The final presentation of the first day at RMC paired up Sheldon Natenberg from Chicago Trading Company and Chris Cole from Artemis Capital Management for a talk about VIX. In VIX Paradigm & Paradox Natenberg and Cole cover both traditional and new approaches to trading volatility, talk about the characteristics of both volatility and even the volatility of volatility. The discussion is completed with an examination of how macro trends and new supply/demand characteristics are changing the dynamics of VIX derivatives.
When analyzing volatility most traders will look at where that volatility has been in the past. This is due to volatility historically reverting to a mean. Natenberg notes that volatility tends to move around more over short periods of time than long periods of time. Even though volatility over a long period of time is easier to predict, just slightly missing on a prediction can be more costly for longer dated options than shorter dated options.
An interesting way Natenberg depicts the difference between implied volatility and realized volatility was to call implied volatility price and realized volatility value. Implied volatility is what you pay in anticipation of expected future volatility. Realized volatility is the value that results from market price changes.
Natenberg overlaid price movements from the market versus bell curve assumptions. It was noted that the actual price changes in the real world do not seem to match the curve. There are more small moves which are centered around the mean on the curve and more really big moves showing up as seven and eight standard deviation moves than occur in the markets than are assumed by models.
He also noted that in response to traders wanting to trade volatility the CBOE created volatility trading vehicles in the form of VIX Futures which were followed by VIX Options. These instruments are well suited for speculation on the direction of volatility, hedging market positions (due to the inverse relationship between volatility and market changes which he puts at -.7539 since 2006), and hedging an indirect volatility position. He defines this in the context of CTC as a market making firm having exposure to volatility as high volatility results in higher volumes which enhances his firm’s profits. A firm that has to rebalance frequently if the market is volatile will also have exposure to high volatility. Finally if you are running a portfolio that is sensitive to volatility, they have indirect exposure as well. For instance a buy-write strategy probably does best in low volatility environment.
Chris Cole took over at this point and starts out discussing how policy makers balance deflation and inflation and how it relates to volatility. He shows volatility in 2008 and notes that it was not nearly as bad as it has been during past financial shocks.
He talks about volatility of an impossible object and states that volatility is a paradox and how we have known unknowns and unknown unknowns. Recent known unknowns include the debt ceiling, a potential China hard landing, war with Iran, European crisis, and fiscal austerity. Unknown unknowns – we don’t know. Although we cannot identify those unknown unknowns they are firmly priced into forward volatility, convexity, tail risk hedging, and volatility curve trades.
Chris noted that low VIX does not necessarily mean low volatility. In August of last year the 2012 low for VIX was 13.45. On the same day one year volatility was higher than it was during the 2008 crisis. He shows that volatility has moved lower during periods of quantitative easing. Finally, relative to the S&P 500 a tail risk continues to be priced into the markets. Put another way, this is the most anticipated black swan ever. Currently the short volatility yield is competitive with the yield on long date US Treasury Bonds.
An interesting observation is that the market is concerned about a left tail move (or downside). No one is worried about a right tail inflationary market move that would result in high volatility as well. Finally, higher cross asset correlations result in higher volatility or volatility. Over the last decade there has been a dramatic increase in S&P 500 correlations.
An interesting observation that I also heard discussed in Chicago last week is that being short front month VIX futures is becoming a crowded trade. As a crowded trade is may be susceptible to a short squeeze. Front month VIX futures tend to have more volatility in the last 15 minutes of trading when VIX is low relative to periods when VIX is high. Cole finishes by showing trading action from February 25th.
Looking forward Cole notes 3 possible macro VIX regimes for the next decade –
1. A continued bull market in fear where longer dated volatility is expensive relative to near dated volatility.
2. An eventual bear market in fear which he also calls the Japanization of US Volatility. The outcome may be a rise of volatility short sellers leading to a 1987 repeat.
3. Finally an inflation volatility spiral which would result in out of the money calls being priced like out of the money puts are currently priced.
He notes that selling volatility or short volatility strategies have become a substitute for fixed income investing in Japan and that may end up being a strategy that works its way into the United States.
Finally, Chris Cole shared a video he created that depicts the evolution of the volatility term structure over the past 20 years. If you have an interest, check it through the link below –