What do you associate low volatility with? A bull market? A slow and steady upward rally? Optimistic future outlook? Do you associate it with the suppression of volatility?
We know that there is a strong inverse relation between equities and volatility, a low volatility would therefore also mean that there is a bull market. But correlation doesn’t mean causation. If A and B are correlated, it does not necessarily mean A cause B, it could be that B cause A. Or, even a hidden factor C that causes both A and B.
If it is low volatility causing a bull market or a bull market causing low volatility, sure, things would turn out fine. Since volatility of market and bull market momentum are factors that most have taken into consideration. But, what if there is a hidden factor C that we fail to take into account?
Do not fool yourself – peace is not the absence of conflict – peace can only exist at the edge of volatility-Artemis Capital, Volatility and the Allegory of the Prisoner’s Dilemma
In the paper Volatility and the Allegory of the Prisoner’s Dilemma, a real-life example is provided as an analogy to the stability in the market.
In recent decades, the world has been more peaceful than ever before, there are still on-going war but if compared to the scale of the past it is certainly more peaceful. But there is a hidden factor that people tend to forget that led to this peace. The development of nuclear weapons that could easily lead to the destruction of earth. As the weapons become more lethal, there would be more damage to the involved parties if a war was to break out.
It would be in both of their best interest to disarm. But in the case of two purely rational entity, they may not cooperate even if it is in their best interest to do so. From each of their point of view, there is only downsides to disarming. If the other party disarmed while they did not, they would have more negotiating power in politics. If the other party did not disarmed and they did, the situation would be reversed against them.
There is only upside to not disarming. And so they achieved equilibrium and peace. But at a drop of a pin, a catastrophe on the scale never seen before could begin.
Similar to this example, the stability seen in the past 2 decades has a hidden danger behind it.
Short Volatility and Margin Calls
Hedge funds, pension funds and all other big financial institutes had known for a long time that low volatility tends to cluster. And they make use of this mechanics to earn premium. Whenever volatility is low and clustering, they take advantage of this fact and sell premiums on volatility (short volatility). They are the counterpart of our volatility hedge against equities.
From the two graphs, we can see that volatility tends to cluster in lows and volatility spike tends to mean-revert quickly. These are the two main identity of volatility.
In recent decades since the dot-com bubble there has been more and more short volatility in the market. One of the main contributing factors is the Fed’s prevention of a bubble from popping.
Whenever there is an impending market crash or after a crash, the Fed would cast one of their financial sorcery. Bail-out, QE and lower interest rates are some of their frequently used magic tools.
Essentially, the Fed is preventing volatility from spiking as they continued propping up the market AKA suppressing volatility, which leads to the institutes increased short volatility.
The danger of this short volatility lies in the fact that short volatility is actually a positive feedback loop. If the volatility falls or remain stagnant, more volatility would be short and the lower it goes. After all why not short volatility when its so low, its basically free money, even if the market did crash, they believe the Fed would come to their rescue. And so, lower volatility leads to lower volatility. In the same sense as the example of nuclear weapon, the more volatility is suppressed, the worse the outcome would be if it is to explode.
If there is a sudden volatility spike that the Fed did not expect or could not control like due to the COVID-19 outbreak and the recession due to lock-down, all those that short volatility would be margin called. And many of those that sold leveraged short position would be forced to close their position and make a lose by buying back volatility at a higher price. And this mass buying of volatility would cause it to go higher and causing more to margin call. Higher volatility leads to higher volatility.
To answer the question from the start of this blog, I will provide a quote that encapsulate the absurdity of volatility.
When volatility is no longer a measurement of risk, but a key input for risk taking, we enter a self-reflexive loop.-Artemis Capital LP, Volatility and the Alchemy of Risk
Short Volatility in Today’s Market
Although in my blog thus far, volatility is only used in the context of the equity market, it exists in other financial products too.
Bonds also have their own volatility known as the MOVE index. And hedge funds are massively short the 30-year treasury, they are starting to long some 10-year treasury but is still net short on 10-year treasury too.
Because the data is very blurry, I would not be posting the images here as it will further deteriorate the quality. Click here (first two graphs) to see how hedge funds are positioning their positions. This is due to the fact that they believe QE would cause inflation and raise interest rates (yield, although they are slightly different, they usually moving in tandem).
Bonds price would rise when yield fall. Imagine you are holding a bond with yield of 1%. If the bonds in the market have their yield decreased to 0%, all of a sudden your bond would be more attractive as it has a higher interest rate than what they could get in the market. And your bond price would increase.
Do note that this is not a 100% accurate representation of bonds.
As for the side of equities, I do not have any solid data on it and will abstain from commenting. Here’s an article on the topic of short volatility in equity in today’s context. It goes into the significance of zero yield bonds and how traders sell volatility in place of their bonds as a fixed income asset.
How to Long Volatility?
There is also the VIX option that you could do, but since VIX option is European-style, there could be the risk of a the crash happening before you can exercise your option. So, I would not be touching on this.
Long Volatility Option Strategy
- Buying a out-of-the-money naked put option
- Buying a out-of-the-money long strangle
- Buying an in-the-money long straddle
Depending on how bearish you are on the future, you could tune your expiration and strike price. If you are very bearish that a market crash is coming soon, you could buy a put options at strike price 20% away from its underlying and is expiring soon (maybe 3 months).
If you are uncertain about the future but still want to use options as a hedge against your equities exposure, consider a long dated expiration. Perhaps 2 years away from expiration, so that the theta decay would not chip too much of your money away.
Since these are option strategies, apart from having your returns based on vega (volatility), it would also depend on delta and gamma.
Vega is the increment of the option’s extrinsic value per 1% increment of implied volatility. It is highest when the underlying is approaching the strike price. This is the ‘volatility’ component of the option and is what causes options to increase in value during an IV spike.
Delta is the change in the options’ price per $1 increase in price of the underlying. Delta increases sharply as the underlying approaches your strike price as there is a higher probability of being in-the-money.
Gamma is the first derivative of delta and it measures the rate of change of delta. The closer you are to the money, the higher the gamma. If we consider delta the when you buy a out-of-the-money (put) option, even when the underlying falls, it is still too out of the money, your option might only increase a little in value.
When strike price is far out-of-the-money, gamma is low and delta increases slowly. As the underlying approaches the strike price, delta accelerates as gamma increases. If we consider delta the speed in which the option’s value increase, gamma is the acceleration of the option’s value. In a sense, delta could be seen as the leverage-ness of the option.
Therefore, when a crash comes, gamma would come and increase the leverage of the option in your favor!
Even if after the crash,the underlying is not in-the-money, by taking into account the increase in extrinsic value due to vega as a market crash would come along with an IV spike. There is a real possibility that profit could be made even if the option is not in-the-money due to all vega, delta, gamma and the option’s ‘closeness’ to moneythat raises its extrinsic value.
And in the case that you do get in-the-money, since a relatively out-of-the-money option is bought, a windfall could be made.
But, there is during a period of low IV, it is hard to predict when a crash would come. In this case, but if your market outlook remains unchanged, rolling-forward the option might not be a bad idea as it keeps theta decay low.
These are the mechanics at play for our long volatility option strategy. But, which to choose, since I have suggested three strategies.
|Sure that incoming crash is BIG||Puts||Strangle|
|Unsure of magnitude of incoming crash||Puts||Straddle|
If you are a bear, it is quite self-explanatory why you buy puts.
The neutral strategy is for when you are unsure when the crash would come, but do not want to miss out on the ‘bull rally’ or in today’s context the speculation where valuations do not matter and people is just throwing money at the stocks.
In this case, you are still confident an incoming crash, it is how we assumed the magnitude of the crash would be different:
- Big crash – Strangle is a out-of-the-money long volatility option strategy would provide more leverage but there is the chance that even after the crash, you still did not make any profits
- Unsure or small crash – Straddle is an at-the-money long volatility option strategy that is less leveraged. But even if a small crash happens, there is a higher chance of profit
The second method that you can get into volatility, is by buying VIX futures ETN like VXX. The upside is that it is more sensitive to volatility. A way to visualize the difference between put options of some variants and VIX ETN is to imagine that VIX ETN shifted the premium paid for time value of delta and gamma and put those into vega.
The downside is that it decays rapidly at ~8% per month! There are many critiques of even the validity of holding VXX as a volatility hedge, as I have not delved deep into VIX ETN, I think I will just end it here. This is just to inform you that there exists such a tool.
- Do not undervalue volatility even if it does not generate returns
- Returns are not even. Protection of downsides could be as important or even more important than maximizing upsides.
- There is a hidden danger behind low volatility. Suppressed volatility is a nuclear warhead.
I would be doing these paper a disfavor if I am to give them a summary. They provide a unique perspective on the nature of volatility and the systemic danger of short volatility. Many of my thoughts are shaped by the philosophy in these papers.
1. Volatility and the Allegory of the Prisoner’s Dilemma
2. Volatility and the Alchemy of Risk