We have said it many times this year. Volatility has been Broken and Mispriced for a very long time. The Trader reads many reports and analysis on volatility, but one of the best pieces on vol this year is Artemis Capital Management piece on the Broken Volatility explaining why the vol market has behaved so “strange”.
Negative Panic = Negative Volatility: In financial markets normalcy bias provides a psychosomatic explanation as to why lower than appropriate volatility can be sustained for long periods of time despite increasing signs of systemic risk. This phenomenon was observable in 2007 as volatility remained at extremely low levels even after problems in the subprime housing market began to take root. The volatility of asset prices is widely considered a metric of fear and panic in financial markets, therefore the lack of sustained volatility following a market shock event could be viewed as a form of negative panic. If we accept that investors may subject to a consensus normalcy bias then it is logical to accept that negative volatility can also exist as a quantifiable response to exogenous shock events. Admittedly this may sound odd since volatility, by mathematical definition, can never be negative, so the term refers more to a cancellation of short-term volatility risk premium that should otherwise exist. The theory of negative volatility is a temporary state of low volatility caused by the market’s failure to acknowledge the enduring risks of a black swan event. The concept may go a long way toward explaining why high geopolitical risk can co-exist with extremely low volatility in the current market.
The Negative Volatility Regime: The behavior of equity volatility has undergone radical changes over the past three quarters the persistence of which is tantamount to a regime change as opposed to a temporary phenomenon. The current volatility market refuses to sustain fear in the wake of several shock events despite flashing continued warning signs of longer-term risks. The regime resembles a more extreme version of the volatility curves experienced between 2006 and early 2007 prior to the onset of the credit crisis. The new paradigm of volatility officially began after the May 2010 Flash Crash but the most extreme changes have coincided with announcement of the Fed’s second quantitative easing program in late-August. The new volatility regime is characterized by:
1. Large declines in spot volatility The past nine months have shown an unusually high number of large declines in spot volatility (realized and implied) that are of a much higher magnitude and length than what has been observed historically. As a result of these large declines the VIX index and short-term realized volatility are below historic averages; 2. Abnormally steep volatility curve The manifestation of an abnormally steep volatility curve (as a % of spot volatility) with a linear shape that more closely resembles a glacial cliff as opposed to the more traditional desert plateau (see chart); 3. Underperformance of Variance Hedges Low volatility-of-volatility on the back of the variance term-structure results in the underperformance of out-of-the-money options and variance as a hedge against market declines;
4. High Volatility Skew: High levels of volatility skew for far out-of-the-money options showing increased likelihood of large declines in equity prices.
Full report, artemis volreport
Buy the Dip, or Wait and see? Meanwhile, a video of last year’s biggest event, everybody has forgotten about.
The Debt issue according to Bill Gross. “Debt man walking….”
- Nothing in the Congressional compromise reached over the weekend makes a significant dent in our $1.5 trillion deficit.
- In addition to an existing nearly $10 trillion of outstanding Treasury debt, the U.S. has a near unfathomable $66 trillion of future liabilities at “net present cost.”
- Aside from outright default, there are numerous ways a government can reduce its future liabilities. They include balancing the budget, unexpected inflation, currency depreciation and financial repression.
Full article, click here.
We have had a similar reaction in the Markets to the capture of Bin Laden. Speculative positions after the Debt Ceiling Deal, both long and short, will shortly be closing out, and the Market will probably reach another support level around these levels. Although the trader is bearish long term, we are approaching some important support levels, just like we did some weeks ago.
Some interesting observations from Macro Story below.
The candles have been eerily similar in both charts since Point F was established. If this analog continues to play out the next few days should be volatile but somewhat range bound. Considering the next major data point is Friday’s NFP report this would make some sense. Additionally having the debt ceiling “nonsense (only word to describe it)” behind us should smooth out some volatility.
Skew Vix Divergence
I don’t fully trade off this signal yet but find its correlation with the SPX too strong to ignore. It is currently at two prior lows which has signaled bounces in the SPX but on a longer time frame this value is of no significance so personally I won’t be rushing out to cover shorts or go long. At least not on Tuesday.
Skew Vix Divergence Historical Chart
Notice how low the divergence can in fact go. An example would be the vix spiking as markets sell off all while the skew falls.
The US looked set to avoid a potentially catastrophic default on its debt, the FT says, after the House of Representatives voted 269 to 161 to increase the debt ceiling on Monday night. The legislation is expected to easily pass a Senate vote on Tuesday. http://ftalphaville.ft.com/thecut/2011/08/02/640141/markets-unimpressed-as-debt-deal-passes-house/
The value of Twitter has jumped to $8bn, more than double the level accorded to the company as recently as late last year, according to the terms of a fresh $800m investment in the company. Twitter announced the on its corporate blog on Monday its latest round of investment had been led by DST http://ftalphaville.ft.com/thecut/2011/08/02/640066/new-investment-values-twitter-at-8bn/
The UK’s benchmark borrowing costs came within a whisker of their all-time lows on Monday as the rapid fall in gilt yields continued apace, reports the FT. UK 10-year bond yields hit 2.797 per centhttp://ftalphaville.ft.com/thecut/2011/08/02/640036/uk-borrowing-costs-brush-close-to-record-low/
Bad economic news bombarded the Treasury on Monday as new IMF forecasts cast doubt on the chancellor’s deficit reduction plan, while near-term indicators suggested the recovery was losing the little momentum it had, http://ftalphaville.ft.com/thecut/2011/08/02/640011/imf-casts-doubt-on-uk-deficit-plan/
South Korea has prevented three conservative Japanese politicians from entering the country in an escalating diplomatic spat over disputed islands, reports the FT. Lee Myung-bak, South Korea’s presidenthttp://ftalphaville.ft.com/thecut/2011/08/01/639946/s-korea-denies-entry-to-japan-politicians/
China has announced its first nationwide feed-in tariff for solar projects in a step that underscores the determination of the world’s biggest energy user to move toward renewable energy, reports the FT. Beijing has made renewable energy a keystone of its energy policy and aims to raise solar power capacity tenfold in the next five years. http://ftalphaville.ft.com/thecut/2011/08/01/639936/china-backing-for-solar-power/
HSBC is planning to hire up to 15,000 people in fast-growing markets in Asia and Latin America over the next three years even after confirmation of the bank’s plans to cull jobs elsewhere, reports the FT.http://ftalphaville.ft.com/thecut/2011/08/01/639926/hsbc-set-to-launch-hiring-spree-in-asia/