There are a lot of reports on Volatility, by clever quants, but very few actually understand Volatility, how to trade it, and what drives it. Mr Cole of Artemis Capital Management, has once again produced another must read Volatility report. Earlier this spring, we published his “Broken Volatility” report, which was the best piece we had read in along time, and besides that, it proved to be very accurate. Enjoy reading.
The world economy is fighting a fearsome wildfire as the European sovereign debt crisis burns its way closer toward the tinderbox of a second global recession. The insolvency inferno has no prejudice and will fuse to the flesh of any asset class fueling a blistering spiral of correlation and volatility. The third quarter of 2011 was characterized by explosive movements in equity markets as the S&P 500 index declined -14% in the worst performance since the crash of 2008. Global indices officially entered bear market territory with the MSCI All-Country World Index down more than -20% since peaking in May. The 10-year US Treasury yield reached the lowest level on record in September as credit markets braced for an economic slowdown. Over the quarter implied volatility increased +96% as the VIX index climbed to 42.96. If you heeded the omens of variance markets earlier this year you were richly rewarded by this increase in volatility.
Thoughts on Volatility – Omens and Intuition
In my last letter I spoke at length about the abnormally steep volatility term-structure arguing it represented structural imbalances in risk driven by the unintended consequences of monetary policy (“Is Volatility Broken: Normalcy Bias and Abnormal Variance” Q1 2011). Earlier this year it was clear the volatility markets were bracing for a correction following the end of QE2. With this thesis in mind Artemis recommended shorting the long-end of the VIX futures curve where volatility of volatility (“VOV”) was expensive and replacing that exposure with more sensitive volatility positions on the front of the curve where VOV was cheap. The strategy was extremely effective when equity markets collapsed and the VIX futures curve inverted while options skew flattened.
What happens from here is much more difficult to understand. The consensus view is that volatility is mean reverting and when the VIX is above 40 and realized volatility is only at 30 the implied volatility premium is very expensive. Nonetheless my intuition tells me that given the current Euro-crisis, hyper-correlations, lack of remaining stimulus options, and structural fragility of markets there are enough catalysts for the VIX to break even higher in the next few months.
Investors have a limited imagination regarding the potential for greater realized volatility. Historical realized volatility data of the DJIA going back to 1929 shows volatility climbed to 2008 highs a total of six times in the past eighty years. If options existed during the Great Depression we would have seen multiple observations of 50+ implied volatility levels from 1928 to 1933 (based on realized volatility calculated from DJIA returns). During the Black Monday crash of 1987 the VIX index would most likely have recorded levels above 100! That blows away the intra-day high of 89.53 reached on October 24, 2011 at the height to the last crash. A retest of volatility extremes last seen in 2008 and 1987 would require an uncontrolled default on Greek debt (similar to Lehman 2008) in combination with some kind of structural shock (similar to the flash crash in 2010). This is improbable but within the realm of possibility so look for signs of contagion that would spark realized and implied volatility to break the rules of power laws all over again.
Full report, Artemis Capital Fighting Greek Fire with Fire