Understanding Volatility

[barn32]

The more I try to find ways of making money in the markets the more I come back to volatility.

Volatility wasn't even on my radar as a trader in previous years, but now I follow it very closely.

If you have followed TastyTrade at all you know their whole "thing" is volatility. However, I think they carry it too far. There are of course ways to make money in low volatilty environments and Sosnoff is famous for not ever going long stocks even coming off of a very long term bull-market.

Personally, I think he got burned in 1987, and has leaned bearish ever since. (Conversely, it was one of Tony Batista's best ever days.)

They do go long, but mostly in spreads, or they sell puts. They always seem to be short stock index futures and rarely, if ever, play them from the upside.

As you can see by the chart over the last two years we have had six major volatility spikes. I've listed the reasons for five of them on the chart.



Most of them are world and or economic events, which are beyond anyone's control, and often time come right out of the blue.

This quote from a 2016 Barron's article explains it best:

"HISTORY SHOWS, however, that the types of issues that tend to trigger a dramatic spike in volatility are those that were not on the radar until the last minute, if at all. Recent examples include the Arab Spring, the Ebola crisis, Russia’s invasion of Ukraine, and China’s devaluation of the yuan. These are the types of events that almost certainly didn’t appear on any list of top concerns in the previous December."

The August 2015 spike in volatility from the same article:

"For example, during the market’s August turmoil, the CBOE Volatility Index, or VIX, rose more than 100% in a week for the first time in its 23-year history. The VIX measures the level of fear and uncertainty priced into Standard & Poor’s 500 options.

That same week, the VIX registered two of the four largest single-day spikes in history—in consecutive trading sessions, no less. Earlier in the year, volatility in emerging markets and crude oil narrowly missed hitting all-time highs."

That August spike was attributed to China and oil. Fear run amok.

But also notice on the chart how relatively quickly volatilty contracts once cooler heads prevail. VOL never seems to stay high for long periods of time. A lot of this has to do with the way volatilaty derivatives are constructed, but be that as it may trying to predict volatility spikes is guesswork at best.

I was long VOL when the Fed last raised interest rates and I got stopped out on that trade when the markets just yawned.

Now look at the September 2016 spike on the charts where the mere "mention" of interst rate hikes sent the Dow down 400 points in one day and you can see there is really no way to predict how markets will react. You can guess, but that's about it.

So what will cause the next rise in VOL? Most likely an unpredictable world event, or the cumulative mix of uncertain economic news, or both.

Either way, the chart tells us two things:

1. Trying to predict spikes in volatility is futile at best

2. When VOL does spike you should take advantage of it quicky...because high volatility doesn't stay around for long.

[dlivery]

No different than a early horse

[Parkview_Pirate]

Nice analysis, Barn. I got caught on the wrong side of a futures trade during the August 2015 spike, trying to catch a falling knife as the market plunged. But I had faith (and enough margin) to ride it out, and made a nice profit when the market bounced back over the next couple of days. Like you say, the timeframe for taking advantage of the spikes is quite short, and requires nerves of steel to make the trade.

IMHO, when volatility spikes, it provides a rare opportunity to sell options. I was able to make a small profit on some covered calls I sold about six years ago during a market spike upwards, and the volatility dropped off shortly afterwards. My trade was made on the downside of the volatility move, and was relatively safe, making a 20% profit or so when buying back the calls after four days. When the market is more stable, I tend to stay away from options, as the theta and vega eat you alive.

If the talking heads of the market have any credibility, the middle of March should provide some excitement as budget and debt ceiling deadlines take hold in Congress. While these issues may provide a catalyst for a spike in volatility, I'm leaning towards a more permanent change to higher volatility over the next couple of years versus short term (2-3 days) spikes. I see the VIX having an average range of 18-20 as the markets decline 20-40%, though when the decline starts - and what triggers it - is still unclear to me.

One thing I still don't understand about volatility is that the upward moves in the market aren't reflected nearly as much (and sometimes never) by a higher value in the VIX. Today is a good example - with the S&P up over 30 points, the VIX has stayed near 13. If the S&P had dropped 30 points, the VIX would be up near 18 or 20...

[barn32]

Originally Posted by Parkview_Pirate

One thing I still don't understand about volatility is that the upward moves in the market aren't reflected nearly as much (and sometimes never) by a higher value in the VIX. Today is a good example - with the S&P up over 30 points, the VIX has stayed near 13. If the S&P had dropped 30 points, the VIX would be up near 18 or 20...

I don't know about the "18 or 20" part, but the VIX goes up mostly in down markets. If it was a gradual 30 point move the VIX would move more gradually, but if there was some bad news somewhere the VIX could really spike and possibly higher than 18 or 20.

However, the last couple of weeks saw some exceptions. From around the 13th to yesterday the DOW was up around 500 points and the VIX went from 11 to 13, which was very perplexing to me. VIX is a measure of fear more or less, that's why it goes down in up markets.

Volatility is also confusing because of all the different components associated with it. Indexes, futures, ETNs, ETFs, etc.

Some of those include:

VIX (index)
VXX
/VX
VVIX
UVXY
XIV
SVXY
TVIX
ZIV

Not to mention the VIX futures which trade weekly in the near month and monthly there after.

And there are probably a few that I left out.

[_______]

There is more than one reason for the usual disconnect between VIX and a big move up like yesterday.

But one very simple one is that the underlying options that constitute the basis of the measure are overweight puts.

[Magister Ludi]

We extract a lot of alpha via volarb. Volatility surfaces can be decomposed into tradeable gammas and readily predicted.

[AltonKelsey]

So far at least 75 PA members have been hospitalized trying to fathom what Ludi said.

[highnote]

Originally Posted by AltonKelsey

So far at least 75 PA members have been hospitalized trying to fathom what Ludi said.

Let me take a shot:

"We extract a lot of alpha via volarb. Volatility surfaces can be decomposed into tradeable gammas and readily predicted."

Alpha is a measure of performance against some baseline, like the S&P.

volarb -- volatility arbitrage?

What is a volatility surface?

decomposed into tradeable gammas. Well, the gamma of an option is expressed as a percentage. This percentage denotes the change in the delta in response to a one point movement of the underlying stock price. If delta is change then gamma is the change of the change. So decomposed into tradeable change of deltas.

readily predicted -- I think he means volatility surfaces can be readily predicted.

So, is volarb somehow used to trade the change of the predicted delta differences?