Friday, September 15, 2006
(8:04 AM) | Anonymous:
The Volatility of Volatility
This is not good:Citigroup's equity derivatives strategists said in a recent note that stock returns have for the last three years been more similar to index returns than at any other time in the past 10 years.It has been possible for quite some time to trade $VIX and $VXO, the two primary measures of market volatility. Why do such a thing? To hedge against any dramatic price movements, reduce broad risk, and even arbitrage out any disparity between the implied volatility in SPX options and the VIX. 'Course, you can also use them to speculate not on whether the market will make a big move up or down, but on whether or not the market will make a big move at all.
By analyzing the Standard & Poor's 100 Index, Citigroup concluded that the low volatility in the market was essentially reinforcing correlation of component stocks.
This means that relying on stock picking to outperform the market is more difficult now than in a long time. Citigroup recommends stock holders sell long-dated options with abnormally high index volatility, such as at-the-money December 2007 options on the Standard & Poor's 500 to enhance stock returns. In addition, what this correlation conundrum further illustrates is that volatility, which once existed in the options market almost solely as a mathematical concept to measure stock price movement, is showing signs of gaining widespread acceptance as its own quasi-asset class.
But treating volatility itself as an asset class will not help the average trader, not to mention the average investor. Don't get me wrong: I love calendar spreads and iron condors as much as the next guy. But since February 2006 it has been possible to trade options on the VIX - that's right, you can bet on the implied volatility of volatility itself. This only sends us further down the rabbit hole. There's nothing stopping us from creating nth level derivations based on the predicted range of an options contract during its short life, or to predict the rate at which a contract will respond to volatility in its underlying asset. Why not just trade the Greeks rather than particular equities, anyway? The best options traders I know already speak of getting long/short delta..
The primary argument in favor of financial derivatives has always been that they help people minimize risk and avoid the vicissitudes of a violently unpredictable world - the idea being that if you can pick good stocks and hedge against risk you can beat the market indexes over time. It's like there's a battle going on between the mammoth index trends and the handful of crazy, devil-may-care stocks that will fly above and below index trendlines over the course of a year. (Such wild, desireable stocks have "negative correlation" because they don't follow - and sometimes even move inversely to - market trends.) Derivatives are tools that let us tame both the brute indexes but also the riskiest and most rewarding stocks.
But, as the Citigroup note shows (and the comment about expiration pinning in the Barron's piece reinforces this point), derivatives themselves now seem to have the upper hand, such that attempts to avoid and profit from risk are now impinging on the very source of that risk - namely, equities diverging from their broader indexes. "Positive correlation" is a scary phrase because it means the end of those wilder equities - as correlation increases the opportunity to do any better than the broad market diminishes. And as volatility becomes not just an external indicator but an integrated component of market movements, even the wilder motions of indexes themselves could eventually be boxed in by cautious hedge funds and program trading.
People always worry that the market will stumble or even collapse due to some specific crisis or macroeconomic disaster - these days it's housing, Iran, energy costs, etc. But these have all been priced in already. My concern, over the long term, is that big players will become so adept at taming the extremes of market motion that entropy will take over and the market will evenly distribute itself into a kind of smooth heat death.
