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The markets are quiet. Too quiet?

Posted by hkarner - 20. Mai 2017

Date: 18-05-2017
Source: The Economist by Buttonwood

The low level of a popular measure of volatility causes alarm

HAN SOLO, a hero from the Star Wars movies, has a habit of saying, at tense moments, “I have a bad feeling about this.” Many commentators are echoing this sentiment after a recent fall in the Volatility Index, or Vix, below ten. Their fears deepened on May 17th, when the Vix lurched above 15 and American stockmarkets had their worst day in eight months. Incessant turmoil in the White House at last seemed to take its toll.

A low Vix reading is usually seen as a sign of investor complacency. The previous two occasions on which the index fell below ten were in 1993 and early 2007 (see chart). One preceded the bond market sell-off of 1994 and the other occurred just before the first stages of the credit crisis.

The value of the Vix relates to the cost of insuring against asset-price movements via the options market. An option gives the purchaser the right, but not the obligation, to buy (a call) or sell (a put) an asset at a given price before a given date. In return, like anyone buying insurance, the purchaser pays a premium.

The price of this premium is set by supply and demand, reflecting the views of the purchaser and the person who sells, or writes, the option. A number of factors determines its size. One is the relationship between the market price and the exercise price; if the market price is $10, then the right to buy the asset at $5 must cost at least $5. Another is the length of the options contract; the longer the time period, the greater the chance that prices will move enough to make the option worth exercising and the higher the premium.

Volatility is also very important. If an asset is doubling and halving in price every other day, an option is much more likely to be exercised than if its price barely moves from one trading session to the next. No one knows what future volatility will be. But if investors are keen to insure against rapid market movements, then premiums will rise. This “implied volatility” is the number captured by the Vix.

As Eric Lonergan of M&G, a fund-management group, points out, the biggest influence on implied volatility tends to be how markets have behaved in the recent past (“realised” volatility). If the markets have been very quiet, then investors will not be willing to pay to insure against market movements, and implied volatility will be low. And markets have been very subdued of late. In early May the S&P 500 moved less than 0.2% in ten out of 11 trading days, the least volatile period since 1927.

Some see volatility as an asset class to be traded in its own right. You can buy or sell the Vix in the futures market or via an exchange-traded fund, or through a “variance swap” with a bank, in which one counterparty gets paid realised and the other implied volatility. There are also a couple of quirks that traders try to exploit. The first is that more people want to protect themselves against a big crash than against a small dip in prices. So the implied volatility of extreme options (covering, say, a 10% price fall) tends to be a lot higher than that of ones nearer the market price. Andrew Sheets of Morgan Stanley calls this a “risk premium” payable to option sellers who take the other side of the crash risk.

Another quirk is that the implied volatility tends to be higher than the realised volatility. So selling options tends to be profitable a lot of the time; you are selling fire insurance for $10 a year when claims are only $8. This sounds too good to be true and there is, of course, a catch. As the chart shows, volatility can suddenly spike; when it does, people exercise their options, leaving those who wrote them exposed to a big loss.

Has such a spike started? The temptation is to buy lots of options while the price is low. But this can be a frustrating strategy. Mr Sheets says that, when volatility was at such subdued levels in the past, it remained low for a further two or three months. Option buyers can lose a lot of money waiting for prices to rise.

Many are surprised that the stockmarket has been so quiet, given the tightening of monetary policy by the Federal Reserve, and the many political worries. Sushil Wadhwani, a fund manager, thinks that many investors were bearish before Donald Trump’s election in November and were caught out by the sudden rally in equities; they are reluctant to be wrong-footed again. They may also hope that, if the market wobbles, the Fed will help by not pushing up interest rates further.

Investors may also think that political worries come and go but the global economy and corporate profits are rebounding. If things do go wrong, and volatility continues to spike, somebody will be left with the bill. Unlike Mr Solo, traders cannot all escape in the Millennium Falcon.

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