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At the risk of teaching Granny to suck eggs ...... ref :- " All quiet on the risky front " , Buttonwood in The Economist, Finance and Economics

May 22, 2017

 

 

 

 

 

 

 

At the risk of teaching Granny to suck eggs ......

 

ref :- " All quiet on the risky front " , Buttonwood in The Economist, Finance and Economics

 

Apologies for using a fine old English expression in case it should provoke some unsettling mental images for some readers. You don't hear it much these days so for those unacquainted with the phrase it simply means to attempt to instruct someone on a topic that they already know well ....news that may come as a bit of a relief. Apologies too then if this brief look at volatility is just old hat to you, and pretty simple hat at that. But after we'd mentioned the Volatility Index, or VIX, a couple of times last week, it was suggested that some basic background might be helpful for those new to markets ..... and as if on command, by happy coincidence this article appeared in the current issue of the Economist.

 

Actually, it's no coincidence at all ...... levels of volatility have been front and centre of investors' attention since a remarkably quiet period in stock markets in particular climaxed (wrong word, surely ?) with the VIX dropping below 10 to record its lowest reading since 1993. The concern with extremely low measures of volatility is that they might reflect investors becoming dangerously complacent, and therefore vulnerable to a sharp counter-reaction. The last two occasions that the VIX fell below 10 were in 1993, just before the bond market got hammered, and briefly in 2007 just ahead of the early stages of the credit crisis..... and we all know what happened then.

 

A spike in the VIX above 15 on Wednesday as US stocks had their worst day since September caused some anxiety as US politics unsettled investors. By way of perspective, a VIX of 15 is still some way below the long-term average and it has fallen back a little since, so fears of some major and immediate correction look misplaced right now. Then again, cynics might argue that the prime factor in markets calming down again is that they've managed to send Mr Trump out of town on a world tour for a while.

 

Anyway, some ABCs about the VIX .....

 

The VIX, traded on the Chicago Board Options Exchange (CBOE), is a measure of the implied volatility of options on the S&P 500 stock index. Its value relates to the cost of insuring against movements in the price of that stock index through the options market.

 

An option gives the buyer the right, but importantly NOT the obligation, to buy (if it's a CALL option) or to sell (if it's a PUT option) an asset at a given price , and by a given date. Like anyone else purchasing insurance, the buyer of an option pays a premium to the seller.

 

Like any true market, the price of the premium to be paid reflects supply and demand, but there are some very basic truths to remember. If the market price of the asset in question is $10 say, and the exercise price (the given price we just mentioned) is $5, then the price of the option must be at least $5. Also, the further forward the given date, all other things being equal the higher the price of the option  --  the longer the time period, the greater the chance of the price of the asset moving enough to make exercising the option worthwhile.

 

Another hugely important element in the pricing of an option is volatility. As the Economist points out, if an asset is doubling and halving in price every other day, then an option on the asset is much more likely to be exercised than if its price barely moves. We cannot know what future volatility will be, but if enough investors are keen enough to insure against wild price movements, then the price of the option premiums will rise. This "implied volatility" is the number represented by the VIX.

 

Unsurprisingly, the level of implied volatility is heavily influenced by recent historical (or "realised") volatility. If the price of an asset has been flat calm for an extended spell, investors will be less willing to pay up for insurance against price swings  --  thus implied volatility will be low.. This of course is what we've seen of late : the S&P 500 had moved less than 0.2% in 10 out of 11 trading days earlier this month. These numbers can give a misleading impression sometimes but that makes it the least volatile period for 90 years.

 

Traders will find a way to trade just about anything, and volatility is no exception. You can buy or sell the VIX for profit (or loss) in the futures market for example, or via an exchange-traded fund (ETF). The Economist draws our attention to a couple of wrinkles that we might want to be aware of if we trade volatility : firstly, investors are keener to buy protection against a big crash for example than they are to do the same against a small dip. This means that the implied volatility of options protecting against a large move is generally much higher than those with a strike price nearer the current market price.

 

Secondly, implied volatility tends to be higher than realised volatility so selling (or writing) options can be a profitable business  --  let's say that the seller takes in a lot of cash in option premiums, the market is quieter than than the buyers feared so many of those options are not exercised. Consequently the seller's downside exposure is less than his income. The danger with that is what happens when there's a big spike in volatility ?  The buyers will exercise their options leaving the option seller exposed to large losses.

 

It was just such a scenario that some were contemplating last week ..... prematurely, it seems. But it's difficult to put your finger on how the markets have remained so stable against a background of Fed tightening and a series of political events that have been little short of chaotic. Perhaps the thinking is that political problems are transitory but the good news about the global economy and corporate earning is here to stay. If that turns out be case, then investors will continue to pay out premiums to option sellers for insurance protection that will expire worthless. But if volatility does really spike, those option sellers will be scrambling for protection of their own and few are likely to get it before incurring some hefty losses.

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