Through The Volatility Seller’s Looking Glass

Via Kevin Muir of “The Macro Tourist” fame

By now most of us are fed up with hearing apocalyptic warnings of the coming VIX disaster when all the naïve short sellers will be squeezed in an epic 2008 style equity crash. Either you buy this argument, or you don’t. No sense wasting too much more time on it. I am of the opinion that for all the uninformed XIV buyers (the short VIX ETF), there are stacks of VXX longs desperately trying to catch the next great VIX rise. But, who knows? I might be wrong, and I definitely am not privy to the extent of institutional equity index volatility selling, so maybe there truly is a massive weak short position whose comeuppance will soon be laid bare for everyone to see.

But yesterday I had dinner with a buddy who passed along some interesting information that caught me by surprise. He is a unique individual. A former derivatives broker who didn’t trade with pension funds and other typical institutional clients, but instead specialized in high net worth individuals and non-traditional corporations. His clients could definitely be described as sophisticated, but with an entrepreneurial, non-traditional flare.

He still keeps in contact with his old shop, and he told me what the brokers are experiencing. Across the board, clients are engaging in volatility selling strategies. And although they are shorting some stock index volatility, they are not limiting themselves to equities.

He described an endemic pattern of these sophisticated clients shorting gold vol, euro vol, bond vol – any listed options, these guys are shorting them. Take gold for example. They pick a three month option, and with gold trading here at 1245, they sell the 1145 put while simultaneously selling the 1345 call. Lever up the position, collect the premium, and let the quiet markets pad your bankroll. And clients are doing this strategy in size.

I was surprised. I didn’t expect the volatility selling to extend to most other financial markets. I had thought it was confined to equities, but I was obviously wrong.

And I guess it shouldn’t really be a surprise. The reality is that volatility has collapsed pretty well across the board.

Have a look at the Merrill Lynch MOVE Index. Think about this as the bond VIX.

Since the index’s introduction in 1992, we have never closed at a lower level than yesterday.

Yet contrast that to the situation ahead of us. We are in the midst of the Federal Reserve interest rate tightening cycle, the debt ceiling issue looms over us, and an upcoming, never-before-attempted-Central-Bank-balance-sheet-unwind is waiting in the wings. Yeah, bond volatility at 25 year lows makes complete sense.

And it’s not just bond vol that’s sucking wind, forex volatility is also struggling. Not as bad as bond vol, but it’s cheap nonetheless.

I guess a perilously balanced global financial system whose reserve currency’s leader is prone to sudden dramatic policy shifts is somehow calming to the FX market.

And yeah, I get it. The reason that many of these implied volatilities are so low is because realized volatility is even lower. Complain as much as you want about the dirt cheap VIX, but realized volatility is even lower.

So even though VIX with a 10 handle seems bat-shit-stupid, when 30 day realized vol is running at 7.5%, a dynamic hedging S&P 500 volatility seller can still make money.

And here is where it gets interesting. I think equity index volatility selling has been especially profitable because of the Great Financial Crisis. In 2008 we experienced a once in a lifetime volatility spike, and human beings find it extremely difficult to forget that sort of trauma. So index vol has stayed bid way higher than rightfully should be the case. Too many people remember the horrors of 2008, and they have consistently paid too much for the insurance to protect against that situation repeating.

Think about it like an insurance company. When is the best time to buy the stock of an insurance company? Contrary to popular wisdom, it’s right after a huge catastrophe. Although they experience a short term large loss, going forward, the business is immensely more profitable as the insurance company can raise rates, and consumers will gladly pay the inflated price.

The period from 2010 to today has been so profitable for equity index volatility sellers because investors have consistently overpaid for this protection. Now eventually human beings forget, and with the VIX at 10, it is definitely becoming less profitable to be short equity index volatility. But investors all too often look backward, and over past few years, shorting equity index vol has had one of the highest sharp ratios of any strategy.

Yet as the equity index volatility selling strategy has become more crowded and less profitable, investors have not simply given up. And that’s why some of the more sophisticated clients, like my buddy’s derivative traders have expanded to other markets.

As I was writing this piece, a new reader called up with a question. As we got to talking, he mentioned a colleague who works at a big Swiss bank in the commodity division. He said that over the past year his buddy has been overwhelmed by a stream of big named quant funds desperate to sell commodity volatility.

I think that in this day and age of minuscule yields, with limited alpha, and Central Bankers desperate to keep financial markets pinned at stupid levels, clients are gravitating towards one of the few last remaining profitable strategies – selling volatility.

But what does Warren Buffett say? What the wise do in the beginning, fools do in the end.

Attracted by the excessive returns volatility selling has garnered in the equity index square, investors have branched out to all other asset classes.

And instead of railing against the foolishness of these volatility sellers, I suggest you instead just take advantage of their idiocy.

The great twitter trader Two&Twenty has recently been highlighting an opportunity where you could buy gold volatility below the recent realized.

I have started moving many of my outright long and shorts into option positions. With all these vol sellers driving down the price of options, why not take advantage of their greed?

After all, the financial system is extremely unstable. Central Banks are trying to keep markets docile, but the longer they suppress volatility, the greater the ultimate reaction will be.

And don’t be so sure it will look like a repeat of 2008. If I had to guess, my money would be that it starts in the bond market. But I also love owning commodity volatility.

My message to all those new quant fund vol sellers, come on in! The water’s warm. Glad to have your new supply keeping implieds low. Don’t worry, I am sure the returns of the next 8 years of commodity volatility selling will be just as good as the last 8 years of equity index volatility selling… Yeah, when didn’t chasing the previous decade’s best returning strategy not work?