Highly Evolved Vol

2018 hasn't been a good year for volatility funds. In February there was a feedback driven catastrophe in the implied volatility space. The details are less important than the result. A lot of volatility funds lost more than 30% in the month and one of the largest funds lost over 80% in a day. The last few months have also been tricky. Equity markets have been more volatile than expected, but the bigger problems have been in the commodity space. In particular, crude oil and natural gas have been, to quote a very experienced trader, "****** unbelievably ****** insane! Like ****! Seriously dude. ****!". And you may have seen a sad youtube video where a hedge fund manager tearfully apologizes to his clients for losing all of their money due to the "rogue wave" in the natural gas market. I'm not dancing on anyone's grave. I hate to see a business fail and I hate to see investors lose money. But there are also some important lessons here. February e

Mid-term elections are not usually very memorable affairs. The voter turnout is much lower than for presidential elections (since 1960, voter turnout has averaged around 40% versus 60%). It seems likely that voter interest is atypically high this year, but that isn't the point of this post. What I want to know is, "How do mid-terms affect volatility?" It is generally true that volatility declines after scheduled events like this. It has been shown to be true for presidential elections, but it also applies to crop reports, earnings announcements and big economic releases. My guess was that mid-terms also produce a similar effect. The average voter might not be interested, but volatility prices are set by the marginal volatility trader not the average voter. Vix data only goes back to 1990. This isn't a particularly large sample, but it does cover some significant political issues including two gulf wars, the Lewinsky affair, a disputed election and the tea party fo

“People, process and product” -Marcus Lemonis, host of CNBC’s “The Profit” In my last post I discussed some of the hazards of assigning numerical measures to hedge fund performance and suggested that keeping things simple might be the most robust approach. Here I’m going to write about evaluating the business side of a fund. In his business turnaround TV show, Marcus Lemonis is fond of saying that he evaluates a business based on people, process and product; his “three p’s”. I’m going to use the same framework but add one more as well. I must list these in some order, but that doesn’t reflect any degree of importance. People Everything a fund does is because of the people running it. You are not investing in a fund. You are investing with people. It is important to know who the managers are, their backgrounds, their experiences, their levels of involvement and the amount, both professionally and financially, they have invested. Do they treat your money even

A siren was a mythological being who  lured sailors with their enchanting music to shipwreck on the rocky coasts of their island. Their songs were almost impossible to resist.  But more generally a “siren” is a bad thing that we are attracted to, either physically or psychologically. For investors, an example of a siren’s song is simplicity. Many investors are prone to looking for just a few metrics to evaluate a fund or a strategy. This is a problem. It is a problem for me because my answers to reasonable sounding questions will be incomplete. “What is your Sharpe ratio?” sounds reasonable enough. But the answer on its own is close to meaningless without a much more detailed elaboration. What is the sampling error around the point estimate? How constant has it been across sub-periods? How distorted is it due to the shape of the full return distribution? But, more importantly, it is a problem for the investor because the simple answer gives a false sense of certainty. Is t

On April the 24 th , 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 a

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 2 nd , 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 34 th largest in history. But Monday the 5 th was truly exceptional. The S&P 500 dropped 4.2%, but the VIX rallied 115.6%. This was the largest VIX mov

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 defe

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.

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 Sti

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 about this a lot . 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 see

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 quan

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