25 Sayings On Vol And Risk

“Pithy Principles for Modern Markets,” via Macro Risk Advisors

1. Big moves matter most

The math of volatility trading is such that substantially large one day % moves have enormous impact on p/l. Over the
course of a month, a single 4% move is the approximate equivalent of five 2% moves.

2. Theta is the rent on gamma and the rent is often too damn high

The linkage between gamma and theta for short dated options means that when realized vol is very low, option premiums
will melt away. This makes even low-priced options difficult to pay for and leaves the market under hedged for a shock.

3. Hedge when you can, not when you have to

It is easy to postpone paying for options when implied vol is low because realized is often even lower. But when a risk-off
occurs, the sticker shock from higher option prices can be difficult to overcome, leaving the investor frozen.

4. Stock returns, like politics, are not normal

The predicted one-hundred-year storm (per the bell-curve), seems to actually occur every 5-10 years in markets. The normal distribution is a seductive construct that creates a dangerous certainty about unforeseen risk outcomes and may contribute to vulnerability to tail events.

5. Financial market insurance is not like hurricane insurance

Derived from LTCM’s Victor Haghani’s quote after the hedge fund’s demise. My read on this is that while Mother Nature dictates the timing and severity of the next hurricane, the financial market equivalent may arise endogenously, propelled by the forceful unwind of trades that enjoyed too much success for too long. Related, Soros theory of reflexivity.

6. The next crisis to occur is the one that happened longest ago

Investors are prone to recency bias and the ability to fully appreciate changes in risk regimes is challenging because of a lack of recent experience in the data. Simply put, we suffer from a lack of imagination, instead believing that tomorrow will unfold much like today has.

7. There are no bad securities only bad correlations

A modern-day version of the old Graham and Dodd inspired “there are no bad securities only bad prices”. Investors often underestimate the co-movement of assets in their portfolios and fail to understand that correlation relationships can change quickly, especially when markets become more volatile. Inspired by the substantially negative correlation between stock and bond returns.

8. Equities are short the straddle on rates

For different reasons, if interest rates either fall or rise very quickly, the outcome is bad for risk assets. In the first, a shock has compelled a flight to safety and a duration rally. In the second, like the 2013 Taper Tantrum, the risk-free asset is itself the sponsor of the event, forcing equity markets to reconsider assumptions used to discount cash flows and sometimes creating a VaR shock.

9. In markets, it’s move fast and things break

Mark Zuckerberg originally stated “move fast and break things” to express a hard charging view on innovation in Silicon Valley. In finance, the inherent fragility of markets reorders this catchphrase to “move fast and things break”. This speaks to the threat imposed on the asset price system by extreme volatility.

10. Greenspan was right, sort of

Channeling Minsky, in 2005, the Fed Chair said “history has not dealt kindly with the aftermath of protracted periods of low risk premia”. Articulated as the largest leverage bubble was not that far from self-destruction. Amen.

11. If history is a foreign country, the history of risk is another planet

When it comes to appreciating risk, investors seem to suffer from amnesia. Past, well-documented risk events are deemed irrelevant as useful analogues to present market vulnerabilities.

12. By definition, there’s a winner to every back-test

Imagine a new fund that presents its trading strategy, showing back-tested results producing vastly negative Sharpe ratios. The fund promises a better future. Would you invest? Conversely, we are sold the “beautiful back-test” too often, an overfitting of the data in which a “winning” strategy, by definition, has emerged, according to the rules imposed.

13. Price is a liar (John Burbank, Passport Capital)

A price is simply where two counterparties managed to transact. Look no further than what VaR models told investors about portfolio risk in late 2006 as the VIX dipped below 10 even as an epic tidal wave of portfolio deleveraging was in the process of building.

14. Volatility is an instrument of truth (Chris Cole, Artemis Capital)

In some ways the opposite of “price is a liar”, volatility results from the adjustment process to finding “truth” in asset prices and investor positioning. Vol events occur when this process occurs in a compressed time frame. Peg breaks come to mind. Volatility reflects a confrontation with mistakes.

15. It ain’t what you don’t know that gets you in trouble. It’s what you know for sure that just ain’t so. (Mark Twain?)

Overconfidence is a psychological shortcoming of humans that often makes its way into market prices. Low implied volatility is a reflection of such precise understanding of probabilities. The EURCHF cross carried a 6m implied vol of 2 as of August 2014. It reached 20 five months later as the SNB walked away from the FX ceiling it had promised to markets.

16. The money money makes, makes more money (Ben Franklin)

Brilliantly crafted to describe the virtues of compound interest, the modern-day application is to carry trades that spin off income. These profits emerging from short vol strategies are often stuffed back into the same trades, but at tighter spreads, ultimately leaving the market vulnerable.

17. ROMO is the risk of missing out

The fund manager equivalent of the individual’s fear of missing out, ROMO reflects the call optionality that defines the compensation structure for the asset management industry. Underperformance risk in bull markets presents a bigger business risk than experiencing large negative returns.

18. Risk-on and risk-off are curious cousins

These two opposites tend to enable one another. Long periods of stability sow the seeds of their own demise. Conversely, it is a risk-off event that, when material enough, creates the opportunity to make a buck in a hurry as the policymakers swoop in to enforce stability, empowering investors to deploy capital on newly cheapened assets and richened vol.

19. Accident-free finance promotes the selling of accident insurance

Vol selling, in all its formats, leads to a happy circularity of profits, confidence and feedback that underpins the growth of the trade. Gains from short vol trade create capital that enforces the stability of the system, but over time, a bad setup with a low margin of safety results.

20. Price is the only fundamental (someone)

In the Soros theory of reflexivity, market prices condition behavior as they create or destroy wealth. Feedback loops result. For fund managers, the need to track the SPX can be a source of demand for a market that is rising, irrespective of whether the rally leaves asset valuations expensive.

21. When I see a bubble forming, I rush in to buy it (George Soros)

Prices may ultimately be governed by fundamentals, but for periods of time – sometimes lasting longer than you’d expect – speculative capital can overwhelm fair value. Better to jump in on the long side.

22. Vol is the only anti-fragile asset

Taleb’s brilliant concept of anti-fragility describes the rare characteristic of not merely being durable to a shock but becoming stronger as a result. In markets, long volatility is the singular asset in this category.

23. When financial markets implode, convexity can be found lurking near the scene (Harley Bassman)

When short vol positions are on the books of mark-to-market sensitive investors, portfolio damage control can exacerbate the original move, often leading to a negative feedback loop between asset prices and volatility.

24. The correlation of vol and the vol of correlation are not your friend

While volatility is common in correlations, the transition to a new correlation regime (i.e., stock/bond) is fraught with risk and carries the potential for market air pockets. Similarly, when asset prices become more correlated as they become more volatile, diversification is rendered elusive.

25. Vol has memory, vol mean-reverts

Market disruption events don’t last forever as cheap asset prices and CB fire-fighting ultimately provides runway for capital to be re-deployed and for vol to mean-revert. Vol’s memory means that the best predictor of vol tomorrow is vol today. Periods of low vol tend to lead to a self-reinforcing psychology of stability. Conversely, de-risking episodes can damage sentiment that serves as an accelerant to vol which in turn, causes forced selling and more volatility.


 

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