In yet another confirmation that the only sure way to make money in the current market is to bet against Goldman's sellside research is the revelation (indeed, reminder) that the primary cause of the firm's now well-known Q2 trading loss, namely the bet that volatility would decline, is precisely what its Top Recommended Trade for 2010 was. During yesterday conference call, David Viniar disclosed that "as a result of meeting franchise client and broader market needs, we had a short equity volatility position going into the quarter. Given the spikes in volatility that occurred during the quarter, equity derivatives posted poor quarterly results." Ironically, on December 2, 2009, as part of its report "Exciting... with Risks" which we previously disclosed, the firm came out with its Top 8 Recommended Trades for 2010, the first of which was the following: "Short S&P 500 Dec10/Dec11 Forward Starting Variance Swap, at 28.20, Target 21. At current levels, forward variance suggests that the coming years will be as volatile as 2009. But this year was the eighth most volatile year on record, and our recent work on the 2004-template—and our models linking macro outcomes to volatility—suggests that even in a sluggish recovery, volatility can continue to decline. While near dated volatilities remain only moderately elevated, the upward-sloping term structure has kept forward variance higher—and well above where it ‘belongs’." In other words, Goldman recommended selling vol, yet it only did so as a flow counterbet after a customer did precisely the opposite of what Goldman was pitching.
As Risk Magazine observes, the sell vol trade was prevalent and many banks got whacked as a result:
Bank of America Merrill Lynch – another of the banks said to have lost money on short volatility positions – reported a $678 million drop in equities profits in its second-quarter report, blaming "unfavourable market conditions and increased volatility, which negatively impacted the equity derivatives business".
Any dealers that held short volatility positions or short variance positions going into May will have endured a rough ride. The dislocations in May followed intense anxiety about Greek sovereign debt, contagion to other eurozone sovereigns and banks, and fears over the future of the euro. Volatility leapt, with the Chicago Board Options Exchange's Vix index, which measures market volatility as implied by 30-day Standard & Poor's option prices, rising from 24.91 points on May 5 to 40.95 points two days later – a jump of 64%. It continued to creep upwards, hitting 48.2 points intra-day on May 20 – a 13-month high.
There was also a peak in skew – the difference in implied volatility between out-of-the-money put options and out-of-the-money calls. Three-month 90–110% implied volatility skew on the Dow Jones Eurostoxx 50 index touched 15% on May 20, compared with a high of 12.8% seen after the collapse of Lehman Brothers in 2008, says Deutsche Bank.
One exotics trader says the whole Street would have struggled in May to a greater or lesser degree. "This move caught people by surprise. Look at the Vix – it moved from 25 points to 40 in two days. It took two weeks to spike that much after Lehman – it's a huge move. I can tell you every dealer on the Street was probably short skew and short volatility," he says.
Here is the relevant page from the Goldman research report:
Of course, Goldman couldn't care less about its sellside team as the Abacus fiasco disclosed: the firm would generally take the opposite side of trades its salesmen pitched to clients. The only reason the firm got hit hard in Q2 is because not only was its research 100% wrong, but that Goldman was unable to offload prop risk from taking the other side of a massive long vol bet as all other dealers were on the same side of the trade and all the Korean and European idiot banks abused during the CDO period of the bank's history were made bankrupt by following Goldman's advice. Also, of the Top 8 recommendations above, we are confident the total P&L loss would be sufficient to destroy all but the largest hedge funds.
Which is once again why we repeat our long-held belief that whatever Goldman's "clients" do, they are in a far better position strategically if they merely take the other side of Goldman's trade recommendations.