The Death of Volatility?
By Tim Taschler, CMT, Sprott Global Resource Investments
On November 21, Venezuela failed to make $247 million in coupon payments on its dollar bonds due in 2025 and 2026. These bonds now trade at around 22 cents on the dollar, a decline of 78 percent below par. Recently, the SOX (semiconductor index), Figure 1, gave up six weeks of gains in three days. Figure 1: Semiconductor Index (SOX) Source: StockCharts.com as of December 1, 2017 Although the above two examples show that volatility (i.e. potential big moves in an asset or a market) still exists, it remains at all-time lows. Volatility (frequently referred to as vol) in the S&P500 is a record low 6.4.[i] For reference, in 2008 volatility soared from 20 to over 60 as the global financial crisis unfolded. During the 1987 crash, volatility spiked to over 170 (with the Dow down 20 percent in one day). These past several years, spikes in volatility (as measured by the VXO volatility index) have been relatively sharp, but are quickly sold. As JPM’s quant Marko Kolanovic put it via ZeroHedge: “Shorting volatility is a multi-year alpha generating strategy utilized by the largest pension funds, asset allocators, asset managers and hedge funds alike that has profited from selling into short-term vol spikes (similar to ‘buying the dip’).” Figure 2, below, shows the VXO volatility index from 1986 through today.  Figure 2: VXO Volatility Index Source: StockCharts.com as of December 1, 2017 So what is selling volatility? You can do it via volatility futures or by selling options (puts and calls) on stocks and ETFs. When I was an option trader on the floor of the CBOE in the late 80s, we sometimes referred to selling vol as “picking up nickels in front of a steamroller.” In other words, it worked for long periods because everyone knows that steamrollers are slow movers although, every now and then, you are flattened. In 1987, the 20 percent plunge in the Dow (Figure 3) began several days before as the market fell 14 percent into October option expiration Friday, a time when monthly puts and calls expire. Many think that one of the main culprits of the crash was the advent of portfolio insurance, something new at the time that used option positions to hedge portfolio risk. Whatever the cause, several days of selling brought on more selling until a panic ensued and the markets plunged. Figure 3: Dow Jones Industrial Average (1987) Source: StockCharts.com as of December 1, 2017 Now, focus on the VXO in 1987 (Figure 4), when it surged from an average of about 25 to 172.79 over a three day period – an almost a 700 percent increase.  Figure 4: VXO Volatility Index (1987) Source: StockCharts.com as of December 1, 2017 What most people don’t realize is that during the crash, the price of both calls and puts went higher, even as stock prices went lower. Puts should go up as the underlying asset price moves lower, but one would expect calls (bets on higher prices) to go down with stock prices. However, with the massive surge in volatility, calls and puts went up, purely as a function of volatility. Many people got hurt that day. I saw many people that were covered call writers (buy the stock and sell a call for income – and what is touted as downside protection) hurt badly when the stock they owned went down in price and the call they had sold short went up in price. People who did this on margin (borrowed money) had to add cash to their account to avoid liquidation, usually at terrible prices that locked in large losses. Today, it’s not just income-seeking ETFs, mutual funds and pension funds selling volatility, but also mom and pop (Figure 5).  https://www.nytimes.com/2017/08/28/business/dealbook/vix-trading.html  Figure 5:Who is selling volatility? Volatility is a function of the natural unpredictability that all financial markets reflect. Today there is no fear, none. People sell volatility without recognition of the risk. As the gentleman in the article above said, “Today I just sat back, ate some popcorn and cashed in my profits.” It’s that easy. But the problem with picking up nickels in front of a steamroller is that complacency sets in; people stop watching the steamroller, and a sudden shift in dynamics causes the steamroller to speed up unpredictably. Having been on the exchange floor in 1987 and watched the carnage, which included bankruptcies and grown men sitting on the trading floor in tears, I can’t sell volatility. Sure, it can work for days, weeks, months, and now, years, but it can end violently and wipe out all of one’s profits, and more, in a heartbeat. Nevertheless, here we are, in late 2017, with “the largest pension funds, asset allocators, asset managers and hedge funds alike,” along with mom and pop, shorting volatility. I think that the recent press release and Tweet (Figure 6) from President Trump sum up just how much complacency there is.   Figure 6: President's tweet and statement reveal complacency It is amazing that the President of the United States is talking about a 350 point market drop (the Dow), one that represents only a 1.4 percent decline (Figure 7) as if it were a meaningful decline – 1.4 percent, really? Note that the market closed down only 40 points (0.17 percent) on the day. Yet, people believe they should sue ABC for all the damages. It is a sign of the times.  Figure 7: Dow Jones Industrial Average Source: StockCharts.com as of December 1, 2017 Here we are with a total global debt of over $217 trillion, an amount equivalent to 325 percent of world GDP (i.e. debt is now 3.25 times greater than global annual production). At the same time, money has flowed from active money managers to passive funds (Figure 8) such as the SPY (S&P500) and DIA (Dow Jones Industrial Average) ETFs. Indexing is all the rage as markets go up and volatility is nonexistent.  Figure 8: Cumulative flow into passive vs. active funds I’ve watched the markets closely since the late 1980s and this year’s price action stumps me. It has been a bit similar to 1999. However, I don’t remember seeing large spikes in selling pressure, causing the major indexes to lose 1 percent or more in a matter of hours (or minutes) only to stop and reverse. Sellers disappear and a steady bid pushes prices higher until the losses are all but erased – just like Friday’s 350-point plunge being bought and the Dow closing down only 40 points. It’s remarkable and unprecedented. Volatility is not dead, just dormant. It will return, and the result will probably be much worse that the current vol-selling crowd anticipates. |
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