Volatilty, Is This Time Different?

We happened to have reached out to several volatility traders earlier this week after reading the Zero Hedge piece to get their input (as always, when we plan on writing about a market doing one thing, the day of posting the market does the other…) and thought no better a time to share that insight then after today’s spike:

We’ll lead off with Tim Jacobson of Pearl Capital Advisors (up about 9% on Wednesday before fees – past performance is not necessarily indicative of future results), who has a handy chart breaking down previous VIX moves based on what price the VIX was at – at the time.

Below is a table that shows what the largest moves in the VIX Index have been since its inception in 1990. The table only includes the 72 instances when the VIX Index spiked by at least 20%. The table then breaks down the largest spikes within four buckets: VIX < 12, between 12 and 15, between 15 and 20, and when VIX is greater than 20. Based on these data, we could support the argument that an unwind of the short-vol trade could cause the VIX Index to spike more than 7 points from its current level. Readers must keep in mind that generally, the VIX futures have about a 50% reaction to moves in the VIX Index. This number is historically lower as VIX is lower. However, if an unwind were to be sudden enough, we could see the VIX futures reacting more than usual/expected. For managers who have a model or process to identify and capture these kinds of moves, a reversal in volatility could present some lucrative opportunities.

The most moves above 20% came when the $VIX was already above the 20 price. This isn’t all that surprising when you consider that historically, the $VIX hasn’t spent very long below 12 or below 15 (except in its current period).  The biggest $VIX Spike was 64% when it was under 12, but what if we see a 100% move? That sounds crazy, but in today’s environment, that would put the $VIX at 20 – a very standard number. Brett Nelson of Certeza Capital says it wouldn’t “break” the market – but it could set the scene for some major movement for the VIX and $ES_F.

Indeed, a VIX move from 10.00 to 20.00 is a 100% increase, but would not have a devastating impact on the vol markets. However, the current condition of the VIX term structure allows for the possibility of an unprecedented event. For example, if SPX were to decline steadily to near 2400, VIX would rise, but likely not above 20. That initial move would be unlikely to rattle the vol sellers, and in fact many would consider increasing exposure because their models would be telling them vol is expensive. It’s not difficult to imagine many algos buying there and pushing VIX back down toward the mid teens; a move that would be reinforced by discretionary vol sellers as they balance their portfolios to accommodate a perceived increase in profit potential. At that time, the stage would be set for a surprise SPX move below 2400. With reasonable momentum it could very well result in a 4-5% drop in a single day. VIX would exceed 50 and severe backwardation in the futures term structure and heavy skew in the options would necessitate a massive short vol offset. The impact on the vol sellers would be felt far and wide because most hedges based on traditional correlation assumptions would fail to deliver on their promise.

Darren Kottle of Caddo Capitalechoess Brett- saying this could be shaping up for a worrisome scenario.

In recent years, equities have rebounded rapidly after every selloff we’ve experienced.  Anybody who has timed the hedge right will by necessity want to unwind quickly otherwise they’ll lose gains.  Coupled with VIX sellers who have been rewarded for selling on spikes, you see a VIX rise that reverses quickly.  A multi-leg equity selloff that is more severe than what we’ve seen recently will show VIX’s true color:  that of an extreme autocorrelated asset that can easily go parabolic.

All this being said, Nelson says it’s important to distinguish between probability and expectancy.

A huge majority of volatility traders tend to confuse probability with expectancy, and it is really the latter that matters. Because of this, they are unwittingly entering a negative expectancy trade simply because it offers high probability. High probability generally equates to consistency over some indefinite time period and skewed risk metrics give the investor a false impression of the managers’ long-term risk profiles. Unfortunately, the combination of high probability and negative expectancy in the same trade is the definition of high tail risk. They are settling for significantly reduced profit at dramatically increased risk, hoping that the eventual spike doesn’t happen at a time when their hands are tied.  On the other hand, I’m typically equally dismayed by habitual vol buyers who love to blindly buy vol at low VIX levels; doing so simply on the basis that a market drop must come at some point. As we’ve experienced many times, grinding low-vol bull markets can last for quite some time. The traditional slope of the VIX term structure offers little in terms of positive expectancy for the persistent vol buyer. Albeit, this is one case where they are correct in spite of their lack of edge. The term structure has thrown the odds wildly in their favor for the last 4 months.

While half the investment world may be shuddering after today’s volatility spike, worrying that there long time gains in equities may be under some stress (not to mention the short volatility traders who are likely seeing some scarring after today –  there’s a substantial amount of investment managers who have been waiting on volatility like this for a long time, and can finally, maybe, put away their voodoo dolls and stop their volatility rain dances for a spell to see what their models can do in an increased volatility environment. Who are they, besides the pros mentioned above – schedule a time to talk to an alternative investment specialist today to learn who’s itching to put money to work in an increased volatility environment.