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The VIX is Not Broken

On April the 24th, the Wall Street Journal ran a story detailing the huge move of the VIX index in the opening 30 minutes of trading on the previous Wednesday. The VIX spiked up 12% in 30 minutes despite the underlying S&P 500 index not moving much at all. To put this 12% move into perspective, the current expected move in a 30-minute period is less than 2%. In addition to being a large move, the timing was suspicious. It was during this period that the settlement price for the April VIX futures was calculated. Anyone holding a long futures position would have benefitted greatly, at the expense of the shorts.
There have been rumors about the manipulation of the VIX index for many years. Whether or not the anomalously large S&P 500 option trades during the settlement period are evidence of manipulation, part of an arbitrage or just coincidence, the fact is that the VIX settlement period is often atypically volatile. This is alarming for market-makers and professional arbitrage…

New Volatility Regime

The equity market hasn’t really decided what it wants to do. However, we are now very clearly in a new volatility regime. From the start of 2017 through to the end of this January, realized volatility was 6.9%. In February and March, it was 23.6%. 

Below I show the S&P 500 from the start of 2017 until the end of this March.


Things have changed.

But what is particularly interesting to me is how exactly things have changed, because that is a little unusual. 

Generally periods of high volatility have one major cause: the Asian crash, LTCM blowup, the dot-com bubble or the housing credit crisis. But this year we have had two distinctly different periods.

The start of the turmoil was on Friday, February 2nd, when the S&P 500 dropped 2.1% and the VIX rallied 28.5% from 13.47 to 17.31. This was a large move: the 34th largest in history. But Monday the 5th was truly exceptional. The S&P 500 dropped 4.2%, but the VIX rallied 115.6%. This was the largest VIX move ever, and nearly twice t…

Adversity and the Variance Premium Part 2

Following on from the last post we will now look at how the concept of adversity can lead to the variance premium.
Let’s think about a $100 stock and the $100 strike call and put. Assuming no interest rates or dividends, and a volatility of 30%, both the one-year call and put will each be worth $9.92. One trader sells the put, and another buys the call. Now let’s look at two price paths for the stock.
Case One:
On the first day, the stock jumps to $119.84. It stays there until expiration. Each trader makes $9.92 at expiry, but the PL evolves slightly differently over time.


Figure One: PL for short put.


Figure Two: PL for long call.
Now consider the case when the jump happens right at expiration.


Figure Three: PL for short put.



Figure Four: PL for long call
My contention is that the shape of Figure Four is the one most preferred by investors. That the long option maintains the ability to “snatch victory from the jaws of defeat” is important. People prefer this, which points to options…

Adversity and the Variance Premium

Recently I’ve come to believe that we don’t know nearly as much as we think we do. Specifically the history of markets is nowhere near as big as we often assume. For example, equity options have only been traded in liquid, transparent markets sine the CBOE opened in 1973. S&P 500 futures and options have only been traded since 1982. The VIX didn’t exist until 1990 and wasn’t tradable until 2004. And the average lifetime of a S&P 500 company is only about 20 years. 
This might seem like a decent length of history that we can study and look for patterns in. But I doubt that it is. I think that while there appear to be many thousands of data points, there might only be dozens. Options and volatility wiggle around a lot but their long-term values are related to macro variables such as inflation, monetary policy, commodity prices, interest rates and earnings. And these change on the order of months and years. Even worse, they are all co-dependent.
I think this …

Stigler’s Law and Option Pricing

Stigler’s law states that no discovery is named after its original discoverer. Some notable examples from science are: Halley’s comet, known since at least 240 B.C.·Venn diagrams, invented by Leonard Euler.Pythagorean theorem, probably discovered by the Babylonians.Avagadro’s number, discovered by Jean Baptiste Perrin.As a result of colonialism and eurocentrism, geographical discoveries are even more often attributed to the wrong people. According to a century of British schoolbooks, Mount Kilimanjaro was discovered by Johannes Rebmann. It is incredible that the people who lived on it hadn’t noticed it before.

Stephen Stigler came up with his law at a conference to honor Robert K. Merton, the sociologist and father of the Robert Merton of option pricing theory.Merton lamented that original discoverers seldom get the credit they deserve. In a piece of nerd humor, Stigler appropriated the comment, assuring that Stigler’s Law would be an example of Stigler’s law.
The obvious interpretati…

Volatility Trading and Risk Management

Last week was interesting.
There is actually NOT a Chinese curse that says, “may you live in interesting times”. Apparently, the whole thing was made up by a British diplomat. Nonetheless, a lot of volatility funds were cursed by last week being interesting.
There are many things volatility funds can do, so their returns have a wide range. I’ve seen numbers ranging from up 25% to down 95% (we made a few percent and thank you for your concern). The median was a loss of about 30%. This is because most volatility funds are option sellers trying to collect the volatility premium. I’ve written aboutthisalot. It is a perfectly viable strategy. So how did a professional fund lose 95%?
I don’t know. Thankfully I wasn’t in that trading room. But some of it may be down to misunderstanding trade sizing when returns are highly negatively skewed, as they are when short volatility. I’ve written about trade sizing in these situations before, but the general problem can be seen in a simple example.

We Don't Know as Much as We Think We Do

Traders don’t know much either. I’m not talking about general ignorance, but specifically that the history of markets is nowhere near as big as we often assume. For example, equity options have only been traded in liquid, transparent markets sine the CBOE opened in 1973. S&P 500 futures and options have only been traded since 1982. The VIX didn’t exist until 1990 and wasn’t tradable until 2004. And the average lifetime of a S&P 500 company is only about 20 years.
This might seem like a decent length of history that we can study and look for patterns. But I doubt that it is. I think that while there appear to be many thousands of data points, there might only be dozens. Options and volatility wiggle around a lot but their long-term values are related to macro variables such as inflation, monetary policy, commodity prices, interest rates and earnings. And these change on the order of months and years. Even worse, they are all co-dependent.
I think this makes quantitative analys…

The Government Shutdown

Over the last ten years, a number of congress members have been elected on a fairly nihilistic platform, voting against practically any spending bill (unless it buys tanks). This is a good way to get elected but it makes it hard to govern. The government has to spend money. While the Republicans have majorities in both houses, there is a huge difference in political philosophies between members of that party. So the current shutdown was probably inevitable.
What does a shutdown entail?
Apart from “essential services” (active military, FBI, air traffic controllers etc, and the congressional gym) federal government functions are frozen, and about 800,000 federal employees will be furloughed.
National parks, monuments and the Smithsonian museums in Washington will be closed. Other things that stop are processing of applications for passports and visas, and the maintenance of U.S. government websites. The Internal Revenue Service and the Federal Housing Administration close. In the 2013 shut…