Surly Trader's  Instablog

Volatility arbitrage generally refers to trading strategies that capture the spread between implied  volatility (forecasted by option prices) and realized volatility (what volatility actually ends up being).  The spread between these two volatilities can be captured by selling options (calls and puts) and delta-hedging the options by buying stock or futures contracts.  This strategy effectively neutralizes the portfolio's exposure to movement in the underlying stock while leaving the option seller exposed to the volatility of the underlying.  If the volatility of the stock between the time that the option is sold and the time the option expires is higher than the implied volatility at the time that the option was sold, then the option seller loses.

It seems that every pull back since the middle of March has only been an opportunity to buy rather than the beginning of a pullback.  It does seem that the equity markets are starting to run out of steam, but shorting a rising market can be a terrible strategy so it makes sense to limit your losses on short positions. That is where options come into play. As an option trader, skew can be your friend or your enemy.  Many individuals naively purchase out of the money puts as protection on their equity portfolios or short bets because they are "cheaper" in the sense that purchasing a put for $1 seems like a much better proposition than buying a put for $5.  Unfortunately, for those who do not know better, the opposite is usually true.

Never before has there been such a dichotomy of opinions emerging from economists.  Some predict utter chaos while others feel that government intervention will spark the next bull market.  Here I will present some of the risks going forward so that we can all reflect on how much uncertainty there really is.

Long gone are the days of 10-13% volatility that we experienced during the leveraging mania of 2005 & 2006. I believe the credit crisis that started in earnest during 2007 has left its mark.  Volatility will remain elevated as continuing uncertainty and fear will impact market participants for months and possibly years to come. When the VIX spiked past 30 at the end of October, many were claiming that it was proof that another market meltdown was upon us.  I explained some reasons for a spike in the VIX, but many were only looking for evidence that supported their beliefs:

There is a current fixation on the U.S. deficit which has received mass media attention in recent weeks.  The fear mongering has caused a frenzy in gold, commodities and other inflation protecting asset classes.  Unfortunately, currencies do not trade strictly on the country’s ability to pay its debt or its government’s monetary policy.  Instead, every currency trades against every other currency  These relationships make currency trades a tangled web of monetary policy/response and relative fiscal discipline.   When placing a trade on the dollar, the trade is for the United State’s relative standing against every country in the world.  This means that you cannot simply state that the United State’s negative current account balance, massive deficit, and loose monetary policy make the dollar weak because the situations of some other countries look even worse. With that as the backdrop, I would like to show why it seems that the current fear over the dollar is a bit overblown.

Group-think can go a long way.  Even though the S&P 500 had a rather uneventful day and the VIX came well off of its highs to close at 28.8, there were other rather eventful market runs that I think are nearing their end.  Gold hit a high of $1,084.4 an ounce today under renewed speculation that the dollar is nearing an epic collapse.  It seems as if I cannot get 10 minutes through any day without hearing or reading that gold will be my salvation in the coming apocalypse.