Summer will soon be coming to an end, and in the beautiful beach town of Laguna Beach summer tourism is reaching its crescendo like it does every year. This year, however, with booming equity markets, a general feeling of well-being, and little in the form of risk of wars and other fears distracting tourists, I sense things are a little overboard. Parking seems just a bit harder, getting into restaurants much tougher, and crowds are considerably thicker. The local economy depends on these tourists, but I can sense the locals are yearning for September. Good vibes abound everywhere, and nothing attracts more tourism than postcards and pictures back home with shots of smiling faces. Hidden gems, like Laguna Beach, always get discovered with time.
In what used to be a hidden gem for derivatives wonks and institutional managers of money, we are now seeing a similar kind of surging investment tourism. It follows a strategy of “selling the noise”, or selling options – via derivatives contracts or packaged products. The end goal is to pocket the premium income.
And boy, has the strategy done well recently! The theory goes as follows – there are two types of market participants, insurance buyers and insurance sellers. The market for options is a market for risk transfer; i.e. the insurance buyer pays a risk premium to the insurance seller. If there is no event that results in contractual payouts to the option buyer, then the option seller gets to keep the premium. On average, the theory goes, the option buyer has to pay the option seller a bit more than the fair value of the premium to take the risk of loss. On average, the option seller keeps the margin between the premium he receives and the theoretical value of the option. This is the option seller’s “edge” that he obtains by having enough capital to make the option buyer whole if needed.
Now a derivatives trader in the energy markets can run a synthetic “refinery” by selling gasoline futures and buying crude oil futures, or another derivatives trader can run a synthetic “crush spread” operation by selling soybean oil futures and soybean meal futures against buying soybean futures. Similarly an investor with an option account can run a synthetic “insurance company” by selling options on margin or capital backing the sale of the options. Margin money is cheap after years of money pumping by central banks, and income is hard to get. So it naively makes sense to take capital at low interest and use it to sell options to generate yield like a perpetual motion machine. Witness the impact of these synthetic insurance factories on the levels of volatility in the equity markets.
Now if running an insurance company out of your garage in the equity markets makes sense, why limit yourself to just one line of business, or why be a synthetic “mono-line” insurer when you can be a “multi-line” insurer? Isn’t diversification the ultimate free lunch? So, again, the theory goes, sell insurance and reinsurance across markets to diversify – act like a multi-line insurance company. Which is probably why as VIX is at an all-time low, volatility in other markets has followed it lower. If the option selling strategy works in one market why not do it in all markets?
A metric of the bond market volatility, the MOVE index (at 47 basis points per year) is the lowest it has ever been. The TYVIX index which measures the volatility of the ten year futures contract, the liquid bond market cousin of the S&P 500 futures market, is at 4%, a level last seen before the quant meltdown of 2007 and right before the taper tantrum of 2013. The VIX at 9% means that the market is expecting that over the next month or so the annualized volatility of the equity market will be no more than 9% (long term volatility has averaged about twice that). But the MOVE index at 47 basis points means that the bond option markets don’t think that yields will move more than about 15 basis points over the same period. And this is while the Fed is in tightening mode! I look at about twenty different volatility metrics daily, and the story is the same across most markets. Here are some examples: According to Bloomberg emerging market implied option volatility is at 14%, the FTSE (UK with Brexit looming!) is at 10%, Indian equity volatility is at 11%, and the KOSPI (Korea – with a possible geopolitical turmoil event, no less) is at 10.5%. The high yield ETF HYG trades with a volatility of about 6% (52 week high of close to 30%). Volatilities of the Yen and Euro are in the 7% range, which is also close to multi-decade lows.
But since macroeconomic volatility has been falling, couldn’t one argue that all volatilities across markets should fall in concert, and if so then why is this approach of running a diversified synthetic insurance factory flawed?
There are three reasons why:
First, the Fed and the other central banks of the world are protecting equity prices even though they will deny this simple fact (“watch not what we say but what we do”). So the fact that the VIX is low can maybe be justified since the VIX is a metric for the equity markets and hence a stimulant for animal spirits. But for every save there is a sacrifice, and bond markets, currency markets and commodity markets have no such implicit central bank put. Selling volatility in other markets by imitation is missing the point of why VIX is so low, which is that there is an underwriter, or insurer of last resort behind the equity markets, the Fed (and the ECB), but not so for other asset classes.
Second, which requires a bit more thought, is that the S&P 500 is an index, and the VIX is a measure of the volatility of the index. The volatility of an index mathematically is a function of the volatility of the individual constituents and the correlation between them. So when either the volatility of the index falls, or the correlation between the constituents decreases, the volatility of the index declines. And correlation between the constituents of the S&P 500 at 27% has also declined sharply (as measured for example by the CBOE implied correlation index). So no wonder that the implied volatility of the S&P 500 as measured by the VIX has fallen so low. I can almost justify these low levels as “fair” but won’t go so far since both volatilities and correlations tend to rise when bouts of greed and euphoria are replaced with bouts of fear. To wit, in 2008 the VIX went to 60% and so did the implied correlation as all stocks started to move down in lockstep.
But coming back to volatility in other asset classes there is little contribution from correlation. The TYVIX is a volatility index of the ten year futures contract, and the futures contract is made up of the deliverable basket of ten year notes, whose correlation is close to one and quite stable. So, betting on a falling volatility of the ten year note is simply betting on falling volatility of the ten year yield, just when the Fed is becoming more activist and possibly eager to tighten aggressively. Similarly the volatility of the Yen and Euro is not a volatility of an index but the volatility of a single exchange rate, so no correlation benefit there either.
Third, the total volatility across markets and assets is generally conserved over time. Risk is transferred from market to market and person to person, not erased. Yes, central bank action might push volatility down in equities for a considerable period, but markets will reprice the risk elsewhere. Like pushing on a balloon, the risk will get transferred somewhere else eventually. Evidence suggests that both currency and bond markets are vulnerable today to the repricing of overall volatility. Certainly one of the areas to watch is the impact of rising volatility in bond markets on various algorithmic strategies that take their cue across assets, mechanically, from volatility signals.
So watch out for the end of the summer calm, and plan for the exit of the volatility tourists. I watch the VIX with one eye, and the signs of volatility repricing in bonds and currencies with the other, where volatility tourism seems to have gotten a bit too popular.
Vineer Bhansali, Ph.D. is the Founder and Chief Investment Officer of LongTail Alpha, LLC, a California-registered investment adviser and a CFTC registered CTA and CPO. Any opinions or views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the opinions or views of LongTail Alpha, LLC or any of its affiliates (collectively, “LongTail Alpha”), or any other associated persons of LongTail Alpha. You should not treat any opinion expressed by Dr. Bhansali as investment advice or as a recommendation to make an investment in any particular investment strategy or investment product. Dr. Bhansali’s opinions and commentaries are based upon information he considers credible, but which may not constitute research by LongTail Alpha. Dr. Bhansali does not warrant the completeness or accuracy of the information upon which his opinions or commentaries are based.
This publication is for illustrative and informational purposes only and does not represent an offer or solicitation with respect to the purchase or sale of any particular security, strategy or investment product. Past performance is not indicative of future results.
Different types of investments involve varying degrees of risk, including possible loss of the principal amount invested. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, or any non-investment related content, will be profitable or prove successful. Nothing contained herein is intended to predict the performance of any investment.