Warnings On Selling Volatility Ahead Of Seasonality
In an investing world that is filled with various investment vehicles, strategies and practices, risk vs. reward usually plays a very critical role in how individual investors participate in the market. An era of central bank Quantitative Easing practices has been blamed for many of the extremes in both the equity and fixed income markets for several years. Many, if not most, investors/traders, analysts and economists believe or promote that central bank influence has driven risk out of the market, thus increasing where the most attractive reward can be extrapolated from the market.
All one has to do is Google search keywords such as central bank, QE, asset bubble or any derivative thereof the aforementioned words and thousands of articles will pour out of Google’s search engine that will lead one to believe that central banks are the root of all financial market evils. This couldn’t be further from the truth. What I just offered was a statement: “This couldn’t be further from the truth.” No supporting evidence, no explanations as to why I made the statement, just a statement. Therein lay the problem when it comes to media headlines and even content or OPED materials. Much of the time, these articles make statements without supportive facts/materials. And even when they have supporting material, they are material that is biased in favor of the articles overarching theme or hypothesis.
Volatility sellers came under peak scrutiny during the February 2018 VIX event that found the VIX climbing more than 100% in a single day, a record feat for the index. The spillover effect from the event was that to satisfy “margin calls”, equity holdings were also found in need of liquidation. It was a troubling time for the equity markets and much of the blame for the dual-1,000 point Dow drops was blamed on VIX sellers or short-VOL strategies. Like anything else that ever happened or will happen in the market, there’s no one culprit, but rather contributing factors/culprits. And yet here we are again, shortly after the February 2018 VIX event, with the VIX back near its lows of the calendar year.
Want to know why the VIX is back to readings that express market complacency? It’s really quite a simplistic answer and one that you don’t need to be a member of Mensa to appreciate or understand: It’s supposed to be. I don’t necessarily mean it’s supposed to be below 13%, but rather it is supposed to express a level of complacency in the market or homeostasis if you will.
Facts are facts! Markets can’t find sustainable participation in volatile markets. The TD-Ameritrade Investor Movement Index expresses a perfect example of the lack of participation that occurs when markets express volatility. Check out what happened during and post the February 2018 VIX event below to TD-Ameritrade’s infamous index reading.
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That big drop in market participation is what occurs during most all volatility events of consequence. Now imagine if such volatility persisted. Nobody is going to put their money into a market or investment vehicle if that market moves 3,4,5 percent on a daily basis. Investors would flee such a situation.
Let’s think about those statements or deduce them rather quickly with respect to the longevity of market declines. How long was the bear market from the 1987 market crash infamously known as Black Monday? And the dot.com bubble crash? What about the financial crisis of 2008? Asking someone how long those bear markets were is somewhat of a contradiction in terminology is it not? When we review the peak to trough moments from these market crashes and juxtapose the timeline against the subsequent market resurgence, we not only validate the contradiction of the words bear and long, but we also validate that markets don’t exist to express volatility of 3,4,5 percent daily moves for very long. So a very broad and general understanding of volatility: market correlation could be defined with the following statement: If you believe in the perpetual existence of the market, you believe in the perpetual existence of market complacency over elevated market volatility. Another way of putting it is, “Unless you believe the market will one day fail to exist you believe in perpetually elevating volatility.” Which seems a more likely outcome to you? Most would vote for statement #1 and as such that is why there are generally more volatility sellers than there are buyers of volatility…nowadays and in part. In part because the volatility complex has grown by leaps and bounds in instruments to participate within the complex and research that lends itself to greater participation.
On June 4, 2018, Atyajit Das penned an article for Bloomberg titled Volatility Trading Is a Problem. Well, that just says it all now, doesn’t it? Of course not as we actually review the article further. At the beginning of this OPED, the author discusses the Goldman Sachs $200mm windfall from buying volatility ahead of the February 2018 VIX event. The article advances with the following paragraph:
“Implied volatility is in practice, unsurprisingly, a poor predictor. It's impossible to estimate accurately the impact on asset prices of political developments, natural disasters, wars, pandemics, or financial events such as the restructuring of the euro, a significant slowdown in China, trade wars, or unexpected growth or inflation figures.”
Based on the author’s paragraph positioned here, I’d like readers to consider the following numerical points.
- Remember, the majority of volatility participants are selling volatility as defined by the CFTC tracking data gathered and disseminated periodically.
- Why does one need to predict all those offered variables by the author?
- With respect to the aforementioned question (#2), is the author simply under the improper premise for understanding the VIX and VIX traders, maybe even markets as a whole?
- Again, remember, markets would likely cease to function or even exist in perpetually volatile markets as we’ve learned from the simplicity of short duration bear market scenarios going back decades. Heck, we’ve even learned this from how quickly the markets not only drop “bigly”, but how quickly they recover as they have since February 2018.
- “Implied volatility is, in practice, unsurprisingly, a poor predictor.” Not to sellers of volatility, that’s actually the known variable. Implied volatility is likely to be found in error over the lifecycle of a futures contract. That’s the way the market works most efficiently AND the vast majority of the time. It’s all about premise people, all about premise.
Here is a chart of Non-Commercial VIX futures short interest that appears in the CFTC Commitment of Traders (COT) report.
So as you can see from the chart above, most VOL traders are short-VOL in aggregate and much of the time. Charts are pretty objective when it comes to aggregating data. Here’s another, more recent chart on the VIX and net VIX speculators.
The trends are pretty clear when it comes to the VIX and spec holdings, subjectively speaking. Back to the Bloomberg OPED we go with another paragraph.
“Yet this fundamental inaccuracy hasn't prevented volatility from being converted into something tradable. VIX futures, over-the-counter variance products, and option selling may total as much as $100 billion. Volatility models also drive trading strategies totaling as much as $2 trillion. Risk-parity or variance-control funds target a set risk level defined by volatility. Long-short strategies, as well as algorithmic and momentum trading require volatility inputs. Firms engaged in stock buybacks indirectly write put options on their own shares. Central banks implicitly sell put options in underwriting market values and liquidity.”
So the author knows the known variable is that implied volatility is expected to be inaccurate and certain financial institutions and entities simply took advantage of the known variable to create trading vehicles. And it’s become a big industry! But… wait, wait, wait, wait a second! Last sentence: Central banks implicitly sell put options in underwriting market values and liquidity.
Is that right; is that what central banks do? Don’t get me wrong, we get the fact that central banks contribute to backstopping an economic downturn or spiraling effect with longevity, but implicitly selling put options? That’s a bit of an overreach in our opinion for actions by the Fed that have a binary outcome potential. Either the Fed’s actions result in greater consumer confidence or they don’t. Equity markets be darned. The consumer is some 70% of economic activity and as such when the consumer feels more confident and has the necessary tools to express that confidence with spending, the economy expands. It wouldn’t matter how low the Fed reduces rates if it didn’t spur the consumer to spend. Equity markets, therefore, would not rebound from such events like 2008.
Much of the “Fed put” colloquialism came about from the grand Quantitative Easing experiment, as a result of the 2008 financial crisis. It suggests, and as the author embellished upon, that the central back has suppressed volatility. When we examine the Fed put under logic and against history though, it simply fails.
The author believes in the Fed put and suggests it serves to boost asset values and suppress volatility. I can actually argue both observations are a misnomer. Simple question: When was the last time QE and central banks were not in the picture enacting QE programs? Easy answer, right? Prior to 2008, there was no QE or grand central bank interference within the financial market. I said grand folks. Of course, central banks always play their role with monetary policy, but grand it is not. Take a look at the chart below.
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The chart is provided by Capital IQ and Yahoo finance. It’s the most simplistic chart of the VIX from 2003 up to 2008. Absent the major spikes during the period, the mode value of the VIX from this time period was 13-14 percent. While the historical model is roughly 19-20 percent, when you strip out major events it tends to be around 13-14 percent. So while the masses and the media find it advantageous to blame the Fed for this, that and the other, I’d be willing to bet that for all the blame placed on the Fed, they would be easily exonerated with dedicated study/research. I could quite literally go on and on, picking apart this particular article and many others with like the subject matter, but to what end?
Here’s another warning with regards to selling volatility by Morgan Stanley. Well, that ought to make it more relevant, precise and valid should it not; it’s Morgan Stanley after all. The article is titled Not Enough Time on Clock to Sell Volatility, Morgan Stanley Says. At the end of this “timely” article, Morgan Stanley offers the following statement:
“Bottom line, selling vol on equity, credit and rates looks quite challenging despite positive carry, unless one is very optimistic on the longevity of the cycle,” they said.
I don’t think many volatility sellers would suggest there is normally an easy time to sell volatility. There are better times to do so certainly, but there are always challenges to the trade. A bear market will happen upon investors and traders at some point, but at present that may need to coincide with the next recession. Most analysts are not calling for a recession until 2020. With the market being forward-looking that may certainly find agitation with equity markets come mid-2019. And even to that extent for considering greater volatility in the market and the potential for a bear market, does that assume traders should BUY volatility? Good luck with that assumption. If the February VIX event did enough to lure unsuspecting traders into that side of the trade, the subsequent months have done enough to wring them out with great disdain for the long-VIX trade.
Additionally, with regards to the Morgan Stanley notes and Bloomberg article, I get the points and understand them to have good selling points. It’s opinion-based, but with sound concerns and data points underlying those points. But with volatility, there’s always a way to argue against selling volatility, always! Morgan Stanley suggested there’s not enough time on the clock to benefit from selling volatility. They did so during a period where, seasonally, it’s actually quite the appropriate time to do so. Russell Rhoads of the CBOE actually discusses this in his latest blog titled VIX Index Summer Seasonality. Rhoads appropriately identifies that the summer months, when there is usually less market participation than in most other months of the year, the VIX has the lowest median averages of the year.
The objective reality is that on a seasonal basis, Morgan Stanley’s assertions are… not optimal. It doesn’t mean Morgan Stanley will be wrong during this particular summer season and as they’ve used more variables than just seasonality to draw their respective conclusion on selling volatility, it just means there’s always another perspective to consider.
Like I said, we could pick this article apart all day long, but to what end given that the premise of the article doesn’t likely align with the general participation of the volatility complex and those strategies for selling volatility that are numerous in quantity and quality. Having said that, I'm not suggesting shorting volatility is for everyone, easy or to be taken up by the average trader on the street. We would actually suggest it to be something that demands of a trader a skill set or even a “driver’s license” of sorts in order to participate in such a manner. The short-VOL trade is indeed a dangerous trade when not performed from a position of expertise and experience.