Tuesday, March 1, 2011

Update - Volatility Where Art Thou?

Wow. I have not posted in a long time. I have been pursuing career development (like opening a law practice) in other areas and relegated blogging more or less to a hobby. To say the world has changed a lot since my last post is an understatement. Instead of giving a detailed chronological account of the last few months, I will jump right in and address the current event topics.

The markets have been on a bullish tear since Bernanke made his announcements of Quantitative Easing in late summer/early fall 2010. Since that time, the bulls have been seemingly undeterred by any bearish news. Even the collapse of two Middle Eastern dictators has not done much to stall their advance. However, there are multiple storm clouds on the horizon that would give even the most ardent among the herd a reason to head for shelter.

I see 2 problems looming, Stagflation and European defaults. Neither of these are new but the context in which they are being presented is changing rapidly.

Stagflation is defined as a combination of weak economic growth and high inflation. It is the one threat that has the potential to impede further progress in equities and other risk trades. After all, the recovery trade is more or less done at this point w/most companies having borrowed to buy back their shares (which is my own belief behind the market's advance). While inflation remains relatively low in the West, it is offset by continuing weak labor markets. Instead, inflation is strongest in emerging markets where food and fuel comprise a larger percentage of residents' budgets.

The fundamentals of higher food prices are linked to dietary progressions up the calorie chain for more expensive items. People used to eating rice and lentils have become hungry for chicken and beef. These added demand constraints on farmers and land use has been further exacerbated by volcanic activity in Kamchatka, Russia and colder weather patterns in the Pacific Ocean. Kamchatka is a remote province in the Russian Far East most famous for its large population of bears and elk. But the same geography that is responsible for its geographic isolation is also responsible for a recent spurt in eruptions that have sent hundreds of tons of soot and ash into the atmosphere. La Nina is a reference to the cooler waters in the southern Pacific Ocean that generally lead to drier weather in North and South America.

As any decent farmer knows, the world turns in cycles. (See some of my past posts on El Nino for example) Most of the seasons can be predicted with a great deal of accuracy. But these additional wild card factors are causing substantial changes in heretofore unforseen ways. The changes have resulted in supply constraints that have sent agricultural prices skyrocketing.

European Defaults

Private creditors are not exactly lining up to buy peripheral EU debt. They have their reasons. A case in point is the recent elections in Ireland that saw the outgoing party, Fiana Fail, lose the most within 3 generations. Irish voters were enraged beyond measure about the party that got them into the current mess and wanted to turn them into slaves to foreign creditors. So, why does an election in a country with a population a tiny fraction of the total EU? EU ministers have been promising that all debts will be repaid. Unfortunately Irish voters basically said NO to that idea with a resounding voice. The new govt is likely to push for
a restructuring - a default in all but name. And when that happens the other PIIGS will also want the same thing. What do you think will happen to the markets when a wave of defaults on that scale occurs?


Ok. Enough fundamentals. Let's talk technicals. After all that's the title of this post. For the purposes of measuring volatility we will look at the S&P 500 Vix (volatility options index). I like the vix because it is about as pure a mathematical indicator as you can get. It has been alternately called the fear index b/c when the vix spikes, it indicates nervousness among options buyers on the S&P 500 stock options prices.

So, how To Protect Against Volatility?

I have put up several charts of the vix which indicate a potential spike in volatility over the next few months. Note the ATR (average true range) and standard deviation indicators. Like all options, vix options pricing reflects market sentiment by the sellers for future months. Outright buying vix options (in this case calls) 3,4,5 months in the future seems feasible at first until you consider that the only way to make a profit on those is by having the rate of change accelerate dramatically (preferably in the near term). To some extent this is true of any options buyer but the vix is different b/c the underlying values change for every month. In turn this is due to reversion to the mean as measured by standard deviation - which is more volatile by far than the vast majority of stocks or commodities.

The vix also spends most of its time in contango - a term used to describe the larger premiums demanded for far off months than compared to near month contracts.(Vix futures can be priced for backwardation but this happens less often - usually when the vix is already flying next to black swans -look no further than the September 2008-March 2009). The reason for this can be readily explained by looking at the vix over a long period of time. While the vix can and does readily revert to the mean, it can spike significantly in the short term and even stay there for protracted periods of time. The higher priced premiums are the result of options sellers demanding suitable compensation for taking on that level of risk.

So, what to do as a trader or even a hedger looking to protect against a fat tail event? In (relatively) low volatility times, debit (put) spreads on index etfs or leading stocks seem to be the way to go. There is limited risk but limited upside (of course the upside can still be considerable). Premium selling strategies are not worth it with low volatility. Of course, one can always buy calls or puts (well in this case puts if you favor a sustained market correction). You still have to be right with both trades (debit spreads and straight options buying) but at least volatility is favoring the options buyers.
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