difference between the two. If the Vix doesn’t rise then the contract expires worthless and the investor loses the premium paid to own the contract.

6) Is this an American or European option?

That’s a very good question considering we have only just established what an option is.

The options used by Ruffer are European. This is not a reference to where they are executed but to the way the contracts pay off. American call options allow the investor to buy at the strike price at any point during the contract’s lifetime. European options only allow the investor to do so at the end of the contract’s maturity. This means if the Vix rises before the contract’s expiry date, Ruffer could simply sell the contract to monetise its position. The contract will be worth more than when it was bought because a call option’s value increases as the underlying price rises.

7) How can you buy and sell the Vix? It’s an index, right?

Another great question. Investors can’t trade the Vix index itself (but there are tradeable futures linked to it). The contracts are cash settled, meaning you are rewarded with actual money, not a security.

8) We seem to have covered a lot of ground and this is only question 8. Are you sure you can get to 21 questions?

It’s touch and go at this point.

9) Why is Ruffer buying these contracts?

A lot of the coverage has focused on a fund making an outsized bet on a stock market crash. While this is not necessarily false, it’s a little misleading. Ruffer isn’t hoping the US stock market crashes, sending volatility higher, so it can cash in on its derivatives position. It has bought the contracts as protection, in case this happens.

The fund owns a lot of stocks which could fall in value if there is a broad ruction in the market. Therefore, the fund wants to own something that would rise in price in the same scenario, to limit its losses on its stock portfolio.

10) How much has 50 cent spent on this strategy?

So far this year 50 Cent has spent about $120m. The fund itself has about $20bn of assets under management.

11) But isn’t volatility meant to be at record lows?

It is certainly very low and has been for a prolonged time. As a result, 50 Cent has lost about $88m this year alone as contracts have expired worthless.

12) How far would Vix have to rise for Ruffer’s contracts to make money?

The Vix would need to rise above its long term average of 20 for the fund to start to see any profit for the contracts, but that would in turn likely mean a downturn in equity markets. Remember, traders say this is a hedge — the trade is not designed to make money on its own.

13) That seems prudent, why don’t other funds do this?

They do. And a lot also use Vix call options. The difference is the way they do it. Systematically buying call options based on the cost of the premium is unusual. Other funds typically buy based on the mathematical exposure they gain from the trade.

14) You seem to have glossed over that last bit. Can you elaborate?

Derivatives are discussed using greek letters. Delta, which is more widely understood, is the option contract sensitivity to a change in the underlying security or index. For example, it tells you how the value of an options contract will change if the Vix moves higher.

Gamma is the rate of change of Delta. Intuitively, a contract’s price will appreciate more quickly as it approaches the strike price than when it is so far out-of-the-money that even a sizeable move in the underlying index will make little difference.

Then Vega measures the price sensitivity of an option to changes in implied volatility. It is not volatility itself. Implied volatility measures the likely size of fluctuations in the underlying asset (in this case the Vix). Changes in the implied size of such fluctuations impact the option price.

Put simply, Vix vega is the option price’s dependence on the volatility of volatility

15) Do we know that 50 Cent is definitely just Ruffer?

Few things are ever certain but it is highly likely. Four different banks confirmed Ruffer is 50 Cent. The unique nature of the trades also makes it unlikely that anyone else is doing this in significant size.

16) 50 Cent is around 10 per cent of the listed Vix call options market; are they the next London Whale?

They are probably more like a beluga whale or a false killer whale. Even though 10 per cent sounds very large, it’s hard to measure the options market accurately. Trades can be executed on an exchange, known as the “listed” market, or they can be done privately, or “over-the-counter”. The size of the over-the-counter market is hard to measure. What’s more, a lot of funds trade in the OTC market.

17) Why execute in the OTC market and not on an exchange?

One factor is price. A lot of hedging strategies involve executing multiple trades. Exchanges charge a “ticket fee” per trade. In some instances that ticket fee becomes large enough that it makes more sense to go and privately negotiate the same strategy directly with a bank.

Another factor is opacity. Listed option trades are reported by exchanges, OTC trades are not. Savvy market participants spot patterns and infer other traders’ positions to exploit this knowledge to their advantage.

18) So is Ruffer going to bring down the US stock market?

The answer is probably no (at least not for this).

Firstly, consistent demand for Vix options entails upward pressure for prices of Vix options and for the implied volatility of Vix. Ruffer is not the only big fish (medium sized mammal?) in the sea. Other players include insurance companies and other big asset managers. Hedging activity in S&P options, or others’ use of Vix options, is easily comparable to Ruffer.

For the activity to be connected with a sell off in the stock market, however, the demand for Vix calls has to translate into share sell-orders. And the amount of any impact depends on the relative size of such sell orders in comparison to overall market volumes.

Nevertheless a possible, if tenuous, link exists. Banks, to hedge the calls they sell, must buy Vix futures. Demand for Vix futures can cause the Vix index level to increase. Other investors, spooked by the increased level of the fear-index could decide to sell shares or stock index futures. Traders, too, sometimes resort to selling stock index futures instead of buying vix futures. One instrument typically rises as the other falls. Liquidity is one deciding factor for which one to prefer.

19) You’re getting close, do you think you might now finish this?

It’s possible.

20) Could Ruffer still impact the market?

It all depends on the overall market’s supply and demand for Vix options. It is possible that the anticipation of a consistent buyer of options priced at 50 cent causes the strike of such options to be higher than it otherwise would be. For the buyer of a Vix call option a higher strike equates to a slightly less advantageous insurance policy.

Similarly, unless demand for Vix options spikes dramatically due (for example) to a broad and deep market sell off, 50 Cent’s position could be a large enough source of supply for Vix options to have a market impact if a large chunk of it would be sold or unwound at the same time.

21) How long have you been trying to think of a final question?

A long time.

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