The Death Of Volatility?

by: Tim Taschler

Volatility sellers are the herd.

Historically low VIX.

Is selling vol picking up nickels in front of a steam roller?

On November 21 Venezuela failed to make $247 million in coupon payments on its dollar bonds due in 2025 and 2026. These bonds are now trading at around 22 cents on the dollar, a decline of 78% below par. Last week the SOX (semiconductor index) gave up six weeks of gains in three days.

Source: as of December 1, 2017

Although the above two examples show that volatility still exists (i.e. potential big moves in an asset or a market), volatility, or “vol” as we call it, remains at all-time lows. Volatility in the S&P 500 (using SPX 100-day realized (actual) volatility) is a record low 6.4. For reference as to how low a 6.4 reading is, note that in 2008 vol soared from 20 to over 60 as the global financial crisis occurred. In the 1987 crash (Dow down 20% in one day) volatility spiked to over 170.

These past several years, spikes in volatility (as measured by the VXO volatility index) have been sharp, relatively speaking, 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 have profited from selling into short-term vol spikes (similar to ‘buying the dip’).”

This chart shows the VXO volatility index from 1986 through today:

Source: as of December 1, 2017

So what is selling volatility? It can be done via volatility futures, and it can be done selling options (puts and calls) on various stocks and ETFs. When I was an option trader on the floor of the CBOE in the late 80s, selling vol was sometimes referred to as “picking up nickels in front of a steam roller.” In other words it worked for long periods of time, because everyone knows that steam rollers are slow movers although every now and then you get flattened.

In 1987, the 20% plunge in the Dow began several days before as the market fell 14% 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 fairly 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:

Source: as of December 1, 2017

Let’s zoom in on the same VXO chart shown earlier, but instead of looking at a 30-year chart, we will only look at 1987, when the VXO surged from an average of about 25 to 172.79 over a three-day period – almost a 700% increase:

Source: 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 stocks 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 went up and puts went up, purely as a function of volatility. A lot of people got hurt that day. I saw many people that were covered call writers (buy the stock, sell a call for income and what is touted as some downside protection) get hurt badly when the stock they owned went down in price and the call they had sold short went up in price. People that did this on margin (borrowed money) had to either add cash to their account or have their account liquidated, usually at terrible prices that locked in large losses.

Today, it’s not just income-seeking ETFs and mutual funds, nor just pension funds and professional money that sell volatility, it's mom and pop:

Source here.

Volatility is a function of natural unpredictability that all financial markets reflect. Today there is no fear, none. People sell volatility and like 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 steam roller is that complacency sets in, people stop bothering to even watch the steam roller, and a sudden shift in dynamics causes the steam roller to unpredictably speed up. Having been on the exchange floor in 87 and watching 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 someone’s profits, plus 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 this morning’s press release and Tweet from President Trump sums up just how much complacency there is:

It is amazing to me that the President of the United States is even talking about a 350 point market drop (the Dow), one that represents only a 1.4% decline as if it were a meaningful decline. 1.4%? Really? And let’s take note that the market closed down only 40 points (0.17%) on the day, yet people are told they should sue ABC for all the damages. It is a sign of the times.

Source: as of December 1, 2017

Here we are with a total global debt of over $217 trillion, an amount equivalent to 325% of world GDP (i.e. debt is now 3.25 time greater than global annual production). At the same time, money has flowed from active money managers to passive funds (ETFs like SPY – S&P 500 – or DIA – the Dow Jones Industrial Average). Indexing is all the rage as markets go up and volatility is non-existent.

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, but I don’t remember seeing large spikes in selling pressure, causing the major indexes to lose 1% or more in a matter of hours (or minutes), and then stop and reverse. Sellers disappear and there's a steady bid that 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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