August 24, 2016

A Year Ago

In Luckenbach, Texas, ain’t nobody feeling no pain. We were just there and I think the reason is the bar out the back of the post office.

A country song by that name about this place released in 1977 by Waylon Jennings begins by asserting that only two things make life worth living, one of which is strumming guitars.

In equities, what makes life worth living is certainty.  TABB Forum, the traders’ community, had a piece out yesterday on the big decline in listed options volume, off 19% from last July to a 14-month low. TABB attributed the drop to falling demand for hedges since the Brexit, the June event wherein the UK voted to leave the European Union and exactly nothing happened.

The folks at Hedgeye, responding to a question about whether volume matters anymore since it’s dried up as stocks have risen to records said, paraphrasing, big volume on the way down, low volume on the way up, is as valid as it ever was for investors wary of uncertain markets and means what you think it does. You should be selling on the way up so you don’t have to join those people distress-dumping on the way down.

I got a kick out of that. Sure enough, checking I found that SPY, the world’s most active stock (an ETF) traditionally trading $25 billion daily is down to $11 billion.  Whether it’s August is less relevant than volume.

On August 24 a year ago, the market nearly disintegrated on a wildly delirious day.  August options-trading set a near-period record.

Now what’s that mean to investor-relations folks trying to understand stock-valuation and trading? We’ve long said that behavioral volatility precedes price-volatility. You can apply it anything. As an example, if housing starts plunge, that’s behavioral volatility.  If a movie starts strong and viewership implodes the second week, that’s behavioral volatility.  Both point to future outcomes.

We track market behaviors. They tend to turbulence anyway around options-expirations, which occurred in the past week, and August 2016 was no exception.  On Aug 19, triple-witching, Asset Allocation (investment tracking a model such as indexes and ETFs) surged nearly 11%, Risk Management – counterparties for derivatives – by 3%.

It’s the double-digit move that got our attention.  Double-digit behavioral change is a key indicator of event-driven activity, or trading and investing following a catalyst such as Activism or deal-arbitrage.  It’s very rare in the whole market.

We also tracked a whopping jump since Aug 15 in Rational Prices, or buying by fundamental money.  When it’s coupled with hedging, it implies hedge-fund behavior.  In effect, the entire market was event-driven under the skin yet not by news. Nor did it manifest in prices or volume (Activism also routinely does not).

We’ve got one more data point for this puzzle. Volatility halts in energy, metals and emerging-markets securities have returned after vanishing in June and July.  Remember, market operators have implemented “limit-up, limit-down” controls to stop prices from moving too much in a short period.

So though the VIX is dead calm other things are moving.  Short volume marketwide is nearly identical (44%) to where it was in latter November preceding December volatility and the January swoon.

We conclude that currency volatility may surge, explaining volatility halts in commodities.  Hedge funds are shifting tactics. The dearth of options trading may rather than mean a lack of hedging instead signal the absence of certainty.

Pricing options accurately requires knowing prices of the underlying securities, plus volatility, plus time.  Volatility isn’t the faulty variable. It’s got to be either the prices of the underlying or the uncertainty of time.

Now it may be nothing. But our job here is to help you understand the market’s contemporary form and function. If behavioral volatility precedes change, then we best be ready for some.  We may all want to pull on the boots and faded jeans and go away.

But hang onto your diamond rings (and that’s all the obscure country-music humor I’ve got for today!).

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