From RMC Munich: Cem Karsan Talks Markets, Tail Risk, and AI with Today's Leaders | U Got Options

Episode Overview

• The episode explores macro-tactical trading strategies, focusing on opportunities in emerging market currencies and the equity volatility term structure.
• Guests discuss the concept of undervalued upside potential (the "right tail") and how replacing equity with call options can be a more efficient way to capture market gains.
• The conversation delves into major structural issues in global finance, including the "nominal illusion" caused by inflation and the massive imbalance between long-only assets and diversifying assets.
• Experts analyze the role and inherent limitations of artificial intelligence and machine learning in financial markets, concluding that its low signal-to-noise ratio makes it poor at predicting tail events.

Key Concepts

• Macro-Tactical Strategy: A trading-oriented approach that uses derivatives to take contrarian positions against crowded flows and consensus positioning in FX, commodities, and equities.
• Emerging Market Currency Opportunity: A strategy focused on a basket of EM currencies to benefit from a weakening U.S. dollar, high interest rate carry, and elevated volatility premiums.
• Equity Volatility Term Structure: A relative value trade that involves shorting more expensive, longer-dated volatility while buying cheaper, shorter-dated volatility to collect the "carry" or premium.
• Right Tail Convexity: The idea that the market's upside potential is undervalued and underpriced in options, largely due to structural volatility compression from call-selling strategies.
• Equity Replacement: A strategy of substituting traditional stock holdings with out-of-the-money call options to capture upside more efficiently while defining downside risk.
• Nominal Illusion: The cognitive bias where investors focus on nominal gains (e.g., a 10% return) while ignoring the erosion of real purchasing power caused by inflation.
• Structural Imbalance: The significant systemic risk created by the massive global concentration in long-only assets (estimated at $500 trillion) compared to the very small pool of non-correlated, diversifying assets (around $15 trillion).
• Machine Learning Limitations in Finance: The concept that AI's predictive power is weak in financial markets due to an extremely low signal-to-noise ratio, making it particularly unreliable for forecasting rare, high-impact tail events.

Quotes

• At 8:34 - "Usually when that happens, we're the other way." - Keith Decarlucci explains his contrarian stance on gold, noting that when a trade becomes universally bullish, his fund often positions for a reversal.
• At 26:27 - "I think there's a great argument for replacing equity with out-of-the-money calls and right tail." - Keith Decarlucci explains that due to the skewed nature of equity returns, buying upside options can be a more efficient way to gain exposure to market rallies.
• At 28:12 - "You shouldn't just put really good brakes on a car and drive the same speed. Otherwise you're just slowing yourself down. You need to drive faster as well." - Patrick Kazley uses an analogy to argue that once downside protection is in place, investors should be more aggressive in seeking upside to compensate for the cost of hedging.
• At 30:52 - "We live in a world of nominal illusion." - Keith Decarlucci introduces the idea that investors often overlook the impact of inflation, focusing on nominal gains that may represent a loss in real purchasing power.
• At 47:30 - "In finance, which is actually the... final frontier in some sense of machine learning, because the signal-to-noise ratio is very low." - Hari P Krishnan explains why predicting financial markets with AI is fundamentally harder than in other fields where data patterns are more consistent and reliable.

Takeaways

• Consider replacing some direct equity exposure with out-of-the-money call options to more efficiently capture undervalued upside potential in the market.
• Always evaluate investment returns in real terms, not just nominal, to avoid the "nominal illusion" where inflation erodes the purchasing power of your gains.
• The massive global imbalance between long-only investments and diversifying assets presents both a systemic risk and a potential opportunity in non-correlated strategies.
• Do not rely on AI to predict rare market crashes or rallies; the low signal-to-noise ratio in finance makes direct ownership of tail-risk protection via options an irreplaceable tool.