An In-depth Look Into Volatility By TTI
I swear I did not time this article. LOL.
Barely 6 weeks past the previous armageddon scenario with VIX going ballistic, it seems like everything’s beginning to repeat itself. In the previous post (The Big Short: TTI’s Version. But Where Are My Millions?!), I wrote about my personal experience. Since then, I’ve spent the past several weeks understanding volatility and its derivatives more. This is an add-on to the previous post, and hopefully, a dissection of my new insights.
There hasn’t been any new updates here for a while, as I’ve been bustling around. As mentioned in my earlier posts, I’ve been keeping high levels of cash. The last outing (deploying of cash) bore some fruits, but not as much as The (Real) Big Short. I’m hoping to nett some durians next week. Durians are cheap now, both literally and figuratively, aren’t they?
I’ve also finally divested away all my PE stakes (Except the one that’s going to IPO) (PE Moving On To Pre-IPO; TTI’s Projected Returns: 1,000% Within 10 years.) (Today, I’m Going To Talk About Private Equity – TTI’s Personal Experience), and consolidated all liquidity into a single place for easy deployment, so I’ve a lot of firepower (relatively) right now. Top of the list would be the private, pre-IPO convertible bonds, for which I’m still working out a JV with interested parties.
But all that is a story for another day.
First, as always, some unrelated stuff.
In late Feb, SGX hosted some of us to a very nice CNY celebratory dinner. I met Heartland Boy, Budget Babe, Kyith from Investment Moats (their blog links in the bar on the right), Rusmin from Dollars & Sense, Shanison from InvestingNote and some others:
Apparantly we didn’t shout “huat!” loud enough. Otherwise, how can there be 2 episodes x 10% drops in the Dow within the Q1 of this year? Yes, that is the only plausible explanation. I blame the other tables for the mini crashes, cos mine certainly did our part:
We will strive to shout louder, throw higher and do better next year.
The event was great fun, SGX is planning to launch a new website soon, as well as a series of investor education seminars. Newbies would do well to look out for them. The basic ones to get you started are usually free (I think). So, why not?
I brought an auditor cum part-time model friend along, since she’s been the go-to for my accounting related questions occasionally, in the midst of doing my DD. Well, TTI is not accounts trained, but I dabble around a bit myself over the years, and if there’s anything else that’s really too arcane, I know where to get expert help from. Team ThumbTack!
(Think she was a bit surprised too, it’s her 1st time hearing of TTI. Like “who the **** are you really?!” kinda surprised.)
SGX made her into a brand new team on her own though:
Yea. I’ve an eye for such details. Dr what. I honestly can’t help staring at that error the whole night. It just kept jumping at me, so I had to hide it away.
In these times of extreme volatility and fear, let me share an excerpt from a famous investor. Of all the different stuff I’ve read, all the various styles I’ve looked at, THIS, seems to be the closest to what I’ve always been doing. These are not my writings huh, they’re his.
You know, one of the core objectives of SG TTI is to promote intellectual discourse. And tbh, I don’t get much of that here. But sometimes, there are gems. Sometimes, these gems email me, sometimes they just add a quick comment here.
Since my last post on VIX (The Big Short: TTI’s Version. But Where Are My Millions?!), I’ve to thank “Homan” for asking the right questions, and “kk” for giving the right answers. You can read their comments in the comments section in that post.
But let me post an article that “kk” recommended, here, so that it doesn’t get buried in the comments section.
Be warned. It’s not an easy read. I had to go through it a few times.
Chris Cole from Artemis is kinda like the beacon of going long volatility as a hedge. He’s spoken and written and posted about it on Artemis Capital for the longest time. I read that recently, some of his work was even presented as supporting evidence in the lawsuit involving VIX manipulation, something that he’s not entirely happy about.
I’d be referring to the Artemis’ article mostly (cos they have pictures!), but if that article is really too arcane for your liking, here’s another slightly more palatable one that I like:
Vineer Bhansali & Larry Harris wrote this a mere 4 months ago. Essentially, they talk about the same stuff, except that Vineer and Larry rearranged and classified the points slightly differently, according to the size of the various participants. (And they write in a more easy to read manner)
This picture, essentially illustrates the gist of what the Artemis article is saying.
Volatility has been kept articifically low for so many years since the GFC. The popular short volatility trade that most of us commoner folks are familiar with, constitutes only the explicit short volume. That’s all the options and futures on VIX and it’s derivative products, including the VXX short that I inefficiently executed.
And that market, is worth about US$60bil.
But that’s a whole new market of implicit shorts on volatility. This involves stuff like risk parity, CTAs and other forms of financial engineering. In fact, going long and holding equities alone, is a form of implicit short. This market is worth far in excess of the explicit shorts, at around $1.4 trillion!
It is this implicit volume that participants are watching, cos if that blows up…. the positive feedback loop of low volatility rewarding strategies shorting volatility, can very rapidly reverse into 1 of high volatility encouraging strategies creating high volatility…..
Hence, the reflexivity in the picture of the snake consuming its own tail.
Stimulus + Share Buybacks
Since 2009, global banks have pumped in $15 trillion in stimulus. That’s mostly the US, Japan and perhaps China. Where has all this liquidity gone to? US companies have spent a record $3.8 trillion on share buybacks, financed by debt issuance. Share buybacks are a form of financial engineering, and are inherently short volatility, by using balance sheet leverage to reduce liquidity, hence generating the illusion of growth.
Lower number of shares in circulation, thus earnings per share goes up, thus market cap goes up, which gives them the room to take on more debt, and thus do more buybacks and the cycles repeats.
How bad is it really?
Chris (Christopher, actually) Cole says that 40% of the EPS growth and by extension, 30% of the stock market growth since 2009, has been a direct result of share buybacks.
The “trickle down” effect that Fed has been banking on hasn’t materialized in the past 8 years. Businesses are supposed to take on cheap debt to grow their businesses, expand, hire and ultimately show earnings growth in this manner.
Instead, US corporations have taken the easy way out. Why take the risk when you can just merely “buy earnings”? I’ve read another article (not in Artemis’) illustrating that M&As in US have occurred at a record pace since 2010.
Excluding the effects of these buy backs, valuation metrics are now at the highs similar to that reached just before market crashes in 1928, 2000 and 2007.
Logically, like the picture of the snake eating its own tail, the markets cannot indefinitely generate this illusion of growth. At some stage, there won’t be any shares left to buy back!
By extension, if the illusion of growth is dispelled, then the metric bubbles that take into account high growth, will have to be brutally busted. When this happens exactly, is up for debate. But I don’t think it’d be too far from here.
Hence, the high cash levels.
Anyone in the fund management business would have felt the effects of the rising popularity of passive investing instruments in recent times.
Chris believes that passivity is itself, creating a bubble. Funds flow into stocks for no reason other than the fact that they are highly liquid members of a certain index.
This has the effect of transferring the volatility of a market into the volatility of the index, since the weightage given by the markets to the participants of the index, is increased proportionately to non-index members.
This is a future amplifier of volatility. Why so?
Active managers serve as a buffer to large stock market moves. They step in and buy when stocks are free falling, effectively providing support, and sell when they get too high, providing liquidity. (In theory, at least)
Take away or reduce the influence of the active managers, and we take away this buffer.
Volatility, when it starts, can go out of control without participants stemming the tide.
Markets are not a closed system. The rules and environment changes. Yet, when machines and bots are used to trade against each other, the risk of reflexivity increases. AI will optimize their trades according to what has worked in the past. That’s how machines learn, isn’t it?
You feed them with data, and they detect trends and devise strategies to capitalize on the trends. Yet, what does the data set over the past several years show?
What has worked?
A massively leveraged short volatility trade. AI’s strategies will thus mimick this trade and milk it, until….. it doesn’t work.
The unraveling will be quite a sight to behold then. If you could bear to watch.
Lack Of Value
Chris also opines that ultimately, short volatility strategies all have something in common: lack of value
It is an index based on futures, which are derivatives after all. That means volatility is a derivative for a derivative! (Is that even possible?!)
How do you value something like that? You can’t.
Final Word Cos I’m Tired Now
All that is a very quick summary and my thoughts. You gotta put in the legwork if you want more, go read them yourselves.
TTI’s thoughts currently on VIX: I wouldn’t want to hop on the short volatility trade for yield right now.
Yes, yes, I know my long previous blog post was all about shorting volatility, but that’s different. I WOULD still short volatility at the peak of volatility, not for yield like what the world has been doing for the past 8 years.
That is, if I could figure a way to short volatility at it’s peak, efficiently.
Even if the world is going to hell, we still won’t get there in a straight line.
I’ve already illustrated how shorting volatility at its peak can’t be done efficiently, to my best knowledge. Volatility spikes up, premiums of options moves up, you can buy put options on volatility, but it’s really expensive.
You could also sell call options, but they’re not efficient (cos no leverage), and the premiums don’t seem to be worth the risk.
So to my best knowledge, I still don’t know how to short volatility at it’s peak effectively, and by effectively, I mean with the judicious use of leverage.
And I don’t wanna short volatility for the sake of collecting puny yields either. That’s kinda like picking up pennies on the train track. The train hasn’t come, but you just need to get hit once…….. Just once. And all the pennies don’t count for noughts anymore.
Going long volatility has some merits, but not now of course. Not when there’s already fear in the markets. I’m lucky to have sold some put options on volatility as the volatility spiked. It isn’t going to make me rich, but it gives me some idea on how to structure long volatility calls, by looking at how the vega affects the option premiums.
And that, essentially, is the conclusion of my weeks of analysis. LOL, I can’t put it more explicitly.
Go long volatility, not right now, but in calmer times, and choose options with strike prices far away from the traded price. I’d want as high a vega as I can get, by extending the time period as far out as possible. I’d also probably stretch my dollar as much as possible by selling some put options.
So what about now, when volatility has already spiked?
Well, of course, short volatility implicitly, like what Chris says!
Going long equities is a way to short volatility, isn’t it?
And that’s what I’d be hoping to do next week.
Good luck to all, and godspeed.
P.S. The writings above was by Michael Burry, 2001