Volatility Tracker for the week of December 14, 2009

My sense of the markets at this juncture is that elevated implied correlations are truthful, even oracular [10], with too-high index implied volatility representing not so much the jump risk with which the VIX is usually associated as the unwelcome prospect of individual equities tracking each other too closely. The most urgent scenario is of a strengthening dollar and unwinding “risk trade” in which good and bad companies are punished alike, and until that worry is alleviated, I see no reason to expect a change in the more sensitive metrics like the VIX term structure [7,8].

Volatility Tracker for the week of December 7, 2009

The jump in volatility indexes noted in our previous report was met with a similar decline last week [see chart 2]. The VIX could easily make a new 52-week low before 2009 is through. Gold implied volatility advanced sharply on Friday’s price decline [3], with GVZ closing just shy of my 30% short-term target.

In early September, I tried to take the other side of the case against UNG, the popular natural gas ETF, regarding its perceived failure to track spot natural gas prices (”The Fuss Over Natural Gas“).

At the time, I admitted that my defense – roughly, “it isn’t as bad as all that” – was anecdotal and didn’t address any of the fundamental worries that caused the dislocation in the first place. I also warned that UNG shareholders weren’t being compensated for the weird risks they were taking – i.e., risks that had nothing to do with the fundamentals of the physical commodity.

Volatility Tracker for the week of November 30, 2009

Volatility indexes popped across the board on the Dubai news last week. [2] If traders are concerned about the effects of this particular event, their reaction is overblown – as is already clear, most of the direct exposure to Dubai World appears to rest with HSBC (HBC) and some Continental European banks. It seems smart, however, to be thinking about the significance of debt burdens in other countries, and about what precedent will be set by the resolution of the situation in Dubai.

Volatility Tracker for the week of November 23, 2009

News-making price changes in gold [see chart 11] have not been accompanied by any particularly noteworthy behavior in the options market. While it would be wrong to suggest that options in any way “anticipated” the gold rally, it is also fair to say that price action in the underlying has been roughly in line with the expectations given by option prices. Notice that the CBOE’s VIX-style gold volatility index (GVZ) has drifted between 20 and 30 since early September [see chart 3]. The spread between the 21-day historical volatility of GLD and the implied volatility in its options 21 days ago has not changed noticeably in recent months, whether we inspect this relationship visually [see chart 12] or as a ratio [see chart 13]. All of this should count in favor of prices staying near or above current levels for the short term.

Volatility Tracker for the week of November 16, 2009 (pdf)

Equity index options are about as evenly priced as they’ve been in some time [5,6], but another continuation of the intermediate-term rally would mean more disappointment for option buyers, especially those who entered new positions in early November.

Felix Salmon is skeptical about the ability of average investors to protect themselves from major economic risks:

[T]here really isn’t an easy or obvious way for an investor to be highly risk-averse in this market, not when one of the biggest tail risks that people want to protect themselves against is inflation. Big investors can try taking the Taleb approach of buying large numbers of out-of-the-money options and reckoning that a bunch of them will pay off when the next crisis hits, but that’s not a strategy available to most of us. There’s only downside and no upside in lending money to the US government or your local bank at near-zero interest rates, and buying gold at $1,100 an ounce looks like a crazy speculative momentum play more than a flight to safety.

Volatility Tracker for the week of November 8, 2009

I wondered last week whether we would see a return to the reflation rally or were entering a new regime dominated by mean reversion. The price action last week counts in favor of both, as we reverted to the closing highs of the prior week; I expect a more definitive answer by November options expiration.

Volatility Tracker for the week of November 1, 2009 (.pdf)

Equity markets have been drunk on the wine of federal stimulus for most of this year. While the increased volatility in the latter half of last week could amount to a mere hiccup in the reflation rally, indicators suggest that more participants are concerned about an equity market “hangover” than at any time since the market bottom. The transition to a different market environment may have just occurred, and in the absence of any plausible catalysts, I’m not yet giving serious consideration to the possibility of a market crash, so the remaining likely regimes are a continued momentum-driven rally or the return of mean reversion.

One average of the volume of contracts traded in VIX futures recently exceeded the level observed during the financial crisis of 2008, indicating that sophisticated traders and investors may be preparing for an end to the recent run-up in equity prices.

The chart below shows the volume of trading in VIX futures (VX) since January 2008, along with a 20-day simple moving average of that volume. As evident there, the average volume in recent weeks is greater than at any time in the past two years. Increased VIX futures trading volumes are to be expected amidst market declines, given the increased activity observed in late November 2007 and October 2008. What is remarkable about the recent surge in volume is that it has coincided with a bull market in which declines are brief and mild.

Volatility Tracker for the week of October 26, 2009 (.pdf)

As I’ve noted on many occasions here, the relationship between spot VIX and longer-dated VIX estimates has not “worked” as a directional indicator for at least several months. [7,8] This looks like a genuine puzzle: the premium VIX futures traders are willing to pay and/or requiring in order to sell is too steep and has been too persistent to be dismissed as a phenomenon typical of the “wall of worry” that bull markets proverbially climb. But neither is that premium indicative of some impending crisis - at least, it wasn’t this summer and hasn’t been this fall. It is tempting to suppose that the effects of artificial government liquidity are overwhelming whatever information this relationship would otherwise provide. But whatever the cause, I won’t regard the VIX term structure data as meaningful until there is some new reason to do so.

Volatility Tracker for the week of October 19, 2009

The time to write "the fear is gone" stories will be with a VIX at twelve, not twenty-two.

Traders have become increasingly focused on the role that the dollar is playing in exacerbating rallies in equities, gold, and other assets, with concern in some quarters about a more precipitous dollar decline to come. At least on the implied volatility front, there’s no sign of such worries yet. EVZ, the index that tracks VIX-style implied volatility for FXE (a EUR/USD ETF) is pushing to new all-time lows.

Note that sudden price spikes in recent history correlated with moves higher in implied volatility; however, the relentless trend of summer and fall 2009 has not seen any corresponding increase in implied volatility. I regard this as confidence among traders that there is little concern of a dramatic rise in EUR/USD, even if the current trend does continue.

CME Group (CME) published the following product update today:

Effective Sunday, October 11, 2009 (trade date Monday, October 12), the following changes to the listing rules for COMEX Gold options will occur:

As Felix Goltz and Wan Ni Lai wrote in the Fall 2009 issue of The Journal of Derivatives:

An at-the-money (ATM) straddle -- i.e., going long on an ATM call and an ATM put with the same maturity -- is generally thought of as a volatility trade. It is essentially delta-neutral, but a large price move in either direction or an increase in implied volatility will produce a profit. A delta-neutral straddle position also has zero beta, so under the CAPMit should earn the riskless rate. Research has shown, however, that straddles with stock index options tend to lose money, which may be attributed to a volatility risk premium: it is the cost of hedging against a rise in volatility. If buying straddles produces losses, writing straddles should yield excess profits. An important aspect of the trade is that the delta (and beta) of the position change when the underlying index moves away from its initial level, and rebalancing is necessary if one wishes to maintain neutrality.

The spread between the volatility realized in the S&P 500 over the last 30 calendar days and the volatility implied in S&P 500 options 30 calendar days ago is about the widest that it has been this year, with the exception of a similar instance in early August [see charts 5,6]. That means stocks haven’t been nearly as volatile as index option prices have assumed they would be.

Put another way, it has paid to be a net seller of options over the period. Whether this persistent “overbid” in implied volatility will continue depends entirely on the risk appetites of traders and on the ability of the market to stay calm and gleeful – an increase in days like Wednesday and Thursday of last week would make options prices more nearly fairly valued.

Monday morning greets us with moves lower in gold, silver, equities, and oil and what looks to be the first consecutive day of gains in the US dollar index since late August. If recent behavior continues, these moves will be reversed promptly, but many traders are increasingly watching for signs that the summer reflation rally may be nearing an end.

Clearly, gains of this magnitude at this rate are only sustainable if you think stocks are still undervalued by half, but at the same time there is no reason to establish major short positions. If equities do decline into the fall, absent some surprise catalyst it seems more likely that they will roll over rather than correct sharply. I would be more sanguine about a gentle correction or continued rally if implied correlations came down form here [see chart 10].

The dollar continued slouching toward Harare, and it is anybody’s guess whether the trend will reverse anytime soon. I track price and volatility changes in FXE, the USD/EUR ETF [see charts 2,3]. The implied volatility index for gold closed down nearly 6%, in line with the expectations expressed last week.

I can’t recommend enough giving a weekly glance at the Implied Daily Move table. These are simply the point and percentage changes (within one standard deviation) implied by the volatility index for each asset, deannualized to reflect daily movement. Where technical analysis might regard a VIX at $24 as somehow cheap – especially in relation to its levels one year ago – any casual market observer knows that, if anything, implied volatility in equities remains on the high side. We simply aren’t seeing 1.5% daily moves in the S&P 500, and until we do, traders should expect options to remain overpriced.

The biggest mover last week on the volatility front was gold, as the "gold VIX" (GVZ) closed 40% higher [see charts 2,3]. Recall that when equity index prices rise, implied volatility typically falls; this inverse relationship does not hold for gold and many other commodities. On the contrary, the volatility implied by option prices will often rise with commodity price increases - a state of affairs with significant implications for option traders. We are short some out of the money gold futures options in managed accounts, based not on any directional thesis but rather in order to capture the relatively rich premium here.

The equity volatility indexes (VIX, VXN, VXD, RVX) all closed higher for the first time since August 2nd, but the steady bid in longer-dated volatility futures persists, with a spread of about 4-5 points between the spot and average futures prices [see chart 7]. This relationship was covered ad nauseam over the summer and I will resist speculating about its significance any further for now, except to note that a baseline level of 29 in the VIX futures has not historically been correlated with raging bull markets. The implied correlation index remains elevated [see chart 10].

People have been up in arms for months now about the troubles at the United States Natural Gas Fund, LP (UNG), the ETF designed to track the price of natural gas. And, as far as I can tell, rightly so: the whole point of ETFs is that they were meant to be a nearly frictionless, relatively simple alternative to the clunky closed-end funds (CEF) and managed products that our parents and grandparents had to contend with. But UNG recently traded at a 19% premium to its net asset value (NAV), behavior far more fitting a CEF. And until UNG begins issuing new shares, they functionally are a closed-end fund.

Why the premium? Regulators are concerned that, given its size, UNG purchases of natural gas futures could overwhelm and distort the market. Some sort of CTFC action is expected, and one review suggests that any likely outcome will result in a dissipation of the fund’s premium to NAV. That’s a good reason not to buy UNG here, and it may offer a good opportunity for a stat arb play for those with the stomach and expertise: the trade would be to buy natural gas futures and sell short the ETF (or, since the shares are hard to borrow, competent options traders will establish a synthetic short position by selling calls and buying puts with the same strike price and expiration date) on the expectation of UNG eventually returning to its net asset value.