Variations on Trading ‘Fear’ In A Risky Future

(Or, why front-month S&P 500 Variance Futures rose 41.36% on Friday.)

For whatever reasons, it seems clear right now that the largely moderate North African states, including Egypt, and their ideological and geographical cousins on the fringes of the Middle East are likely to face days of reckoning in the next few months.

I leave the subject of causality to students of international relations and geopolitics.

Instead, I want to concentrate on how the sudden eruption of events characterising them were reflected Friday in the way the long-dormant VIX Volatility Index exploded back into life, closing with a 24% gain at 20.04, the largest rise since May 20.

Of course U.S. Treasuries prices and the dollar, the so-called ‘safe havens’, also rallied.

What we have is a classic, suddenly-emerging geopolitical ‘risk event’. It’s characterised at least by the facts that the outcome and the consequences [and the geographical reach] are unpredictable.

Such events tend to prompt investors to rush to the exits of ‘risk markets’. And that’s often concomitant with the type of jump in the CBOE’s VIX Volatility Index which we saw on Friday.

Market professionals widely assume that such gains in the index imply the return of ‘fear’ after a long period in which the market relaxed to such an extent that it was greatly at ‘ease’ with a long climb upward over an extended period.

As we know, encouraged by the Fed’s just as ‘easy’ policy, gains in many major benchmarks approached 20% over the last six months.

And the longer such a period of gains continues, the closer the feet of market players get to the brakes, in readiness for the time to stop dead.

That time, most likely arrived on Friday.

That’s a safe enough summation. But, it’s not the whole story.

I don’t want to claim that I know the whole story, but I want to look a little closer and beyond, at the commonly accepted view of how things work in general during times like these.

The first thing I want to remind you of is that whilst many call the VIX the ‘fear index’, that is of course not its official name. And the reason why it’s not the official name is because ‘fear’ might not be precisely what the index measures in any material way.

As the Chicago Board Options Exchange says in one of its education ‘Research notes’  (5.1.09, Issue 2):

“While it may be a handy nickname, ‘the fear gauge’ is really a bit of a misnomer and, when taken too literally, may lead to some confusion. It is important to remember what VIX truly measures: the stock market’s expectation of future volatility implied by S&P500 stock index options prices. In other words, VIX uses options pricing as a way to measure perceived market risk and uncertainty.”

In its paper, the CBOE seems to allow for the possibility that ‘fear’ and ‘uncertainty’ might well segue into each other and even overlap at times, to such an extent that they appear indistinguishable. But the Board seems to want to make it clear that even if that’s the case, the two qualities are not the same thing.

Once we understand that ‘fear’ is not necessarily the characteristic which VIX measures, even if gains in the index often correlate with a quality of increased fearful behaviour in markets, we can start to see that if the VIX jumps 24% it’s also a time of opportunity, for some.

The other major thing I want to note is that despite the VIX index’s gain on Friday, it was not the biggest gainer in the CBOE’s brace of volatility indexes on that day.

It’s telling us something that the largest gain was actually in the front-month contract of CBOE’s S&P500 Variance Futures. [The ticker symbol is VT/HI].

CBOEVAMAR11 [the March contract of S&P 500 Variance Futures] rose 41.36% to 249.50 [higher than the last delayed quote on CBOE’s website].

OK, but what exactly is that telling us?

Well this is where we take another small step beyond the common beliefs which underlie our basic day-to-day market activities.

Introducing Lewis Bicamp and Tim Weithers.

They are respectively Head of Financial Engineering and Director of Education at Chicago Trading Company LLC.

They remind us that  “Even though volatility is the more commonly used term in the financial markets and media, an asset’s volatility is actually derived from its
variance.”

We don’t have to go back to school and get our heads round formulas to understand this.

In practical terms, if you already understand what volatility ‘does’, then you understand what an asset intended to capture ‘variance’ does too.

Helpfully, Messrs. Bicamp and Weithers also point out that “CBOE variance futures contracts are essentially the same as an OTC variance swap” contract.

The main difference of course is that the former are exchange-traded, with all the benefits that brings. (For one thing, we can see when people are piling into them!)

I want to use the technicians’ words again because they explain the potential uses of these contracts much more succinctly than I can:

“In principle, any institution which seeks to hedge or speculate on volatility might want to strongly consider trading variance, either in the form of an OTC variance swap or a CBOE variance future….some businesses have natural exposure to volatility that could be reduced by trading variance swaps.”

In the end, just like protesters in Egypt seeking greater freedoms, anyone involved in financial markets also needs to ‘be careful out there’ right now, during this time of heightened risk.

At the same time, it’s interesting to be aware that much bigger figures in the background are probably capitalising on the extremely fluid nature of the outlook.

References 

‘VIX – Fact & Fiction’ (Research Notes Issue 2, May 1 2009) The Research Department of The Chicago Board Options Exchange

’S&P 500 Variance Futures’ Biscamp, L. and Weithers, T., Chicago Trading Company LLC

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