How many more times will we be forced to hear platitudes and meaningless mantras about markets? That they hate uncertainty; this creates volatility; sharp moves are not good for investors; that we need a level playing field. Stop, think. Uncertainty is one of life’s perennials. I don’t know if I’ll be run over by a bus as I leave the office. No volatility means a lack of opportunity in business, career prospects and life. As James Goldsmith famously said, "when you marry your mistress you create a vacancy". As for the playing field, as a trader I believe I have an edge just as stockpickers believe they have one too.
What is interesting is that, as reported recently by the Financial Times, investors have doubled (to $2.5 billion) the amount allocated to ‘inverse’ Vix exchange traded products. They believe the US S&P 500 index will settle down and the so-called ‘fear gauge’ will drop.
The Vix index, originally developed by Menachem Brenner and Dan Galai in 1986, was launched as a futures contract on the Chicago Board Options Exchange in 2004; options on this future were introduced in 2006. It measures the implied volatility of a series of options on the expected annualised change in the S&P futures with a one-month time horizon. Robert Whaley computed this series retrospectively to 1986 and the record low was 8.89 per cent in 1993. We have matched this for the first time this year – explaining the rise in popularity of the inverse Vix funds.
Deutsche Börse, in conjunction with Goldman Sachs, developed the VSTOXX index which measures the volatility of the Euro STOXX top 50 shares in the eurozone. The options are traded on the Eurex exchange and again have a rolling 30-day expiry. Look at the chart below and you can see that the volatility here is quite a bit higher than that of the S&P. This does not necessarily mean the shares themselves are more volatile; it means that those selling the options are able to charge more for the privilege of owning this insurance product.
The FTSE 100 index also has a one-month implied volatility measure called VFTSE. While volatility has on occasion been lower than the S&P’s, what is striking is how expectations regularly double and halve.
The final chart is the implied volatility of 30-day at-the-money options on the euro against the US dollar. Generally, foreign exchange volatility – both implied and observed (also called historical) – tends to be lower than that of equity indices. It’s due to a mix of an ultra-competitive market and an instrument that’s less flighty.
As those writing options know, it’s like ‘picking up nickels in front of a steamroller’. If you charge too little the chance of getting wiped out when the claims start coming in is high. A black swan event cannot be ruled out and the result is catastrophe. Conversely, buying options may give one a false sense of security and recurring expenses quickly eat into potential profits.
And for some, equity volatility options provide no adequate cover. This is becoming more of an issue as investors are warned against over-diversification and encouraged to hold between 10 and 20 core holdings. Unlucky, if one of those had been the UK’s Provident Financial, which dropped 66 per cent in a day.
Charts for this piece Vix, VSTOXX, VFTSE, VEURUSD.
