Search Results for: volatility

Euripides Volatility

Question everything.

That saying is a famous Euripides attribution, the Athenian playwright of 2500 years ago. The Greeks were good thinkers and their rules of logic prevail yet today.

Let’s use them.  Blue chips dropped over 600 points Monday and gained 200 back yesterday. We’re told fear drove losses and waning fear prompted the bounce.

What do you think the Greeks would say?

That it’s illogical?  How can the same thing cause opposing outcomes?  That’s effectively the definition of cognitive dissonance, which is the opposite of clear thinking.

The money motivated to opposite actions on consecutive days is the kind that profits on price-differences. Profiting on price-differences is arbitrage.

Could we not infer then a greater probability that arbitragers caused these ups and downs than that investors were behind them?  It’s an assessment predicated on matching outcome to motivation.

Those motivated by price-changes come in three shades. The size of the money – always follow the money, corollary #1 to questioning everything – should signal its capacity to destabilize markets, for a day, or longer.

There are Risk Parity strategies.  Simon Constable, frequent Brit commentator on markets for the Wall Street Journal and others, suggested for Forbes last year following the February temblor through US stocks that $500 billion targets this technique designed to in a sense continually rebalance the two sides of an investing teeter-totter to keep the whole thing roughly over the fulcrum.

Add strategies designed to profit on volatility or avoid it and you’ve got another $2 trillion, according to estimates Mr. Constable cites.

The WSJ ran a story May 12 (subscription required) called “Volatility in Stocks Could Unravel Bets on Calm Markets,” and referenced work from Wells Fargo’s derivatives team that concluded “low-vol” funds with $400 billion of assets could suddenly exit during market upheaval.

Add in the reverse. Derivatives trades are booming. You can buy volatility, you can sell it, you can hedge it.  That’s investing in what lies between stocks expected to rise (long bets) and stocks thought likely to fall (short bets).

This is the second class:  Volatility traders. They are trying to do the opposite of those pursuing risk-parity. They want to profit when the teeter-totter moves. They’re roughly 60% of daily market volume (more on that in a moment).

The definition of volatility is different prices for the same thing.  The definition of arbitrage is profiting on different prices for the same thing.

The third volatility type stands alone as the only investment vehicle in the history of modern capital markets to exist via an “arbitrage mechanism,” thanks to regulatory exemptions.

It’s  Exchange-Traded Funds (ETFs). ETFs by definition must offer different prices for the same thing. And they’ve become the largest investment vehicle in the markets, the most prolific, having the greatest fund-flows.

EDITORIAL NOTE: I’m hosting a panel on ETFs June 5 at the NIRI Annual Conference, one of several essential market-structure segments at the 50th anniversary event. You owe it to your executive team to attend and learn.

Size matters. Active Investment, getting credit for waxing and waning daily on tidal trade fear, is about 12% of market volume. We can’t precisely break out the three shades of volatility trading. But we can get close.

Fast Trading, short-term profiteering on fleeting price-changes (what’s the definition of arbitrage?), is about 44% of volume. Trades tied to derivatives – risk-parity, bets on price-changes in underlying assets – are 19%.  Passive investment, the bulk of it ETFs (the effects of which spill across the other two), is 25%.

One more nugget for context:  Options expire May 16-17 (index, stock options expirations), and May 22 (VIX and other volatility bets). Traders will try to run prices of stocks to profit not on stocks but how puts, calls and other derivatives increase or decrease far more dramatically than underlying stocks.

The Greeks would look at the math and say there’s an 88% probability arbitrage is driving our market.

Euripides might call this market structure a tragedy. But he’d nevertheless see it with cold logic and recognize the absence of rational thought.  Shouldn’t we too?

Blocking Volatility


As the market raged high and low, so did Karen and I this week, from high in the Rockies where we saw John Denver’s fire in the sky over the Gore Range, down to Scottsdale and the Arizona desert’s 80-degree Oct 30 sunset over the Phoenician (a respite as my birthday is…wait for it…Oct 31).

Markets rise and fall.  We’re overdue for setbacks.  It doesn’t mean we’ll have them, but it’s vital that we understand market mechanics behind gyrations. Sure, there’s human nature. Fear and greed. But whose fear or greed?

Regulators and exchanges are tussling over fees on data and trades.  There’s a proposed SEC study that’ll examine transaction fees, costs imposed by exchanges for trading. Regulation National Market System caps them at $0.30/100 shares, or a third of a penny per share, which traders call “30 mils.”

The NYSE has proposed lowering the cap to $0.10/100, or a tenth of a penny per share, or 10 mils. Did you know there’s a booming market where brokers routinely pay eight cents per share or $8.00/100 shares?

What market? Exchange-Traded Funds (ETFs).

We’re told that one day the market is plunging on trade fears, poor earnings, geopolitics, whatever. And the next, it surges 430 points on…the reversal of fears. If you find these explanations irrational, you’re not alone, and you have reason for skepticism.

There’s a better explanation.

Let’s tie fees and market volatility together. At right is an image from the iShares Core MSCI EAFE ETF (CBOE:IEFA) prospectus showing the size of a standard creation Unit and the cost to brokers for creating one.  Divide the standard Unit of 200,000 shares by the usual cost to create one Unit, $15,000, and it’s $0.08/share (rounded up). Mathematically, that’s 2,600% higher than the Reg NMS fee cap.

Understand: brokers provide collateral – in this case $12.5 million of stocks, cash, or a combination – for the right to create 200,000 ETF shares to sell to the public.

Why are brokers willing to pay $8.00/100 to create ETF shares when they rail at paying $0.30/100 – or a lot less – in the stock market?

Because ETF shares are created in massive blocks off-market without competition. Picture buying a giant roll of paper privately, turning it into confetti via a shredder, and selling each scrap for a proportionate penny more than you paid for the whole roll.

The average trade-size for brokers creating IEFA shares is 200,000 shares.  The average trade-size in the stock market where you and I buy IEFA or any other stock is 167 shares (50-day average, ModernIR data).  Do the math on that ratio.

ETF market-makers are pursuing a realtime, high-speed version of the corporate-raider model. Buy something big and split it into pieces worth more than the sum of the parts.

In a rising market, it’s awesome.  These creations in 200,000-share blocks I’ve just described are running at nearly $400 billion every MONTH. Create in blocks, shred, mark up. ETF demand drives up all stocks. Everybody wins.

What happens in a DOWN market?

Big brokers are exchanging your stocks, public companies, as collateral for the right to create and sell ETF shares.  Suppose nobody shows up to buy ETF shares.  What brokers swapped to create ETF shares is suddenly worth less, not more, than the shredded value of the sum of the parts. So to speak.

Without ETF flows to drive up it up, the collateral – shares of stocks – plunges in value.

The market devolves into desperate tactical trading warfare to offset losses. Brokers dump other securities, short stocks, buy hedges. Stocks gyrate, and the blame goes to trade, Trump, earnings, pick your poison.

How do I know what I’ve described is correct?  Follow the money. The leviathan in the US equity market today is creating and redeeming ETF shares. It’s hundreds of billions of dollars monthly, versus smatterings of actual fund-flows. You don’t see it because it’s not counted as fund turnover.

But it fits once you grasp the weird way the market’s last big block market is fostering volatility.

What’s ahead? If losses have been sorted, we’ll settle down in this transition from Halloween to November. Our data are still scary.  We may have more ghouls to flush out.

Currency Volatility

 We interrupt the white-hot arc of the stock market for this public-service announcement: Watch the dollar.

While any number of factors might be selected as reason for the DJIA’s 360-point drop yesterday, one macro factor correlates well: The relative buying power of the US dollar, the world’s reserve currency.

Give me two minutes, and I’ll show you.

Sure, one can say the market is due for a pullback. But randomly? Donald Trump’s first inaugural address is an easy target. Do we call investors schizophrenic if the market regains yesterday’s losses today or tomorrow?

How the US dollar fares versus other global currencies remains a barometer for US stocks. It’s been especially true since 2008 because the Financial Crisis marked a stark turn for central banks toward coordinated global policy.

But all the way back to 1971 when the United States left the gold standard for the 20th century’s version of a cryptocurrency experiment, a floating-rate dollar, shocks to equities trace to gyrations in the currency (the economy’s risk assets like stocks and bonds have replaced gold as the backing commodity but that’s another story).

Black Monday, the October 19, 1987 global stock crash that hacked 508 points or 23% of blue-chip value off the Dow Jones Industrial Average (DJIA) followed a stretch of currency volatility (and interest-rate volatility as the two are intertwined).

For perspective, the DJIA lost a greater number of points just now, Jan 29-30 (533), than it did Oct 19, 1987 (508). Heights today are so lofty that past ravines are wrinkles.

The collapse of the Internet Bubble in 2000 came after a sharp acceleration for the dollar on rate hikes by Fed chair Alan Greenspan to slow what he famously called “irrational exuberance.” He recognized the stock market reflected inflation, which as Milton Friedman said, is always and everywhere a monetary phenomenon.

Inflation is more money than an economy can readily deploy, not rising prices, which is a consequence. Stuffing money into economies is like squeezing a balloon. You don’t know where the air pockets will form.  Prices rise, but not always how or where central bankers suppose.

On May 6, 2010, market seams split fleetingly in the Flash Crash, the DJIA first plunging down and then bucking back up about a thousand points.  Before it, volatility was rattling the euro/dollar trade, a product of 2009’s massive “quantitative easing” by the Federal Reserve as the US central bank gave the global money balloon a giant squeeze and the dollar went into a steep dive.

In latter August 2015 the DJIA lost more than 6% over a series of days following a sudden currency-devaluation in China that tripped the delicate global balance.  And remember the Fed’s first post-crisis rate hike – a buck-booster – in Dec 2015? Near catastrophe for stocks (most for energies as oil plunged when the dollar rose) in January 2016.

We come to yesterday. What came before it? Last week the dollar plummeted about 3% as traders interpreted comments by US Treasury Secretary Steven Mnuchin to mean he wanted a weaker dollar.

Sure, there’s a sort of Clockmaker God quality to the idea that if we can pan back in the mind’s eye, the financial markets are all perched atop a giant dollar bill that occasionally flutters and spills something into the abyss.

On the other hand, it could be fixed. The dollar, that is. If the dollar wasn’t always fluctuating, we could better concentrate on, say, saving more, or investing capital without worrying about the corrosive effects on returns of a depreciating currency.

So, Jay Powell.  You’ll be steering the Fed after Janet Yellen bids us adieu this week. Imagine how much easier everything would be if the dollar wasn’t one of the things gyrating like stock-prices.

Hidden Volatility

Volatility plunged yesterday after spiking last week to a 2017 zenith thus far. But what does it mean?

“Everybody was buying vol into expirations, Tim,” you say. “Now they’re not.”

Buying vol?

“Volatility. You know.”

It’s been a long time since we talked about volatility as an asset class. We all think of stocks as an asset class, fixed income as an asset class, and so on.  But volatility?

The CBOE, Chicago Board Options Exchange, created the VIX to drive investment in volatility, or how prices change. The VIX reflects the implied forward volatility of the S&P 500, extrapolated from prices investors and traders are paying for stock futures. The lower the number the less it implies, and vice versa.

(If you want to know more, Vance Harwood offers an understandable dissection of volatility and the VIX.)

For both investor-relations professionals and investors, there’s a lesson.  Any effort to understand the stock market must consider not just buying or selling of stocks, but buying or selling of the gaps between stocks. That’s volatility.

It to me also points to a flaw in using options and futures to understand forward prices. They are mechanisms for buying volatility, not for pricing assets.

Proof is in the VIX itself. As a predictor it’s deplorable. It can only tell us about current conditions (though it’s a win for driving volatility trading). Suppose local TV news said: “Stay tuned for yesterday’s weather forecast.”

(NOTE: We’ll talk about trading dynamics at the NIRI Southwest Regional Conference here in Austin on Lady Bird Lake Aug 24-25 in breakout sessions. Join us!)

Shorting shares for fleeting periods is also a form of investing in volatility. I can think of a great example in our client base. Earlier this year it was a rock star, posting unrelenting gains. But it’s a company in an industry languishing this summer, and the stock is down.

Naturally one would think, “Investors are selling because fundamentals are weak.”

But the data show nothing of the sort! Short volume has been over 70% of trading volume this summer, and arbitrage is up 12% while investment has fallen.

Isn’t that important for management to understand? Yes, investing declined. But the drop alone prompted quantitative volatility traders to merchandise this company – and everyone is blaming the wrong thing. It’s not investors in stocks. It’s investors in volatility. Holders weren’t selling.

“But Tim,” you say. “There isn’t any volatility. Except for last week the VIX has had all the enthusiasm of a spent balloon.”

The VIX reflects closing prices. At the close, all the money wanting to be average – indexes and ETFs tracking broad measures – takes the midpoint of the bid and offer.

Do you know what’s happening intraday?  Stocks are moving 2.5% from average high to low. If the VIX were calculated using intraday prices, it would be a staggering 75 instead of 11.35, where it closed yesterday.

What’s going on? Prices are relentlessly changing. Suppose the price of everything you bought in the grocery store changed 2.5% by the time you worked your way from produce to dairy products?

Volatility is inefficiency. It increases the cost of capital (replace beta with your intraday volatility and you’ll think differently about what equity costs).  Its risk isn’t linear, manifesting intraday with no apparent consequence for long periods.

Until all at once prices collapse.

There’s more to it, but widespread volatility means prices are unstable. The stock market is a taut wire that up close vibrates chaotically. Last week, sudden slack manifested in that wire, and markets lurched. It snapped back this week as arbitragers slurped volatility.

It’s only when the wire keeps developing more slack that we run into trouble. The source of slack is mispriced assets – a separate discussion for later. For now, learn from the wire rather than the tape.  The VIX is a laconic signal incapable of forecasts.

And your stock, if it’s hewing to the mean, offers volatility traders up to 2.5% returns every day (50% in a month), and your closing price need never change.

When you slip or pop, it might be the volatility wire slapping around.  Keep that in mind.

Volatility Insurance

In Texas everything is bigger including the dry-aged beef ribs at Hubbell & Hudson in the Woodlands and the lazy river at Houston’s Marriott Marquis, shaped familiarly.

We were visiting clients and friends before quarterly reporting begins again. Speaking of which, ever been surprised by how stocks behave with results?

We see in the data that often the cause isn’t owners of assets – holders of stocks – but providers of insurance. To guard against the chance of surprises, investors and traders use insurance, generally in the form of derivatives, like options. 

Played Monopoly, the board game? A Get Out of Jail Free card is a right but not an obligation to do something in the future that depends on an outcome, in this case landing on the “go to jail” space. It’s only valuable if that event occurs. It’s a derivatives contract.

At earnings, if you shift the focus from growth – topline – to value – managing what’s between the topline and the bottom line – the worth of future growth can evaporate even if investors don’t sell a share.

Investors with portfolio insurance use their Get Out of Jail Free cards, perhaps comprised of S&P 500 index futures. The insurance provider, a bank or fund, delivers futures and offsets its exposure by selling and shorting your shares. It can drop your price 10-20%.

Writers Chris Whittall and Jon Sindreu last Friday in the Wall Street Journal offered the most compelling piece (may require registration — send me a note if you can’t read it) I’ve seen on this concept of insurance in stocks.

Investors of all ilks, not just hedge funds, protect assets against the unknown, as we all do. We buy life, auto, health, home insurance.  We seek a Get Out of Jail Free card for ourselves and our actions.

In stocks, we track this propensity as Risk Management, one of the four key behaviors setting market prices. It’s real and by our measures north of 13% of total market cap.

But the market has been a flat sea.  No volatility.  This despite a new President, geopolitical intrigue, global acts of terror, a Federal Reserve stretching after eight Rumpelstiltskin years, and a chasm between markets and fundamentals.

Whittall and Sindreu theorize that opposing actions between buyers and sellers of insurance explains the strange placidity in markets where the VIX, the so-called Fear Gauge derived from prices of options on stocks, has been near record lows.

The thinking goes that the process of buying and selling insurance is itself the explanation for absence of froth. Because markets seem inured to threats, investors stop buying insurance such as put options against surprise moves, and instead look to sell insurance to generate a fee. They write puts or calls, which generate cash returns.

Banks take the other side of the trade because that’s what banks do. They’re now betting volatility will rise. To offset the risk they’re wrong, they buy the underlying: stocks. If volatility rises the bet pays, but the bank loses on the shares, which fall. 

This combination of events, it’s supposed, is contributing to imperturbable markets. Everything nets to zero except the stock-purchases by banks and cash returns generated by investors selling insurance, so there’s no volatility and markets tend to rise.

Except that’s not investment. It’s trafficking in get-out-of-jail-free cards.

And despite low volatility, there’s a cost. We’ve long said there will be a Lehman moment for a market dominated by Risk Management.

We’ve seen hedge funds struggle. They’re big players in the insurance game. And banks have labored at trading. Maybe it’s due to insurance losses. Think Credit Suisse, Deutsche Bank, HSBC.  Someone else?

From Nov 9-Mar 1 the behavior we call Risk Management led as price-setter marketwide, followed closely by Active Investment. The combination points to what’s been described: One party selling insurance on risk, another buying it, and a continual truing up of wins and losses.  

Now, for perspective, the VIX is a lousy alarm system. It tells us only what’s occurred. And intraday volatility, the spread between daily high and low prices across the market, is 2.2%, far higher than closing prices imply.

We may reach a day where banks stop buying insurance from selling investors, if indeed that’s what’s been occurring.  Stocks will cease rising.  Investors will want to buy insurance but the banks won’t sell it.  Then real assets, not insurance, will be sold.

It’s why we track Risk Management as a market demographic, and you should too.  You can’t prevent risk. But you can see it change.

Correlating Volatility

“Measure the performance of equity securities in the top 85% by market capitalization of equity securities listed on stock exchanges in the United States.”

I made it a sentence here but I clipped that phrase from a Blackrock iShares “minimum volatility” Smart Beta Exchange Traded Fund (ETF) prospectus and Googled it, and got back pages of references.  Apparently many indexes and ETFs meant to diversify and differentiate investments are built on the “top 85% by market capitalization.”

That by the way is about 700 companies. There are now over 700 ETFs in the US stock market and about 3,700 total public companies when you strip out funds and multiple classes of stock.  That’s a 1-to-5 ratio.  If many ETFs track indexes comprised of just 20% of the stocks, would that not produce high correlation?

Answer:  Yes.

I ran correlation for five ETFs from Blackrock, First Trust, Schwab, Vanguard and Invesco (USMV, FVD, SCHD, VIG, SPLV) over the past three months and it was about 90%.  Now, all five seek similar objectives so correlation isn’t surprising. But in truth they’re brewing a mixture of the same stocks.

We had the chance to participate in a wine-blending last month in Napa. The group was tasting mixtures of a core set of grapes.  What if we make it 94% Zinfandel, 3% Petit Syrah and 3% Malbec?  How about 7% Malbec, 3% Petit Syrah, 90% Zinfandel?

The same thing is happening with ETFs. They’re blending the same grapes – stocks.  What if we weight a little more than the index in WMT and a little less in AMZN?

It’s still the same stocks. And it’s earnings season.  Think about the impact of high correlation when in nearly all cases save an outlier handful ETFs track underlying indexes with defined composition.

Say you report results and your stock plunges (we’ll come to why in a moment). Even minute weighting in a falling stock can skew the ETF away from the benchmark, so the authorized participants for the ETF sell and short your shares, raising cash to true up net asset values and ridding the ETF of the offending drag.

At some future point now that your shares are sharply discounted to the group and the market, arbitragers will find you and the authorized participants (brokers creating and redeeming ETF shares to ensure that it tracks its benchmark as money flows into and out of the investment vehicle) who shorted will cover, and suddenly you’re the star again.

Neither up nor down did the behavior of your stock reflect fundamental value or rational thought. It’s high correlation, which rather ironically fosters mounting volatility. We’re seeing a notable increase in instances of large moves with earnings.  And your shares don’t drop 15% because active investors saw your numbers and decided, “Let’s destroy our portfolio returns by buying high and selling low.”

In the last week through Monday, Asset Allocators (indexes and ETFs) and Fast Traders (arbitragers speculating on intraday price-changes) were top price-setters.  Both are quantitative, or machine-driven, behaviors. One is deploying money following a model and the other is betting with models on divergences that will develop during that process.

Both create mass volatility around surprises in earnings reports. Fast Traders are the athletes of the stock market racing to the front of the line to buy and sell. Asset Allocators are lumbering, oblivious to fundamental factors and instead following a recipe.

You report.  Active investors stop their bits and pieces of buying or selling to assess your fundamentals. Sensing slight change, Fast Traders vanish from order books across the interconnected web comprising today’s stock market.  Asset Allocators tracking benchmarks stop buying your shares because you’ve now diverged from the broad measure.

This combination creates a vacuum.  Imagine selling your house and there was a bidding war for it and suddenly all the bidders disappeared. You’d have to cut your price. What changed?  The number of potential buyers, not the value of the house.

This is the problem with how a combination of Fast Traders and Asset Allocators dominate the market now.  Fast Traders set most of the prices but want to own nothing so the demand they create is unreliable and unstable.  Asset Allocators are trying to track benchmarks – that depend on Fast Traders for prices. Throw a wrench into those delicate gears with, say, a surprise in your quarterly earnings, and something will go awry.

Speaking of which, our Sentiment Index just turned Negative for the first time since February and yet the market soared yesterday.  From Feb 8-11, futures contracts behind some of the most actively traded ETFs in the market, concentrated in energy, rolled. The dollar had just weakened. Stocks roared.

The same futures contracts just rolled and the ETFs rebalanced (May 6-11). Counterparties covered. The dollar is rising. We may be at a tipping point again for stocks. Derivatives now price the underlying assets.


You’ve heard the saying that’s it all in your perspective. It applies to volatility.

Volatility is up 150% since the post-financial-crisis nadir of 10.32 for VIX Volatility in mid-2014. The “Fear Index” closed yesterday over 26, the highest since August 2015 when it topped 28 (way below 43 in 2011 and nearly 80 in 2008). VIX expirations are hitting today.

I’ve been seeing Mohamed El-Erian, whom I admire, chief economic advisor to Allianz and former right hand to Bill Gross at PIMCO, also now gone from the bond giant, on the business TV circuit saying central banks are ending programs designed to dampen financial volatility.

I think he’s got a point, and he means they’re starting to broaden trading ranges in everything from interest rates to currencies (as if we want them setting prices). But volatility is price-uncertainty reflecting evolving valuation.  Conventional measures often fail to reveal change because behaviors in markets morph while the metrics used to understand them don’t.

Figure 1

Figure 1

I can prove it.  In the first chart here (Figure 1), a small-capitalization technology stock on the Nasdaq hasn’t moved much in the year ended Dec 16, 2015 (I’ll explain that date shortly) but the stock rose from a 200-day average price of $20.67 to a five-day mean of $21.05, up 1.8%.  Not too great – but the Russell 2000 Index was off 1.3% in the year ended Dec 16, 2015. Perspective matters.

Now notice:  Daily volatility, or the difference between highest and lowest prices each day, is greater than the change in average price in all four periods.  Think about that. The price changes more every day than it does in moving averages for months and quarters.

Now see Figure 2 showing short volume Dec 1, 2015-Jan 15, 2016 for the same stock. The upper half is long volume (owned shares), the bottom short volume, or rented stock. The blue line is closing price. The data further back show short volume over the trailing 200 days averaged 60.2% daily.

Figure 2

Figure 2

Combine the charts. The stock moved less than 2% on average over the entire period but 60% of the shares trading every day were borrowed, and the spread between high and low prices was nearly 3% every single day.

Do you understand? On the surface this stock is not volatile. But up close it’s torrid – on rented shares. For a solid year, traders have kept this stock in stasis by borrowing and trading, borrowing and trading, because the cost of borrowing was substantially lower than daily price-movement. That’s market-neutral arbitrage.

Everything changed recently. Short volume in Figure 2 plunged Dec 22, 2015.  On Dec 16 (here’s that date now) the Federal Reserve bumped short-term rates to 0.25-0.50%. On Dec 17-18 vast swaths of interest-rate swaps tied to options-expirations lapsed. On Dec 21, the new series of options and futures (and interest-rate swaps) began trading. And on Dec 22, our small-cap’s short volume imploded, finally landing at 33% Jan 11, down from 71% Dec 10, a decline of 54%.

We’ve slung numbers here, I know. But the conclusion is simple. Whatever traders were doing in this small-cap, the Fed’s rate-hike ended it.  We think that’s good. But markets have been addicted for years to cheap credit, which includes borrowing shares for next to nothing, which shifts attention from long-term owning to short-term renting. That changed when the Fed bumped rates. And equites corrected.

There’s another lesson by extension.  What sets your stock’s price may be radically different than you think.  We’ve offered one example that shows short-term borrowing fueled persistent volatility trading masked by apparent long-term placidity. When interest rates crept up minutely, the strategy stopped working.

What’s your stock show?  Price-performance isn’t story alone, perhaps even over the long run, as we’ve just shown. There’s so much to see when measurements reflect current behavior (as ours do). Volatility is price-uncertainty that thanks to policies promoting short-term behavior is now concentrated intraday.  Sorting this out will take time. We won’t change seven fat years with a lean month. The good news is it’s all measurable.

Behavioral Volatility

I recall knowing one particularly volatile fellow. I should have called him VIX.

Speaking of the VIX, options on that popularly titled Fear Gauge expire today as a raft of S&P components report results. Many will see sharp moves in share-prices and attempt to put them in rational context.

Volatility derivatives are no sideshow but a mainstream fact. Yesterday the top five  most active ETFs included the SPDR S&P 500 ETF (SPY) a Standard & Poor’s Depositary Receipt from State Street that traded 68 million shares, more than any single stock including Apple ahead of results, and the VIX Short-Term Futures ETN iPath (VXX), with 38 million shares, matching Facebook’s volume (out-trading all but seven stocks).

Louis Navellier turned the concept of volatility into quantitative analytics for investment at his Reno advisory firm managing $2.5 billion. Oversimplifying, rising volatility signals change. Mr. Navellier used increasing volatility as a signal to sell highs and buy lows.

By the same token, when your shares break through moving averages, it’s at root a volatility signal. Your price is changing more than the historical central tendency.  But what causes volatility?

This is why we introduced Market Structure Alerts in June for our clients. They’re predicated on the seminal principle that volatility signals change. Rising standard deviation is a pennant pointing to developments you should know. But we want more than surface answers.  Measuring tides alone offers no reasons. So we measure behavioral volatility, not price or volume volatility – which is a byproduct of the former.

When the ocean rolls or roars, we understand that it reflects something else ranging from the gravitational pull of the earth and the moon to earthquakes undersea. We use these facts to shape our understanding of how our ecosystem called earth functions.

A conversation I have often with IR professionals is what I’ll call Story versus Structure.  “My CEO wants to understand why we’re underperforming our peers.”  We have a simple answer and an elementary model that demonstrates it. Yet it can be hard to let go of the notion that underperformance traces to a fundamental feature, the Story. “Our return on equity trails our peer group, so that’s got to be the reason.”

Now sometimes Story is the problem. When it is, it manifests in behavioral change. But don’t forget that the biggest investors are Blackrock and Vanguard. We’re told they’re perpetual holders. No, they’re perpetual trackers of benchmarks like the S&P 500 so they are perpetually in motion, relentlessly sloshing like tides. When these tides crash more violently it’s because money in 401ks and pensions is uniformly beginning to buy or sell, producing disparate impact in stocks.

It’s not Story but Structure. The market functions in a defined way, according to a set of measurable mathematical rules, just like the universe. If we omit some part of market function because it’s complicated it doesn’t cause the behavior to cease to exist. Every IR program today should measure behavioral change.

How many ETFs own your shares?  Our smallest client with market cap of $200 million is in 14. Most are in 30, 40 or more, some over 100. Each of these probably has options and futures and tracks an underlying index, which also has options and futures. All the components of each ETF and underlying index likely have options and futures, just as your shares might. There are exchange-traded notes that directionally leverage indexes and ETFs. Swaps that substitute returns in baskets of these for proceeds in other asset classes. Traders pair futures with stocks and change them each day. And throughout, Blackrock and Vanguard and the rest of their asset-allocation kin behind two million global index products move like massive elephants ever crossing the Serengeti.

Sound dizzying?  It’s your ecosystem. The good news is we’ve reduced its complexities to a set of central tendencies and now we have Alerts that signal when these change.

Why should you care in the IR chair? We’ve got a friend who’s a realtor in Steamboat Springs. She knows everything about it, down to the details of any house you can mention that’s on the market. She knows which neighborhoods get sun in the afternoon, where you should be for easy access to amenities. She knows her market.

We want you to know yours. We hope to help you move from seeing price and volume as a tide moved by mysterious forces to understanding your ecosystem and what distinct behavioral change is behind volatility.

That in turn makes you a powerful expert for your Board and management team. You don’t have to do it, of course. But the quest to be better, to know what there is to know about the market you serve is the difference between something that can become mundane and an enterprise ever fresh and new, an exhilarating exploration.  Some volatility, so to speak, is refreshing!

Volatility Implications

Like a billboard reading, “Illiterate? Write for free help,” record demand for VIX futures in a market nearly devoid of volatility seems at best paradoxical and perhaps idiotic. But it’s a touchstone for institutional behavior now.

“The VIX” is the Chicago Board Options Exchange’s index of implied monthly volatility in the S&P 500 index. It’s called the Fear Gauge because ebbs and flows signal waxing and waning market uncertainty.

There are 34 different Exchange Traded Products (ETP) providing risk managers and traders variations on the VIX volatility theme. Record levels of ETP shares outstanding, according to an article yesterday in Traders Magazine, denotes extreme demand for volatility products. (more…)

The Volatility Class

We write this week from sun-splashed Steamboat Springs, where visitors to the slopes are relishing more than seven feet of new snow in the past month.

A word on markets:

You’ll hear knee-jerk blame for yesterday’s 200-point Dow Jones double-black-diamond plunge placed on “returning economic worry.” It’s about currencies. Unaware of our inviting vantage here, stocks saw only a strident march upward by the US dollar. Dollar up, stocks down.

It started two weeks ago. The Chinese devalued the yuan ahead of dimming economic views. The European Central Bank lopped a hunk off the euro by handing out bales of them to banks ahead of crucial European sovereign debt auctions (there are no coincidences in central-banking, only consequences).

At the same time, US Treasury auctions fell to $90 billion offered this week, the lowest level of the year. Supplies of other currencies expanded at the same time that safe-harbor alternatives shrank. So stocks fell.

The good news is that the dollar must weaken soon to align currency baskets. But it’s oddly perverse to hope your currency is worth less so that stocks might appear to be worth more.

Which brings us to volatility. The Chicago Board Options Exchange’s VIX, which tracks implied S&P 500 volatility, is at historical norms between 20 and 21. Before jumping nearly 16% yesterday on big market declines it was below 18.

Dead-calm water, that would suggest. But maybe we’re not measuring the right thing anymore. Henry Chien writing at TABBForum related how TVIX, the VelocityShares Daily 2X Short-Term Exchange Traded Note, exploded with VIX expirations Feb 15.

Don’t get lost in the name. TVIX is a way to invest in volatility. Lots of money buys gaps between things rather than things, because gaps may be more predictable than future values. How’s that for irony?

In TVIX, what traders call “vega,” or dollar-exposure to changes in volatility, went off like a Geiger counter. Here’s a way to think about it: Suppose instead of seeing price or volume for your shares you could track total money exposed to their fluctuations (price and volume are the parts of the iceberg above water).

And suppose you were liable for all that.

Well, unlike an Exchange Traded Fund, an ETN is a debt obligation. TVIX is sponsored by Credit Suisse. So the ETN is unsecured debt for which Credit Suisse is liable.

Normally, authorized participants for the dealer backing ETNs and ETFs create and redeem units to expand or contract the supply of units to fit dollar demand. On or about February 21, Credit Suisse risk managers decided that the ETN had “exceeded internal limits” and the firm abruptly stopped authorizing more units.

In short, Credit Suisse believed it was over-exposed to money speculating on the potential for big moves in S&P securities ahead. Or money compelled by floating currencies to buy volatility rather than stocks or bonds.

Magnify this reality. It’s everywhere, lurking beyond equities with a misleading appearance of dead calm. The tail of volatility, formerly a consequence of uncertainty in assets, is now beginning to wag the dog of asset values.

It’s something to contemplate: Volatility may be a cause rather than an effect, thanks to money buying it as an asset in place of actual assets.

The root cause of any belief in volatility is asset-price uncertainty. Which leads us back to the start. Currencies.

Yet another reason to understand what drives your trading. These things are measurable. We saw big increases in hedging the past two weeks.

PS – We wrote last week about SEC Section 31 fees and how light volumes would cause them to increase. Our friends at Themis Trading yesterday sent a note that the SEC has indeed filed to increase its fees to cover its $1.3 billion budget.