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Moral Hazard, "Supernormal" VIX Swings, And Why August 2015 Was Just An Appetizer
Excerpted from Artemis Capital Management letter to investors,
True knowledge is not what you know but certainty in what you do not. Volatility is simply about putting a price on that. Drawing from the famous quote by Donald Rumsfeld, former US Secretary of Defense(20), the trader of volatility must be able to identify “known unknowns” and “unknown unknowns” while simultaneously making a market in both. Modern volatility markets know that the global economy is facing deflation... but they also know that global central banks will be right there to respond to any crisis. The single most important “unknown unknown” today is any random event that may unexpectedly cause global central banks to withdraw their stated support of markets.
Moral hazard has contributed to a significant build up in short and leveraged volatility creating a shadow ‘volatility gamma’ that reinforces the current trend in volatility direction. Rising volatility is followed by more rising volatility and vice versa. Volatility is crushed whenever a central bank responds to crisis and thereafter leverage is re-applied in even greater amounts in a cycle of moral hazard. The pattern is creating a pro-cyclical monster of short volatility that, if left unchecked will contribute to a repeat of the May 2010 Flash Crash or 1987 Black Monday Crash. August 2015 was just an appetizer.
In 2012 Artemis coined the term “Bull Market in Fear” to explain a regime of volatility defined by investor's willingness to pay almost anything to shield their portfolios from the next deflationary crash. Between 2013 and October 2014 we experienced a “Bear Market in Fear” defined by a rising short volatility complex and low risk premiums for selling variance. Ever since last fall, we have entered into one last dangerous phase in the volatility cycle. Forward volatility markets no longer fade volatility out of denial; they fade volatility out of the prospect of central bank support.
This is a new era of hyper-moral hazard whereby a central bank reaction function is fully priced into option markets. Volatility markets do not believe central banks will let us fail.
For evidence, consider that the VIX futures markets faded the August VIX spike by the greatest margin in history. The graph below shows the ratio of the VIX to the market’s one-month forward expectation of the VIX. The higher the ratio the greater the market’s confidence in volatility mean reversion. August 2015 dwarfed all other crises in mean reversion expectation including October 2008, May 2010, and August 2011. The entire VIX market was essentially one large leveraged bet that central banks would respond to the crisis… and it paid off! What if it didn’t?
The VIX is experiencing epileptic seizures including erratic and violent outbursts up and down at the most frequent pace in history as new sources of structural short convexity interact with interventionist policy responses to crisis. The VIX has registered a quantifiable ‘supernormal’ (five standard deviation +) move up or down every three months over the last two years.
In July-August 2015 alone, we experienced the single largest multi-day drawup and drawdown in the history of the VIX index. Artemis ranks consecutive drawups and drawdowns (trough-to-peak or peak-to-trough) in volatility and models them as a power law distribution. The distributions of a wide variety of physical, biological, and human phenomena closely follow this form. Examples include earthquakes, deaths in war and terrorism, populations of cities, solar flares, word frequencies in language, movie box office receipts, and asset price movements. When you logarithmically rank the event magnitude of these natural and human phenomena the majority of observations will align linearly along the x-axis as a power-law function (see white line below). Violations of the power-law function are supernormal events because their results contain a degree of reflexivity that exceeds the exponential growth function. Examples of supernormal violations in power laws across other phenomena include death counts in WWII ranked among all wars, box office receipts of the movie Titanic, the Titanic disaster itself, the 9.2 Magnitude 1960 Chilean Earthquake, the population of Tokyo, the 1987 Black Monday Crash, and the 9/11 terror attack in NYC. Three of the top ten supernormal VIX increases and four of the top eight supernormal VIX decreases have occurred in the last year alone! The top eight ranked drawdown collapses in VIX have all occurred during the post-2012 monetary regime. Power-law violations in VIX to the downside and upside are now happening with regularity!
Volatility markets are demonstrating deep uncertainty in the very nature of uncertainty itself. The schizophrenic behavior of volatility is a deep warning sign for policy makers that something is not right. Implied Volatility-of-the VIX (“CBOE VVIX”) reached the highest levels in history on August 24th, 2015. The volatility-of-VIX rose higher than levels achieved even during the 2008 financial crisis, 2010 Flash Crash, and 2011-debt downgrade crisis.
Many will point to structural considerations as a driver including the proliferation of VIX exchange traded products and the new spot-VIX calculation methodology. While these are important factors, they are only part of the story.
To understand why the volatility of volatility reached new highs we have to engage in deep meta-thinking about our reaction to change. Volatility provides exposure to our collective insecurity towards an unknowable future. Likewise, to short volatility is to express personal confidence in the status quo of market affairs despite a broader fear of change. To go long volatility is to express fear that change is coming.
Volatility-of-volatility is simply the war between these two different modes of perception... shifting perceptions in the nature of uncertainty itself. If uncertainty is rising so should the VIX... but there is a very different type of uncertainty to evaluate … the uncertainty that central banks will intervene. When global central banks seek to defend the status quo and mean reversion it becomes increasingly difficult to accurately gauge the probability of change in markets. Volatility markets are now gaming central banks in addition to fundamental economic and technical conditions. If we are unclear from one moment to the next whether radical change or the status quo will prevail than volatility-of-volatility should logically rise.
Volatility mean reversion has been an abnormally profitable bet during the regime of pre-emptive strikes on financial risk. Following each tail event in volatility, we are experiencing another tail event in the magnitude of volatility declines. Central banks refuse to let volatility remain elevated and are quick to react to any crisis.
Between August and September 2015 the VIX collapsed faster than ever before following a spike to 40 (see red line below) due to another massive stimulus response by central banks. China cuts rates, devalued the Yuan, and purchased an estimated $263bn of equity (9.2% of freely traded shares) to artificially prop-up their stock market before a nationalistic military parade. Following China, the ECB expanded their QE program. The graph below demonstrates the historic decline in volatility by showing the average, high, and low trajectory paths of the VIX the ensuing fifteen days following every implied volatility spike to 40.
Likewise, the area chart below graphs the forward probability distribution of S&P 100 implied volatility (VXO) following a breach of the 35 barrier in spot-vol.
As expected, implied volatility exhibits an exceptionally positively skewed distribution following a ‘risk-off’ event, but notice how the current trajectory of VXO lies on the far left of the distribution. Central banks refuse to let volatility remain elevated but this is creating a new set of shadow risks...Global central banking has artificially incentivized bets on mean reversion.
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The VIX is dead....Long Live the VIX
It's a great time to learn how to use Bitcoin.
http://bitcointeaching.com/bitcoin-lessons/
I don't think they understand. The Fed has a $4 trillion investment in the market and they cannot allow deflation to make it go poof. They've force feed the stock market and it has experienced inflation much > 2%. Deflation scares them.
When everything is a bubble, there is no room for growth.
...if left unchecked will contribute to a repeat of the May 2010 Flash Crash or 1987 Black Monday Crash.
doom fail. nobody is afraid of the flash crash or 1987.
Exactly right, there is no fear anywhere. No panic sell days, only panic buys.
Why should they be afraid? VIX is indicating everything is awesome, nothing to worry about, just keep BTFD.
Exactly the right time to go long vol with very cheap OTM calls. Use these to help hedge deflation and buy physical to hedge CB insanity.
Pretty long article to explain BTFD... No Fed/PPT then crash.
This kind of game cannot go on indefinitely and it will end very badly.
That's some chart porn right there.
Fed naked shorts VIX
This is a highly technical piece about market dynamics in 2015, a piece that accepts central bank intervention in markets as if it were really god's work. Moral hazard means absolutely nothing in the face of human nature.
Ask yourself, seriously. With the many trillions central banks dispensed in ZIRP loans since 2009, how much has landed in your pocket?
And then ask yourself, why should your hard-earned money have to compete in the marketplace with all this "borrowed" money, especially since there is absolutely no indication that those entities that did get bailed out have either any intention of paying the free money back, or even have the capacity to pay that newly minted money back. It all went toward equity purchases, stock buybacks and bonuses.
Bernanke saved nothing. He merely stole from the economy as a whole to bail out the criminals who stood the whole financial system on its head as they loaded their pockets. People, individuals not corporations, are getting immensely rich on the dynamics of what the central banks are doing. And it is all insider trading, because there is no real market any more. Every penny being made is only made because of foreknowledge of what the central banks are going to do. That's not a real market. That's not god, doing his work.
That is criminal buggery of the markets. The central banks have essentially created a system that devalues every penny you earn and save, while making it a zero risk proposition for financial industry (and political) insiders to steal unbelievable sums from the economy as a whole.
+1,000
What's the solution?
I keep thinking of the end of the first Godfather movie.
You are absolutely correct.
The problem I have with this is that it contains no actionable information, upon which I can act.
I successfully trade VXX only on the long side. I have a small position in comparison to the totality of my investments and cash.
Of course the Fed does naked shorting. Of course, those who load up on the short side have foreknowledge of what is coming down the pike in the next trading session.
I do not do a quantitative analysis. I do a probability analysis, in the sense that the Fed is back-filling 24/7 to prevent stocks and bonds from collapsing. The Fed gets no lift from the US or world economies - they are in a bad downtrend. We are in an Election cycle - the Fed will try harder. But, there are too many loose cannons on deck (and below deck) - a couple of them are going to suddenly crash and make big holes in the gunwale, threaten the seaworthiness of the economic vessel. Even if the Fed can contain the breaches, the VIX will spike somewhat closer to heaven. That is when you bag. Before that, if you get a good profit, you bag. Like always, pigs get slaughtered.
By trying to control markets Central Banks are, in effect, "squeezing a balloon". It's a futile effort that will end very, very badly.
Like Renoir's mother used to say: "Such pretty pictures, but can he make any money?"
Have you ever ridden a bike down a hill so fast that the front wheel started wobbling more and more until it quickly became uncontrollable? That is what is happening in markets now.
https://atokenmanblog.wordpress.com/2015/09/11/speed-wobbles-kill-why-bo...
I believe we'll see a short term High for the S&P500 this Friday/Monday, as they represent Cycle Turn Dates based on my own developed model. Yesterday, I closed the shorts entered OCT 13 @ 2017 at the Support Trend Line 1990 area, Target Price for that day. If you're interested, you can read more here:
http://tripstrading.com/2015/10/15/sp500-a-short-term-high-for-oct-1619/
http://tripstrading.com/2015/10/08/sp500-tripstrading-cycle-model-3/
http://tripstrading.com/2015/10/10/sp500-suffering-from-low-energy/
http://tripstrading.com/2015/10/09/sp500-how-cycles-take-their-time/