March 7, 2012

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.

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