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Comment by lordnacho | Hacker News Reader

Former vol trader here.

This is an old article but the dynamic is always applicable. Your main issue is that anything that isn't statically replicating, ie simply holding a constant basket of whatever it's supposed to track, needs to rebalance. The bigger the deviation the more unfavourable that is. What vol traders call negative gamma or convexity if you are from the fixed income world. The problem is you are pushing the wrong way on prices when you need to rebalance.

The thing is the markets have been in a very low vol environment for a long time, possibly ending in the last couple of months. We'll see. But until then it was quite a popular trade to be short options.

You can Google optionsellers.com to see what happens when things go wrong.

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It sounds like this applies to broad total market index funds too. I still feel like I don't know shit about the stock market so forgive me if that's a 101 question.

If I am an index broadly tracking the market, weighting each stock by market cap or whatever, then if it goes up, I have to buy more. If it goes down, I have to sell. Is that right? Is the that kind of rebalancing you're talking about?

It sounds like a positive feedback loop that could run away. Stock X goes down, forcing some index to sell it, forcing it further down, forcing them to sell more, etc.

If you’re keeping a balanced portfolio of assets and the price of one goes up, you sell to rebalance, not buy.

Is that because the underlying indeces are defined as each asset being a fixed percentage of the whole? Like, hypothetically, the S&P 500 would define MSFT as 1% of the index so if MSFT goes up then the fund would have to sell it to keep it from being more than 1% of the total holdings?

For what it's worth, the S&P 500 uses float-adjusted capitalization weighting.

https://en.m.wikipedia.org/wiki/Capitalization-weighted_inde...

After reading more about stock index funds I'm more confused how their rebalancing works. I now understand that the S&P 500 index is basically the total market cap of the free float of the 500 companies combined. I just don't see why a tracking fund would have to rebalance at all. If you own the 500 stocks at the right proportion it should stay balanced as each company's market cap grows or shrinks relative to all the other companies. The only time you would have to rebalance is when companies are added or removed from the index.

A market-cap weighted tracking fund still has to rebalance if one of the companies issues new shares, or buys some back, as well. But that's a relatively unusual situation (like dozens of events per year, not daily).

It seems like you mostly have a good understanding of how it works. A tracking fund would have to rebalance in the advent of a company issuing or buying back shares, when there is a corporate action like a spinoff or merger, or when a company is added or removed from the index.

Additionally, you have the reality that every day, investors buy and sell that fund. The tracking fund, therefore, has to liquidate or buy new holdings to match the NAV (net asset value) as shares are created or redeemed. This is where tracking funds will vary in their performance as some ETF providers might be a lot worse at matching up inflows and outflows.

A couple of things:

1) A fair few of those 500 stocks are not very liquid, you'll lose a fortune chasing the shares.

2) Think about what happens if you want to provide exposure that isn't 1x the index.

3) What happens when there's a replacement?

4) What about things that aren't statically replicable?

No. The index fund has a fixed amount of money. It can't keep buying when the stocks go up.

If I'm a seller of a put option (sort of "price insurance") on the index, and want to hedge my exposure, then every time the price goes down, I have to short the stock. Every time the price goes up, I have to buy the stock.

This is largely seen as the cause of the 1987 stock market crash - a small correction caused portfolio insurers to start selling more, which made the market go down, which made them sell even more, etc.

https://realmoney.thestreet.com/articles/10/21/2017/real-cau...

I’ve looked and not found the daily volume for the entire market before now. Is there a simple way to look that up? Or even other time frames? All I see are volumes for particular stocks.

Thank you for your insight! Iirc, low volume is consistent with elevated prices across the board. And, of course, corrections are to be expected.

pretty sure he means vol==volatility here

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