McDonald's complex strategy revolves around trading short-term volatility index futures (UVXY) which are associated with Wall Street's so-called fear gauge, known as the VIX.
He believes the index been pushed artificially low by the Federal Reserve's pledge to do whatever it takes to combat the economic weakness caused by the COVID-19 pandemic.
Investors are mis-pricing risk and a likely possibility of a spike in volatility surrounding the U.S. elections in November, he told Reuters, and sees an opportunity to make a big payday by betting against that complacency.
- The Democratic National Convention and the Republican National Convention are over, which means there's going to be a lot more focus on the upcoming elections. James McDonald, the CEO of Hercules Investments, thinks that he can turn a $50 million dollar bet into a $1 billion return. Let's see how he plans to do that. Thank you for joining us, James.
JAMES MCDONALD: It's a pleasure to be here, Conway. Thank you for having me.
- So talk to me about this trade. And keep in mind that I'm not an options expert, so be gentle with me.
JAMES MCDONALD: Sure. And so we're in extraordinary circumstances. We've had a pandemic enter our society and shut down businesses. And shocks to markets are common. But this one is different. And the shock was so strong that it forced our central bank to come to the rescue in a way that is unprecedented, as well. The fed committed to do, quote, whatever it took to save the economy.
At the time it did that, the market rallied from a 30% drawdown in the S&P and in the Dow to new highs. When that happened, volatility returned to an all-time low. Now, we're not in an all-time low in absolute terms. But volatility is disproportionately lower than it should. And we're going to take this millions of millions of dollars that we've invested, we're currently about 52 million dollars into a volatility instrument. It's called UVXY. UVXY simply rises when volatility rises.
And because volatility has been pressed so far low, the coming shocks to the market are going to cause it to spike. We've got post-election call options that are trading in about one twelfth of their true value when volatility returns. And so that's how we trend to do that. And then we can go a couple strikes out and get 20x returns. And that's how we're going to grow this capital we've been entrusted with in this trade to a $1 billion.
- So if I understand this trade correctly, you're basically betting against the complacency that's in the market, right?
JAMES MCDONALD: Yes.
- We got the DOW now erasing all of its losses for the year. We've got the S&P 500, what, on track for its best August since 1986, NASDAQ at record highs. And so you're betting that the market is too complacent and that it has to fall.
JAMES MCDONALD: Well, they're usually inversely correlated. The stock market usually goes down and volatility goes up. But sometimes they move in the same direction. But complacency is just right, but it's beyond complacency. There is a calmness now going into a storm that we all know is coming. And when volatility returns to normal-- we don't need an extravagant spike in volatility. If you look in June, we had pressure around June 11 in all three indexes. Markets came down one or two or three percentage points.
At that time, UVXY jumped over 45% in a single day. What we're looking at is a mean reversion of volatility to its normal price, which should be around 50, 60 dollars a year based on what we see coming with the overvaluation of the market with the political tensions between the parties, with the geopolitical risk with China right now, and then, of course, the elephant in the room, which is the businesses that have been shut down and the consumers that are no longer earning income. Prices will come down and volatility will spike. And we will celebrate this trade.
- Now, there are some out there who might say that this is a pretty risky bet. The complacency is probably well in place. You know, you take a look at normally during an election game, markets go up. You know, we got the corporate profits picture is looking better than expected. We've got these job cuts coming, which means companies are trying to right-size their balance sheets. And so just talk to me about the risk to this strategy that you have. Right
JAMES MCDONALD: OK, so the risk of this strategy would be significant if it was a short-term bet, right? And so we have no idea what the market will do on any given day. This is more of a macro bet. And so we've seen volatility ground down. In the short-term futures instrument that we talked about, we've seen UVXY come down from $120 down to about $19 and some change. And so that six months macro cycle of the market rising, volatility falling, is what's presented us this opportunity.
We're looking for a mean reversion, also in a macro sense, as markets stop going up. We just talked about this being a record August, you know, the biggest August in 36 years. And so this is a macro play. This is not a short-term bet. We've been accumulating, exiting, and entering as volatility bounces around. By the election, we will see the culmination of depressed earnings, contractions in employment, defaults from consumers not paying their bills on time, and then, ultimately, a stock market correction, which is normal for any market that's run up like this.
Any number, any one of those things between now and the election will take UVXY back into the 40s. And simply put, the election itself is going to cause a spike in volatility. And so for that reason, we've finally de-risked this by purchasing December call options. And so this bet does not have to pay off until December on one tranche. And then we have a second tranche for June call options.
And so these are how we are de-risking this strategy. We're not expecting an immediate spike in volatility. We're expecting a grind back up to the 25, 30, 35, level and then a spike beyond that. And we'll take this billion dollars to the bank for our clients.
- Real quick, before I let you go, how much does the success of this trade depend on who wins the White House in November?
JAMES MCDONALD: It's a great question. It does not matter who wins. However, if the Democrats win and are expected to lose, there will be a bigger spike. If the Republicans win and are expected to lose, there will be a bigger spike. What we're betting on is uncertainty and the unfolding of an uncertain outcome with a surprise. And we saw this when Hillary Clinton conceded, she didn't even come to the stage. You know, she was surprised herself. Things are not predictable.
Whoever wins, there is going to be a de-risking of the opponent. And what we're going to see is a spike in volatility before then and will probably fall through. Now, if the Democrats take the White House back, taxes will go up and it will further depress stock market prices. And we're seeing that. Recent polls have suggested that Biden is the front-runner now, from corporate CEOs, not just from the consumer polls.
But it does not matter who wins the election. What matters is that there's uncertainty going into it. And the unwinding of that uncertainty always causes a spike in volatility.
- Well, that's one way to trade the upcoming elections. That's James McDonald. He is the CEO of Hercules Investments. I'm Conway G Gittens and this Reuters.