Unfamiliar to even many sophisticated asset managers, volatility investing provides unique opportunities for risk management and market understanding.
Volatility investing involves trading programs based on market price volatility. The primary volatility market is based on the stock market, but variations of volatility investing methods are used in commodity markets as well. In light of an approaching debt crisis and always unpredictable world events, volatility-based investment techniques, both long and short, are worthy of detailed investigation.
A recent educational opportunity sponsored by AlphaMetrix and the CBOE Futures Exchange revealed interesting issues as it relates to the debt crisis and volatility investment techniques. In addition to stock and commodity option contracts, one of the primary methods of volatility trading occurs with the VIX, the CBOE’s popular measure of implied volatility in the equity market.
Did Volatility Skews on December 21, 2012 Reveal a Market Imbalance?
“Just before the conclusion of the fiscal cliff debate, the time horizon spread in the VIX options exhibited unusual expectations,” noted Christopher Cole, managing partner at Artemis Capital Management and one of the panelists. “We could buy the front month VIX options and sell the back month with a positive carry.” This is unusual because such a long volatility position typically involves the purchase of premium, but in this unusual relative value situation the trading manager collected premium and had long volatility exposure.
“What was the shoe that was expected to drop?” questioned Bruce Rogoff who, as managing partner of option market making firm Gargoyle Group, noted highly unusual professional action leading up to the fiscal cliff negotiations. “And when is that shoe expected to drop.”
Behind the scenes, derivatives professionals have been observing the mathematical properties of the US debt crisis for several years. While predicting the exact date of a potential volatility implosion is speculative, what is known is there is a certain point at which compounding on the debt and a continued path of deficit becomes unsustainable, potentially leading to a transformational market crash. While the date cannot be predicted, the mathematical underpinnings of the problem are generally understood along with the practical knowledge of the likely political battles that could arise out of the problem. If the US debt crisis is left unaddressed, speculation is a transformational debt crisis crash could occur within three to five years, while more conservative estimates indicate a 10 year time horizon. Just like former CFTC Chairperson Brooksley Born predicting the OTC derivatives would eventually cause a market crash, she didn’t know the date would be 2008 but a logical understanding of derivatives structure and mathematical probability also indicates that at some point a debt crisis crash should be considered.
Can Market Volatility Be Predicted?
Perhaps one of the more interesting discussions to take place occurred regarding the predictability of market volatility.
“Volatility can be predicted,” said Scott Reamer, CIO at volatility trading program Rotella Chora. In subsequent conversations Mr. Reamer, who operates a short-term time horizon volatility strategy, observed that even longer term volatility events can be predicted to a degree based on structural instability leading up to the event.
It has been assumed that volatility can be more easily subject to a probability table on a short term basis, due to the cyclical nature during a given trading day, week or month. It is the major volatility events, such as September 11, 2001 that would be difficult if not impossible to predict just by looking at previous pricing data. To this Mr. Reamer responded the insight that a pattern of structural instability often led up to major volatility events.
Fascinating conversations to be sure.
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