Monday, May 29, 2017

High Yield Spreads and The Volatility Index

Last week, we presented arguments that the volatility index is too low compared to high yield spreads. We then found another quantitative model, presented by Russ Koesterich, that says that the VIX should be higher than it is currently now:

Since 1997, a two-factor model incorporating the Chicago Fed National Activity Index ( CFNAI ) and high yield spreads (the difference between the yield of a high yield bond and that of the 10-year U.S. Treasury) explained nearly 60% of the variation in the VIX. Adding the Uncertainty Index to the model does not improve its efficacy. Right now both leading indicators and credit markets are suggesting what most investors intuitively realize: The VIX should be low, although arguably not as low as 10. The two-factor model suggests fair value for the VIX somewhere in the mid-teens, roughly where it peaked last week. To the extent credit markets take the events in Washington in stride-even during the worst selling last week high yield spreads remained comfortably below 400 basis points (4%)-equity investors can breathe a little easier, at least until they can’t. Read more

High Yield Spreads and The Volatility Index
High Yield ETF (HYG) and the VIX. Source:

Notice the last sentence (in bold) in the above paragraph. It means that the credit market was calmer during the “panic” 2 weeks ago.

Another article by  Dave Sekera of Monrningstar corroborates this observation:

All the political commotion in Washington had little impact on credit spread trading levels in the corporate bond markets last week. The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) widened only 1 basis point to +118. In the high-yield market, the Bank of America Merrill Lynch High Yield Master Index widened slightly in sympathy with the sell-off in the equity markets midweek but quickly rebounded. By the end of Friday, the average spread of the high-yield index was only 1 basis point wider, closing at +378. Among the underlying sectors in the high-yield space, energy performed relatively well, tightening 6 basis points. The outperformance of the energy sector was driven by the price of oil, which rose $2.60 to about $50.50 a barrel, back to the middle of its trading range over the past six months. In the equity market, after being down as much as 1.42% midweek, the S&P 500 recovered most of its losses and ended the week down only 0.38%. The greatest movement over the course of the week was in the Treasury bond market. Investors sought a safe haven in the Treasury market, bidding up prices and sending yields lower. Interest rates on 5-year, 10-year, and 30-year bonds dropped 7-10 basis points, bringing yields down to 1.78%, 2.23%, and 2.90%, respectively. Read more

But why did the high yield spreads not react strongly as the volatility index. Was it because the VIX was undervalued and the high yield spreads fairly valued?

We think that stronger evidences can be found elsewhere, for example, to name a few, a high level of short interests of volatility ETFs or the increased leverage and position size.


Friday, May 26, 2017

How to Invest in a Low Volatility Environment?

We often discuss how to use options trading strategies for hedging portfolios and investing in general.  Yesterday, we argued that the current low-volatility environment can pose significant risks to portfolios through increased position size and leverage.  So a natural question arises: can we still use options to invest in a low-risk way these days?

Before answering this question, let’s look at another article published on Bloomberg. Dean Curnutt pointed out the same problem posed by the low realized volatility, i.e. increased position size through the use asset allocation models.

Asset prices are full, but negligible volatility encourages exposure to them without any discomfort. There are losses here and there, but in general, the daily experience of mild moves is the relevant, affirming scorecard. Further, low volatility serves not as just an anxiety-reducing palliative, but also is a mathematical driver of trade sizing codified into hundreds of billions of risk managed investment strategies. Volatility control products, for example, gear up or down exposure to the equity market based on the level of realized volatility versus a preset target. Because of the diminutive daily moves in equity indices, products such as volatility control move toward their maximum long exposure. The sell signal for volatility control and other strategies like it is unambiguous: a rise in realized volatility. Stewards of capital should be actively considering the potential knock-on effects that result from contractual deleveraging triggered by the inevitable volatility spike. Read more

Therefore, in this low volatility market, short premium strategy can be dangerous. Recently, Man group CIO Sandy Rattray gave a warning

“Historically there seems to be a new group of people each time that underappreciates the very significant risks of being short volatility and wants to learn this expensive lesson.”

That “expensive lesson” can occur during a volatility spike when an overleveraged portfolio learns how sharp the two-sided sword of volatility can become. The strategy is known for generating consistent and sometimes oversized returns regardless of minor market gyrations. On a correlation matrix, the strategy appears noncorrelated, until that faithful moment of crisis hits, then an improperly leveraged portfolio with insufficient risk controls can get wiped out – and using margin, a net worth can go negative.

While some in the derivatives space have dismissed short volatility as a viable strategy, Rattray notes that, in proper doses and with risk management, the strategy [has] a place. “Shorting volatility should only comprise a relatively small part of a portfolio, and should have a clear risk-management process around it. If you don’t follow those two rules, then you could potentially end up in significant trouble,” he said. “There is no question that these short-vol strategies can pose significant risk to individual investors pursuing them if they are not managed appropriately.” Read more

So the last paragraph answers our question. We’d suggest reading it multiple times.


Thursday, May 25, 2017

Low Volatility and The Danger of Increased Leverage

After a sharp move in the VIX a week ago, today the volatility index finished below 10 (9.99 to be exact). It looks like we are going into a low-volatility period again.

Last week, just before the volatility spike, Mohamed A. El-Erian warned of the danger of investing in a low-volatility environment. He said that low volatility encourages excessive risk taking.

The smoother the road, the faster people are likely to drive. The faster they drive, the more excited they are about getting to their destination in good, if not record time; but, also, the greater the risk of an accident that could also harm other drivers, including those driving slower and more carefully.

The lower the market volatility, the less likely a trader is to be “stopped out” of a position by short-term price fluctuations. Under such circumstances, traders are enticed to put on bigger positions and assume greater risks.

But why do traders take more risks when volatility is low? According to El-Erian, asset allocation and portfolio optimization models allocate more funds to assets that have lower volatilities.

Expected volatility is among the three major inputs that drive asset-allocation models, including the “policy portfolio” optimization approach used by quite a few foundations and endowments (the other two variables being expected returns and expected correlation). As the specifications of such expectations are often overly influenced by observations from recent history, the lower the volatility of an asset class, the more the optimizer will allocate funds to it. Read more

Similarly, Man Group Chief Investment Officer Sandy Rattray said

One concern is that many people choose to scale their positions by the level of realized volatility, which means there could be very large positions out there today with potentially significant leverage that might be vulnerable should volatility rise whether due to a tail risk event or other developments in the market,” raising an issue that analysts such as JPMorgan’s Marko Kolanovic and others have pointed out. Read more

He was referring to the risk parity model that also allocates more funds to assets that have lower volatilities, thus increasing the size of the positions.

In the equity market-neutral world, funds are also increasing size through leverage. The explanation is, however, different. In time of low volatility, equity market neutral funds suffer due the muted asset movement, and in order to maintain the returns they need to increase the leverage. Indeed Dani Burger of Bloomberg reported:

The pain of an almost paralyzed stock market has seeped its way into the money machine of equity quants, raising anxiety levels among analysts who say they’ve seen this movie before.

“If you’re in a long-in-the-tooth factor that everyone is involved in, that’s going down in volatility, one way to offset the reduced returns is with leverage,” said Mark Connors, the global head of risk advisory at Credit Suisse Group AG. “For any event, whether it’s a blip or a big macro event, there’s then a greater chance of sharp deleveraging.” Read more

Regardless of the reason for an increase in position size and/or leverage, a sound risk management plan is critical, as emphasized by Man Group CIO:

...investors need to have a plan to manage risk, not just focus on stock market reward.

That plan could potentially involve a hedging strategy, a fund-management strategy, or it could come down to asset allocation or rebalancing—though rebalancing, of course, may exacerbate drawdowns

Originally Published Here: Low Volatility and The Danger of Increased Leverage

Wednesday, May 24, 2017

Is Risk Parity an Overcrowded Trade?

We just recently discussed what has caused the increase in volatility lately. A plausible explanation is that hedging and short interests have caused a dramatic increase in volatility. Another cause for concern is the popularity of the risk parity strategy.

But what is the risk parity strategy?  According to Peter Tchir:

At its most basic level – it is buying stocks AND buying bonds under the assumption (hope) that when one goes down, the other goes up, dampening volatility while generating positive returns over time.

How can it affect the volatility?

…more investors are allocating money, directly or indirectly into Risk Parity strategies.
  • Investors wouldn’t need to sell stocks out of fear as they would be hedged – check
  • Investors wouldn’t be buying options so the price of volatility, or VIX, would be low – check
  • Investors would be buying bonds, particularly ‘safe’ bonds – check

If I am correct, the risk in the  market is not to increasing volatility but something that changes the relationship to stocks and bonds that causes them to both drop. 

The strategy has had long periods of success – not surprisingly up until the financial crisis as bond yields were high and reasonably stable while equities rallied.  In the Quantitative Easing Period when Central Banks helped inflate the price of all assets – which was rudely interrupted by the Taper Tantrum and again in the post Brexit era of more central bank support.

It is far from clear how well this strategy will do going forward, especially if central banks are scaling back their support and it is becoming a crowded trade in a world where liquidity often seems fickle.
Read more

But we note that if the risk parity strategy does not involve volatility products, then it will affect the realized volatility rather than implied volatility.


Tuesday, May 23, 2017

What Caused the Increase in Volatility of Volatility?

Last Wednesday saw a huge increase, in percentage terms, of the volatility indices. The 1M spot VIX increased by 46%, while the underlying SPX index decreased by only -1.8%. As discussed in our previous post entitled Is Volatility of Volatility Increasing?, such a big percentage change in the VIX associated with a “normal” down day is rare. It happened only 0.16% of the time since 1990.

VIX/VXV ratio as at May 23 2017. Source: Yahoo Finance

Consistent with our observation, Dana Lyons also pointed out that such a change in volatility was outside of the normal range:
Wednesday saw the single largest daily spike in the history of the VXST. But even that is understating things. The VXST actually more than doubled on Wednesday, rising 125% from 8.96 to 20.17. The spike was nearly 50% larger than even the previous record (8/21/2015). Read more
But we ask ourselves again the question: what caused such a big change in volatility?
While it will take a long time to arrive at satisfactory answers, we have found explanations provided by Deutsche Bank analysts, as reported by Tracy Alloway of Bloomberg, plausible:
Large dealer banks that buy or sell the S&P 500 to hedge exposure to U.S. equities are helping to suppress realized volatility and keep the VIX low, the Deutsche Bank analysts say. By their estimates, dealers would have to buy $14 billion if the S&P 500 fell by 1 percent. It’s all about "gamma" -- the third Greek letter.
“When dealers are long gamma they sell equities when equities are rising, but buy them when they’re falling,” write Deutsche Bank analysts led by Rocky Fishman. “The primary reason" for the VIX index being so low is the multi-decade low in fluctuations in the market itself, according to the team. And the long gamma positions of dealers "is a contributing factor to the ongoing low-realized vol,” they wrote.
The above explains why the volatility is usually low these days. This is consistent with an explanation we provided earlier in the post entitled Why is Volatility so Low?
However, in time of panic, the volatility can increase very quickly due to short covering and rebalancing of VIX ETNs:
While the hedging needs of big banks have helped keep a lid on volatility by providing a backstop to moves in U.S. equities, the analysts note, the rebalancing requirements of the plethora of exchange-traded products now tied to the VIX could pose a risk to that stability. Such ETPs typically buy VIX futures as the underlying index rises, and sell futures as it declines, creating a so-called ‘short gamma’ position."
If the VIX were to spike, then Deutsche Bank calculates those ETPs would have to buy a record amount of "vega" -- meaning they’d have to put on trades to bet that volatility will increase. “Vega to hedge on a spike has continued its steady rise since the vol increase around U.S. elections, and sits close to $90 million,” a record, they said. Read more
It is difficult to estimate the impact of VIX ETNs on the markets going forward. As always, a solid risk management plan is in order.

Originally Published Here: What Caused the Increase in Volatility of Volatility?

Monday, May 22, 2017

Is Volatility of Volatility Increasing?

Last Wednesday, the SP500 index went down by just -1.8%, but in the volatility space it felt like the world was going to end; the volatility term structure, as measured by the VIX/VXV ratio, reached 1, i.e. the threshold where it passes from the contango to backwardation state. The near inversion of the volatility term structure can also be seen on the VIX futures curve (although to a lesser degree), as shown below.

VIX futures as at May 16 (blue line) and May 17 2017 (black line). Source:

With only -1.8% change in the underlying SPX, the associated spot VIX went from 10.65 to 15.59, a disproportional increase of 46%. The large changes in the spot and VIX futures were also reflected in the prices of VIX ETNs. For example, SVXY went down by about 18%, i.e. 9 times bigger than the SPX return. We note that in normal times SVXY has a beta of about 3-4 (as referenced to SPY).
So was the spike in volatility normal and what happened exactly?
To answer these questions, we first looked at the daily percentage changes of the VIX as a function of SPX returns. The Figure below plots the VIX changes v.s.  SPX daily returns. Note that we plotted only days in which the underlying SPX decreased more than 1.5% from the previous day’s close. The arrow points to the data point of last Wednesday.

Daily VIX changes v.s. SPX returns

A cursory look at the graph can tell us that it’s rare that a small change in the underlying SPX caused a big percentage change in the VIX.
To quantify the probability, we counted the number of occurrences when the daily SPX returns are between -2.5% and -1.5%, but the VIX index experienced an increase of 30% or greater. The data set is from January 1990 to May 19 2017, and the total sample size is 6900.
There are only 11 occurrences, which means that volatility spikes like the one of last Wednesday occurred only about 0.16% of the time. So indeed, such an event is a rare occurrence.
Table below presents the dates and VIX changes on those 11 occurrences.
Date VIX change
23/07/1990 0.515
03/08/1990 0.4068
19/08/1991 0.3235
04/02/1994 0.4186
30/05/2006 0.3086
27/04/2010 0.3057
25/02/2013 0.3402
15/04/2013 0.432
29/06/2015 0.3445
09/09/2016 0.3989
17/05/2017 0.4638

But what happened and what caused the VIX to go up that much?
While accurate answers must await thorough research, based on other results (not shown) and anecdotal evidences we believe that the rise in the popularity of VIX ETNs, and the resulting exponential increase in short interest, has contributed greatly to the increase in the volatility of volatility.
We also note that from the Table above, out of the 11 occurrences, more than half (6 to be precise) happened after 2010, i.e. after the introduction of VIX ETNs.
With an increase in volatility of volatility, risk management became more critical, especially if you are net short volatility and/or you have a lot of exposure to the skew (dGamma/dSpot).
Source Here: Is Volatility of Volatility Increasing?

Sunday, May 21, 2017

Is The Volatility Index VIX Too Low Compared to High-Yield Spreads?

In the previous post entitled Relationship Between Credit Default Swaps and Equity Options we discussed about the link between corporate credit spreads and equity volatility. We also provided an academic reference that formally proved their relationship. Basically, there is a high degree of correlation between the VIX and corporate credit spreads.

Recently, John Lonski of Moody published an interesting report in which he presented the correlation between the VIX index and the high-yield credit spread. However, the difference here is that the high-yield credit spread was shifted by 3 months. His calculation also showed a high degree of correlation:

The VIX index’s moving yearlong average generates a very strong correlation of 0.89 with the high-yield default rate of three-months later. 

The high lagged-correlation is consistent with another observation presented in the article: the VIX is a leading indicator of where the high-yield credit spread is going:

Throughout much of 2016, the VIX index proved to be a reliable leading indicator of where the high-yield spread was headed.

These are very interesting observations, indeed.

Finally the author also pointed out:

Nevertheless, if only because the VIX index now resides in the bottom percentile of its historical sample, a higher VIX index is  practically inevitable.  Once the VIX index approaches its mean, the high-yield spread will be much wider than the recent 377 bp.

The VIX index’s latest moving yearlong average of 13.4 points favors a 1.6% midpoint for August 2017’s  default rate, which is less than the 3.3% predicted by both May -to -date’s high -yield EDF (expected  default frequency) metric and Moody’s Credit Policy Group.  An August 2017 default rate of 1.6% seems improbable given April 2017’s much higher default rate of 4.5%. (Figure 4.)

Profits growth is key to realizing lower default rates, as well as avoiding both a deep plunge by share  prices and a ballooning of corporate bond yield spreads.  Given how today’s substantial overvaluation of  equities  heightens the vulnerability of earnings-sensitive markets to adverse developments, the imperative of achieving profits growth cannot be understated.  For now, the weight of the available evidence suggests a mild rise of 2% to 7% for 2017’s pretax profits from current production. Read more

The above seems to say that the VIX index will have to rise in order for the VIX-HY credit spread differential to contract. This is in agreement with a recent comment made by Bill Gross that high-yield bond spreads have become too tight and can only widen going forward:

Gross, who manages the $2 billion Janus Global Unconstrained Bond Fund, is betting that high-yield bond spreads have gotten too tight and can only widen after reaching an almost three-year low in March. The so-called Trump trade, which has buoyed risk assets, will gradually unwind as markets are overpriced because investors are too optimistic about the president’s ability to boost U.S. economic growth to 3 percent. Read more

So the consensus is that the high-yield spread will not go lower and the VIX will rise in order to catch up.

But does this mean that the high-yield spread is leading the VIX? Let us know what you think.

Article Source Here: Is The Volatility Index VIX Too Low Compared to High-Yield Spreads?

Saturday, May 20, 2017

“True Volatility Is Created by What is Not Anticipated”

Last Wednesday, the VIX index experienced a huge spike; it jumped from 10.65% from the day before to 15.59% at the close of business. In the days leading up to the event the volatility index hovered around its lower range, despite many existing political and economic uncertainties such as

  • Slowdown in the US economy
  • Debt crisis in China
  • Intensifying tensions on the Korean Peninsula and in the Middle East
  • Parliamentary elections in Italy with a strong showing by the Five Star Movement

If the above uncertainties do not increase the volatility then what does? And why did the VIX index experience an outsize spike despite the fact that the underlying equity index, SP500, just went down by -1.8%?

It turned out that the political storm in Washington was the cause of the big spike in volatility. But why did it cause such a big spike?

We found an interesting quote in an article by Mark Melin on ValueWalk

But what really is of concern is the risk that is not anticipated. Here Jackson and Vig rely on a volatility trader’s traditional mantra: true volatility is created by what is not anticipated. What the report titled the “unknown unknowns,” a borrowing on former US Defense Secretary Donald Rumsfeld’s famous quote. Read more

So the political event in Washington was an unknown unknown, i.e. an event that was not anticipated.

Probably that’s why it caused such a huge jump in the VIX?

But a more important question is: how do you manage volatility risks, especially the ones resulted from an unknown unknown?


Wednesday, May 17, 2017

US Oil Producers Reducing Hedging Activities

We often argue that economic hedge is a necessary risk management tool

To Hedge or Not to Hedge

Hedging Should be Based on Risks and Not on Forecasts

Last week, Alex Nussbaum et al. of Bloomberg reported that based on the put skew in the oil option market, the US producers are reducing their hedging activities:

Oil bulls, take heart! U.S. drillers have dramatically reduced their hedging activity, a move that could portend a break in the production gains that have upended global crude prices.

The relative cost of options protecting against a drop in West Texas Intermediate crude has fallen to its lowest since August, thanks to a big drop in producer hedging, Societe Generale SA said on Friday. The so-called put skew for contracts delivered a year from now — weighing the difference in value between bullish and bearish options — fell to just below 6 percentage points, after rising above 8 points in February.

However, the article also pointed out the benefits of the existing hedges

Still, drillers are also forging ahead with plans to increase production, in part thanks to the financial cushion provided by existing hedges. Pioneer Natural Resources Co., one of the most prolific actors in Texas’ Permian shale basin, has contracts in place for 85 percent of its expected oil and natural gas output this year, the company said on a May 4 conference call. Read more

So after all, hedging is beneficial for the commodity producers.


Tuesday, May 16, 2017

How to Find Cheap Hedges

In the previous posts entitled
Where are the Cheap Hedges for Equity Portfolios?
Now Is The Time to Hedge, But The Cost of Insurance Can Be Expensive,
we outlined some solutions for finding inexpensive hedges in this low volatility environment. In this post we will continue to explore some more opportunities, and elaborate on additional risks that we have to take.
Buying far-dated options
Some experts believe that buying far-dated options is a good hedge right now, because we would minimize the hedging cost due to options time decay.  Recently Dani Burger et al. of Bloomberg reported:
However, moving further out on the VIX curve there’s still a bid for September futures. And it’s one that Macro Risk Advisors’ Pravit Chintawongvanich likes. On the long-end, investors can buy contracts that are less exposed to decay from time and more exposed to volatility risks, he said.
“Over the next four-to-five months, there is a good chance to monetize these long-dated VIX futures,” Chintawongvanich wrote in a note to clients Monday. Read more

VIX futures as at May 16, 2017. Source:

Note, however, that if investors buy far-dated options, they will then pay for not only the volatility risk premium, but also the term structure premium. In other words, there is no free lunch here.
Cross-asset hedging
Investors can use other highly correlated asset for hedging their portfolios. For example, they can buy puts in the emerging market ETFs.
"In spite of the ongoing correction in the commodity complex and emerging market equities' historically strong correlation to commodities, investors continue to push emerging market equites higher. Positioning recently jumped to 5 year highs, and the MSCI EM Index posted its largest volatility-adjusted outperformance vs. commodities in the past 10 years. While EM equities appear increasingly vulnerable to a commodity-induced near term correction, the volatility market remains extremely sanguine with short-dated implied vol rarely trading cheaper and EEM puts screening as the best equity hedge against commodity drawdowns. Hence we believe EEM puts are significantly undervalued to hedge or capture potential emerging market equity downside. For instance, a long EEM Aug 39.5/37 put spread costs indicatively 66c (1.6%), with comparable put spreads cheaper less than 1% of the time in the past 8 years." Read more
Similarly, as suggested by the Bloomberg article above, investors can also buy Euro or Sterling options.
Other potential hedges are
  • Buying defensive stocks
  • Buying calls instead of owning stocks
However, we note that if investors use the cross-asset hedging technique, they take on additional risks, of which correlation is the most important. Other additional risk factors are: cross-asset volatilities, sector risks, excessive risk premium.
As we can see, with some critical thinking, we can come up with ideas for finding cheaper hedges. However, prudent investors should evaluate additional risks when employing such techniques.
Article Source Here: How to Find Cheap Hedges

Sunday, May 14, 2017

“It might be that VIX is fairly priced for the first time, and that risk is fairly low”

Last week, the volatility index hovered in its lower range. However, the low volatility phenomenon is occurring not only in the equity space, but across the board, from fixed income, to currency, to commodity markets around the world.  Still, experts are divided whether this current low volatility is pricing in the risks correctly.

Steve Heston, who developed a stochastic volatility model that addressed some of the weaknesses of the Black-Scholes model, came out with an interesting statement regarding the current volatility. He said that the VIX is fairly priced for the first time:

The VIX gauges expectations for future stock market gyrations based on prices in the options market. It represents the price the market is willing to pay to capture any profit from market movement over the next month, or three months. When the VIX is low, investors are betting that stock prices aren’t going to gain much, or lose much, over a prescribed time.

“So either options have gotten cheap because they should be cheap, because the market is not moving much lately, and it’s not expected to move, or it’s gotten cheap because people are not willing to pay as much for options, because they realize they’ve been historically overpriced,” Heston says. Read more

We don’t know whether he is correct or not. However, a graph in a Bloomberg article by Tanvir Sandhu depicted a picture that is consistent with Heston's statement. It showed that the short interest of VXX ETN has gone exponentially in recent years.

Short-volatility strategies have performed well since 2009, just as black-swan funds were pitching end-of-the-world portfolio protection. The mindset of short-volatility sellers is characterized by expectations of preemptive central bank action to any crisis, making the trade a structural strategy as global rates hover near the lowest in human civilization. Read more

This means that investors just keep selling volatility.

Another article, by Jamie McGeever et al of Reuters, told a similar story. It said that there is little evidence of investors hedging, protecting themselves from a market correction:

Implied volatility is an options market measure of investors' expectation of how much a certain asset or market will rise or fall over a given period of time in the future.

It and actual volatility can quickly become entwined in a spiral lower because investors are less inclined to pay up for "put" options -- effectively a bet on prices falling -- when the market is rising. Read more

So the question is: when volatility is low, why are investors unwilling to protect themselves from a potential market downturn?

If we use the insurance analogy, then one should buy insurance when it is cheap, and not when a disaster happens and insurance is impossible to buy.

We think the problem is that even when the volatility is low, investors still find the insurance expensive. Probably it’s just their perception.

But still, one can ask

What are the cheaper hedges?

In the next installment we will explore some less expensive options for hedging.

Post Source Here: “It might be that VIX is fairly priced for the first time, and that risk is fairly low”

Thursday, May 11, 2017

Link Between Realized and Implied Volatilities

A recent post by Rebecca Ungarino of CNBC pointed out that the current realized volatility is low. It also said that the low realized volatility is influencing the implied volatility through volatility selling.

“We have a historically low level of realized volatility in the markets. In fact, Q1 was the lowest realized volatility on record since 1965,” Weinig said.

1M and 3M Realized (blue) and Implied (red) volatilities. Source: Yahoo finance

Furthermore, the low levels of actual volatility are easily flowing into the implied volatility measured by the VIX. This is due to what Weinig calls the “excessive” number of volatility sellers in the market, with assets pouring in to ETFs like the XIV, which reflects a short volatility position and has surged over 70 percent this year. Another fund, the SVXY, has risen by nearly the same amount.

“As long as there’s that realized premium from implied to realized volatility, you are going to have vol sellers in the market, and that’s creating very low levels of VIX,” he said. Read more

However, as discussed earlier in the posts entitled Why is Volatility so Low? and Why Is VIX So Low and What To Do About It , we think that there are multiple causes for the low volatility environment, not just volatility selling. These can be

  • Realized volatility is low, resulting in a low implied volatility,
  • Inflow into equities is increasing,
  • Popularity of shorting volatility through VIX ETNs is rising,
  • Investors are shorting volatility through options,
  • Market makers and sell-side institutions are delta hedging their inventories.

Let us know what you think.


Wednesday, May 10, 2017

Risks Involved When Investing in Exchange Traded Funds

The asset under management (AUM) of the Exchange Traded Fund (ETF) industry has grown substantially in the recent years. From 2007 to the end of 2016, AUM increased from $851 billion to $3.546 trillion. Investors have been enjoying many benefits, especially the low cost, offered by ETFs as a result of this explosive growth. However, there are risks that they are not often aware of. In this post, we are going to present some of the risks embedded in the illiquid and leveraged ETFs. An exhaustive list of all the risk factors will follow.

Investing through Exchange Traded Funds is a good way to access illiquid markets, for example high-yield corporate or emerging market debts. Also, investors can short sell or employ leverage by using inverse or leveraged ETFs. However, besides market risks, there are structural risks embedded in these ETFs that investors should be aware of. They are:

  1. Liquidity risk: exotic ETFs are characterised by liquidity mismatches, leverage or both – and it is on these products that concerns tend to focus. In the event of a sell-off in a high-yield ETF, for example, where liquidity in the underlying bonds has all but disappeared, gaps may emerge between the price of the ETF and that of the index it is trying to replicate.
  2. Counterparty credit risk: Synthetic ETFs, which are backed derivatives not physical securities, with investment banks as counterparties, also present some issues. In many cases, the collateral the counterparties post to the derivative arrangement bears no relation to the assets of the underlying index being tracked. At times of stress, this mismatch exposes the ETF to credit risk from its counterparties.
  3. Operational risks: Leveraged ETFs present other difficulties. Due to the requirement to rebalance leverage daily, investors using such ETFs to match their exposure to an index may find that after three days of market volatility they have not had the gains or losses they expected based on the performance of the index. Read more

In addition to these (more or less) apparent risks, there exist other ones which are less obvious and are caused by the herd mentality. For example, as investors have flocked into smart-beta funds, they increase these funds correlations. When the FED stops providing a “protective put” and market volatility increases, the smart-beta funds will likely underperform, and investors will pull their money out of these funds. This can cause a flash crash, or at least a deterioration of the ETFs' performance. In a long term, these smart-beta funds can lead to other problems, for example:

  1. Companies will adjust their accounting to become attractive to these publicly-known factor models.
  2. A small number of securities favored by the same academic models will receive large inflows.
  3. Prices will rise beyond their fair value, not because these theories are right but because the academic marketing machine keeps inflating their prices in a predictable manner.
  4. Quant funds will prey on pseudo-quant funds. Read more

Investing in smart-beta ETFs does not necessarily mean we make a smart decision. “Smart” investing requires careful evaluation of the risks involved and decide whether we can afford to take them.


Article Source Here: Risks Involved When Investing in Exchange Traded Funds

Sunday, May 7, 2017

Does Buying 50-Cent VIX Call Options Make Sense?

News came out last week that the identity of the mysterious VIX options buyer has been revealed. Mark Melin of Valuewalk reported:

The Financial Times first reported that Jonathan Ruffer, co-founder of a $20 billion London-based discretionary fund manager for private clients, trusts, charities and pension funds bearing his name, “has been systematically buying up derivative contracts linked to an index known as the Vix, according to four people from trading departments at banks who are familiar with the trades.” Read more

JUN 13 VIX Call Payoff. Source:ThinkorSwim

While we have no opinion on the accuracy of the information, nor we know the exact details of the hedging strategy, we think that the Fund is doing the right things because of the following reasons:
  1. They execute a hedging strategy, especially in this politically uncertain area. As shown in our studies, hedging comes with a cost, but it will provide a good protection for your portfolio in time of turmoil.
  2. They execute an explicit hedge using VIX (an index) options. Explicit hedge is necessary because hedging through portfolio diversification is not enough. Portfolio diversification relies on asset correlations that can change dramatically during a financial crisis.
  3. They execute a hedge that is cheaper to carry. Our research indicated that the cost of carry of long VIX calls is less than that of long SP500 puts
In addition to the above points, the article also mentioned, at a high-level,  other hedging strategies of the Fund:

The VIX calls represent a small fraction of portfolio exposure, near 0.1%, but there are other hedged positions in the portfolio, including index-linked bonds and gold, according to the source.

We also think that cross-asset hedging strategies make sense.


Saturday, May 6, 2017

“The most valuable commodity I know of is information”

In the world of quantitative trading, traders and portfolio managers utilize more and more data these days. So it’s not a surprise that the Economist calls data the “new oil”:

A NEW commodity spawns a lucrative, fast-growing industry, prompting antitrust regulators to step in to restrain those who control its flow. A century ago, the resource in question was oil. Now similar concerns are being raised by the giants that deal in data, the oil of the digital era. These titans—Alphabet (Google’s parent company), Amazon, Apple, Facebook and Microsoft—look unstoppable. They are the five most valuable listed firms in the world. Their profits are surging: they collectively racked up over $25bn in net profit in the first quarter of 2017. Amazon captures half of all dollars spent online in America. Google and Facebook accounted for almost all the revenue growth in digital advertising in America last year. 

What has changed? Smartphones and the internet have made data abundant, ubiquitous and far more valuable. Whether you are going for a run, watching TV or even just sitting in traffic, virtually every activity creates a digital trace—more raw material for the data distilleries. As devices from watches to cars connect to the internet, the volume is increasing: some estimate that a self-driving car will generate 100 gigabytes per second. Meanwhile, artificial-intelligence (AI) techniques such as machine learning extract more value from data. Algorithms can predict when a customer is ready to buy, a jet-engine needs servicing or a person is at risk of a disease. Industrial giants such as GE and Siemens now sell themselves as data firms. Read more

This reminds us of the movie Wall Street that was released 30 years ago. Yes, it was 3 decades ago.

“The most valuable commodity I know of is information”

So is the Big Data old news on the Street?


Friday, May 5, 2017

Another Quarter Loss for Metlife

Metlife just reported its Q1 earnings recently,  and it suffered another loss due to derivative hedging this time again. Interestingly, interest rates did not move that much since the previous quarter.

Operating profit beat analyst expectations, but included after-tax net losses of $602 million related to its derivatives portfolio in the first quarter. The prior quarter included $3.2 billion worth of such losses.

As written previously, derivative accounting was to blame for Metlife marked-to-market loss. We hear the same argument this time again, as reported by Suzanne Barlyn

Kandarian cited several factors in response: a rising U.S. stock market, a decline in 10-year Treasury note prices, higher rates for hedges, accounting standards that treat MetLife’s positions unfavorably, plus general “ineffectiveness” all hurt the company, he said.

The “ineffectiveness” alone cost MetLife $139 million, Chief Financial Officer John Hele said. Two-thirds of the losses were “non-economic,” meaning they reflect accounting standards regarding how assets and liabilities are valued, rather than the underlying health of the business, MetLife said.

MetLife’s painful derivatives positions are largely a result of positions it put in place to ensure Brighthouse would be financially strong from a capital perspective, and the spinoff would go smoothly. The company is awaiting regulatory approvals for the spinoff, which are unlikely to happen within the first half of the year, Kandarian said. Read more

But the question is: why are other insurers, who also practice hedge accounting, not suffering losses of this magnitude?


Thursday, May 4, 2017

Another Weapon of Mass Destruction?

Right after we published our thoughts on ETFs and their impact on the markets

Are ETFs Weapons of Mass Destruction?
Why is Volatility so Low?

CNBC reported that a new leveraged ETF is coming to the market. Its leverage is 4 times the daily SP500 returns

ForceShares has introduced two new exchange-traded funds that deliver four times the returns, either higher or lower, of S&P 500 futures. The ForceShares Daily 4X US Market Futures
Long Fund and ForceShares Daily 4X US Market Futures Short Fund are designed to return 400 percent of the performance of the index.

While such “leveraged” ETFs are hardly new — a plethora of products offer double or triple up or down movements in various parts of the market — this marks the first time a quadruple fund has been launched.

Some market participants worry that the temptation of such outsized returns will be impossible to resist, with dire results possible. Read more

This reminds us of CDO (Collateralized Debt Obligation) squared:

A special purpose vehicle (SPV) with securitization payments in the form of tranches. A collateralized debt obligation squared (CDO-squared) is backed by a pool of collateralized debt obligation (CDO) tranches. 

This is identical to a CDO except for the assets securing the obligation. Unlike the CDO, which is backed by a pool of bonds, loans and other credit instruments; CDO-squared arrangements are backed by CDO tranches. CDO-squared allows the banks to resell the credit risk that they have taken in CDOs. Read more

Can you see what is going on here?


Where are the Cheap Hedges for Equity Portfolios?

Last week, professor and Nobel Laureate Robert Shiller came out with a statement regarding the market high valuation. He referred to the CAPE ratio which is at 29 at the moment and is considered high.  However, he also said that the high CAPE ratio does not necessarily mean investors should sell stocks right now.
Still, Shiller makes it clear this doesn't necessarily suggest that investors should sell stocks.
"I'm not saying pull out of the market — I'm saying that it looks dangerous now," the Yale economics professor said Wednesday on CNBC's "Trading Nation." "But it could keep going up." Read more
Shiller PE Ratio as of May 3, 2017. Source:

So the question is, once again, how can investors protect their portfolios at a reasonable price and still be able to participate on the upside?
One solution is to employ a hedging strategy such as the US Equity Portfolio Enhancement Trade that uses listed options.
Another solution is to use a proxy hedge. Such a solution was suggested recently by another academic giant, Jeremy Siegel.
Prominent stock-market bull Jeremy Siegel says the best bet in a severe market downturn may be owning 30-year, U.S. government paper.
“And don’t forget, the long bond is the ultimate hedge against a stock-market crash. If there’s going to be a bad event internationally, North Korea, Europe or whatever, everyone runs to the long bond,” the University of Pennsylvania economist and professor of finance at the Wharton School of Business told CNBC during a Monday interview.
“It’s an insurance policy, it gives [the bond] a premium and a premium means a low yield on that instrument,” he said. “If something happens, they will go up if the stock market goes down 500 points.” Read more
Right now, investors appear fearless as they are pouring money into equities. But they have forgotten that hedging is like buying insurance. And the best time to buy insurance is when we don’t need it. When the house catches fire, it will be too late to buy an insurance policy, or we have to pay an exorbitant price for it.
Article Source Here: Where are the Cheap Hedges for Equity Portfolios?

Wednesday, May 3, 2017

Financial Market Insurance is Not Hurricane Insurance

In a previous post, we pointed out several reasons why the VIX is so low

There are several explanations. But in our opinion, currently nobody knows the exact reasons yet. However, a consensus started emerging. Several market experts say that volatility is low because of the increase in the short volatility trade through VIX-based ETFs. Dani Burger reported:

While gallons of ink have been spilled on whether the VIX is “broken,” some traders are now suggesting that exchange-traded products linked to the index have a hand in the perceived distortion. What’s more, they warn, their popularity — VIX ETPs have absorbed $700 million this year — could exacerbate a selloff if volatility spikes.

Yet budding evidence suggests that VIX ETPs — a more than $3 billion industry that includes the popular $1 billion iPath S&P 500 VIX Short-Term Futures ETN, symbol VXX — have altered the futures market, and at times indirectly influenced the index itself.

However, there are people who don’t agree

Most strategists believe there are stronger forces than ETPs keeping the VIX low. An accommodative Federal Reserve and European Central Bank, strong earnings, low sector correlation and numerous other positive market indicators have capped pessimism, they say.

It’s difficult to prove that ETPs apply constant pressure that pushes the VIX lower, according to Ramon Verastegui, head of flow strategy and solutions in the Americas at Societe Generale SA. Still, with ETPs looming as such a large market presence, they affect the VIX’s term structure while the threat of a sell-off hangs over the index. When VIX futures move 1 point, typically the VIX spot price moves 1 to 2 points, Verastegui said. Read more

Regardless of the reasons, the short volatility trade seems to be crowded. Therefore, it can have a huge impact on the market in case of panic and everyone wants to exit. Dean Curnutt wrote

The hurricane is not more or less likely to hit because more hurricane insurance has been written. In the financial markets this is not true. The more people write financial insurance, the more likely it is that a disaster will happen, because the people who know you have sold the insurance can make it happen. So you have to monitor what other people are doing.

While Haghani’s statements were focused on the manner in which LTCM-specific trades were seemingly attacked by the market, they remain highly relevant today because the notion that financial market insurance is not like hurricane insurance is broadly applicable. When trades are especially crowded, their unwinding can amplify market moves as investors seek to de-risk in unison. Stable markets not only invite trades that bet on the continuation of stability, they almost force investors to pursue them in an investment climate so deprived of nominal return. Read more

The title of this post, Financial Market Insurance is Not Hurricane Insurance refers to Haghani’s statement above, i.e. unlike the insurance markets, in financial markets everyone can sell insurance, and this can lead to a crowded trade.

Interestingly, from a mathematical point of view, pricing an insurance contract is vastly different from pricing an option contract. The former is priced in the statistical measure, where the latter is valued in the risk-neutral world. But this will be the subject of another post.

Why is Volatility so Low?

Last week, after the French election, the VIX plummeted and started its journey into the low-volatility regime again. Consequently,  volatility selling strategy began gaining traction.  However, published a warning

Jim Keohane, the chief executive of the Healthcare of Ontario Pension Plan, compares selling volatility to picking up dimes in front of a steamroller. “You are not getting paid a lot in the current market for the potential to get killed. That can happen very quickly,” he warns. Read more

The chart below shows the price of Catalyst Hedged Future Strategy, a fund specialized in shorting volatility

Catalyst Hedged Future Strategy price as of May 2 2017. Source: Yahoo finance
As we can see from the chart, shorting volatility is indeed a game of picking up dimes in front of a steamroller, i.e. when we win, we win small, but when we lose, we lose big.

But why is volatility so low?

We provided some explanations in our previous posts

Why Is VIX So Low and What To Do About It?
Now Is The Time to Hedge, But The Cost of Insurance Can Be Expensive

Recently,  Vineer Bhansali provided more clarifications. According to him, the low volatility is due to the facts that

  • Realized volatility is low, resulting in a low implied volatility,
  • Inflow into equities is increasing,
  • Popularity of shorting volatility through VIX ETNs is rising,
  • Investors are shorting volatility through options,
  • Market makers and sell-side institutions are delta hedging their inventories.

Of all the reasons above, which one is the most important?

We don’t know the exact answer yet. But what we do know now is that it’s very difficult to time the market turn, therefore it’s important to protect our portfolios by using some inexpensive hedges.  The author also pointed out:

In most cases historically, it has paid to replace outright risk with cheap options, or to perhaps build in some cheap downside protection, even without knowing accurately the timing of the correction. While it is almost impossible to time the corrections, it is equally unwise to be superstitiously short volatility when the dissonance between common sense and market behavior becomes so wide. Read more

We are in agreement with him in this regard.

Article source here:  Why is Volatility so Low?

Tuesday, May 2, 2017

How Will the FED Cut its Mortgage Backed Securities Holdings?

Tomorrow, the FED will meet again to make the decision regarding interest rates. Most experts expect 2 more rate hikes this year. Interestingly, Brian Chappatta  of  Bloomberg reported that hedge funds are going long treasuries

For the first time since July, hedge funds and other large speculators are bullish on Treasuries across the yield curve, U.S. Commodity Futures Trading Commission data show. The shift in 10-year futures was particularly striking, with the group adding an unprecedented 255,942 net-long contracts as of the latest figures, covering the week through April 25. Their bias is so skewed toward gains that the group is the most vulnerable to a bond-market selloff since 2008. 

Their change of heart came at a risky time. While almost no one expects the Federal Reserve to raise interest rates Wednesday, traders are betting that officials will reiterate a plan to hike twice more this year and potentially deliver further signals on their intention to trim the central bank’s balance sheet. What’s more, the same day, the Treasury is set to release documents as part of its quarterly refunding announcement that could shine light on the prospect of ultra-long debt issuance, which has already sent 30-year securities tumbling. Read more

Along with the issuance of ultra long-term debts, traders will closely watch the Fed’s decision regarding the unwinding of its Mortgage Backed Securities holding. As we wrote before, the unwinding of its Mortgage Backed Securities can increase market volatility

Today, concerns regarding the MBS were raised again, as pointed out by Rich Miller

Such securities can unexpectedly come due early if home owners decide to move or to refinance their mortgages. So, if the Fed wants its drawdown to be predictable, it will have to actively manage its holdings and not just passively accept what happens in the market.

He was referring to the prepayment risks embedded in Mortgage Backed Securities

While the Fed has made clear its desire to rid itself of much of its mortgage-backed debt, it’s not been so forthcoming on how far it wants to reduce its asset holdings overall. Read more

Let’s watch the FED tomorrow

Monday, May 1, 2017

Are ETFs Weapons of Mass Destruction?

With the huge inflow of asset under management into the ETFs, a natural question arises: how do ETFs influence the markets?

Opinions are diverse. Connected Wealth presented a nice report on Valuewalk and concluded:

The rise of passive investing, mainly via ETFs, appears to be changing the structure of the markets. This could be supressing individual company variance and making the market more macro driven. As more money flows into passive ETFs, this structural change would likely continue to rise over time. At some point this could be a big enough driver to create greater opportunities for more fundamental research to add value. Perhaps opportunities to take advantage of blanket basket driven price moves. Not sure if we are there yet, but it is likely coming. Read more

Other observers are more specific. Dani Burger wrote

Exchange-traded funds are making stock markets dumber — and more expensive.
That’s the finding of researchers at Stanford University, Emory University and the Interdisciplinary Center of Herzliya in Israel. They’ve uncovered evidence that higher ownership of individual stocks by ETFs widens the bid-ask spreads in those shares, making them more expensive to trade and therefore less attractive.
 This phenomenon eventually turns stocks into drones that move in lockstep with their industry. It makes life harder for traders seeking informational edges by offering fewer opportunities to capitalize on insights into earnings and other signals.
The study is the latest to point out signs of diminished efficiency in markets increasingly overrun by the funds. Read more

Similarly, Charles Stein calls ETFs Weapons of Mass Destruction:

Exchange-traded funds are “weapons of mass destruction” that have distorted stock prices and created the potential for a market selloff, according to the managers of the FPA Capital Fund.
“When the world decides that there is no need for fundamental research and investors can just blindly purchase index funds and ETFs without any regard to valuation, we say the time to be fearful is now,” Arik Ahitov and Dennis Bryan, who run the $789 million fund, said in an April 6 letter to investors in the actively managed fund.
The flood of money into passive products is making stock prices move in lockstep and creating markets increasingly divorced from underlying fundamentals, the managers said. As the market moves ever higher, there’s the potential for a sharp decline. The U.S. ETF market has about $2.7 trillion in assets, the majority in products that track indexes. ETFs have attracted more than $160 billion in new flows so far this year, Bloomberg data show. Read more

On the research side, Wesley R. Gray is more conservative, he said:

We’ve heard a lot of questions recently from clients and readers regarding how ETFs might affect financial markets.
The short answer is “nobody knows.” The long answer is researchers are trying to figure it all out. Read more

His post also includes brief summaries of recent academic research.

To conclude, both academic and practitioners communities are still debating on the exact impacts of ETFs on the markets. However, we started seeing a consensus: ETFs will increase volatilities and correlations.

Using a Market Timing Rule to Size an Option Position

Position sizing and portfolio allocation have not received much attention in the options trading community. In this post we are going to apply a simple position sizing rule and see how it performs within the context of volatility trading.

An option position can be sized by using, for example, a Markov Model  where the size of the position can be a function of the regime transition probability [1]. While this is a research venue that we would like to explore, we decided to start with a simpler approach. We chose an algorithm that is intuitive enough for both quant and non-quant portfolio managers and traders.

We utilize the market timing rule proposed by Faber [2] who applied it to different asset classes in the context of portfolio allocation. The rule is as follows

Buy when monthly price > 10M SMA (10 Month Simple Moving Average)
Sell and move to cash when monthly price < 10M SMA

This remarkably simple timing rule has been used successfully by Faber and others.  It has proved to significantly improve portfolios’ risk-adjusted returns [3].

Within the context of volatility trading, we compare 2 option strategies

1-NoTiming: Sell 1-Month  at-the-money  (ATM) put option on every option expiration Friday.  The option is held  until maturity, i.e. for a month.  The position is kept delta neutral, i.e. it is rehedged at the end of every day.

2-10M-SMA: Similar to the above except that Faber’s timing rule is applied, i.e. we only sell an ATM put option if the closing price of the underlying is greater than its 10M SMA. Note, however, that unlike Faber,  here we define the end of month as the option expiration Friday, and not the calendar end of month.

A short discussion on the rationale for choosing a market timing rule is in order here. Within the context of portfolio allocation, the 10M SMA rule is used for timing the direction of the market, i.e. the PnL driver is mostly market beta. Our trade’s PnL driver is, on the other hand,  the dynamics  of the implied/realized volatility spread. But as shown in a previous post, the IV/RV volatility dynamics correlates highly with the market returns.  Therefore, we thought that we could use a directional timing strategy to size an options portfolio despite the fact that their PnL drivers are different, at least theoretically.

We tested the 2 strategies on SPY options from February 2007 to November 2016. Table below provides a summary of the trade statistics (average PnLs, winning/losing trades and drawdowns are in dollar).

Strategy NoTiming 10M-SMA
Number of Trades 115 81
Percent Winners 0.68 0.69
Average P&L 18.84 14.87
Largest losing trade -269.79 -248.50
Largest winning trade 243.54 154.22
Profit Factor (W/L)            1.77            1.64
Worst drawdown -633.24 -339.91

Graph below shows the equity curves of the 2 strategies

As it is observed from the Table and the Graph, except for the worst drawdown, we don’t see much of an improvement when the 10M-SMA timing rule is applied.  Although the 10M-SMA strategy avoided the worst period of the Global Financial Crisis, overall it made less money than the NoTiming strategy.

The non-improvement of Faber’s rule in the context  of volatility selling probably relates to the fact that we are using a directional timing algorithm to size a trade whose PnL driver  is the volatility dynamics . A position sizing algorithm based directly on the volatility dynamics would have a better chance  of success.  We are currently extending our research in this direction;  any comment, feedback is welcome.


[1]  C. Donninger, Timing the Tail-Risk-Protection of the SPY with VIX-Futures by a Hidden Markov Model. The Wool-Milk-Sow Strategy. April 2017,

[2]  M. Faber, A  Quantitative  Approach  to  Tactical  Asset  Allocation, Journal  of Investing , 16, 69-79, 2007

[3] See for example A. Clare, J. Seaton, P. Smith and S. Thomas, The Trend is Our Friend: Risk Parity, Momentum and Trend Following in Global Asset Allocation, Aug 2012,

 Originally posted here Using a Market Timing Rule to Size an Option Position