October 7, 2020

Vahlcue

You’re wondering what the heck “vahlcue” is. It was up almost 4% in the last hour yesterday as stocks tipped off the diving board.

Meanwhile, cue fall.  The photo at right reminds us that today is a consequence of yesterday. Autumn follows summer. In the Flat Tops near Steamboat, fall flames as summer smolders out.

In the stock market, cue volatility.  Pursuing “vol,” as the traders call it, is big business. It’s everything that depends on an implied price, such as the VIX index tracking implied volatility over the next 30 days in the S&P 500.  It’s priced from options on the index, which in turn is comprised of futures.

Got that?  Volatility is the implied price of an implied price, gleaned from other implied prices.  All instruments derived from implied prices are ways to trade volatility – gaps between rising and falling prices.

Cue intro music.

The Nasdaq, in concert with the Chicago Mercantile Exchange (CME), launched the VOLQ this past Monday, Oct 5, another way to play volatility.

I assume it’s pronounced “vahlcue.”

VOLQ is a futures contract reflecting the implied volatility of the Nasdaq-100, the NDX. It employs a methodology developed by Nations Indexes, innovator in volatility products that isolates the implied volatility of at-the-money options.

Ready to run a power drill through the palm of your hand to stay awake?  If you want intricate details about how it works and how it’s calculated, you can read more.

I’ve got a specific purpose.

VOLQ, like the VIX, is a futures contract derived from options on underlying stocks – three steps from the asset.  It’s a particular set of both put and call options designed to get to the volatility of instruments priced the same as the futures contract, called at-the-money options.

Have you moved on from drilling a hole in your hand to braining yourself on a brick wall?

Here’s the point. Derivatives have proliferated in the stock market. All derivatives are a right but not an obligation.  As such, the propensity to quit them is much higher than one finds in the actual asset.

Famed hedge-fund manager Lee Cooperman, whom I interviewed in the plenary session of the 2019 NIRI Annual Conference, back when humans gathered innocently, lamented in a CNN interview that stock indexes shouldn’t gap 50 points in a matter of minutes.

He blamed trading machines, the rapid-fire intermediaries setting prices. And he’s right.  But the more trading chases products that are rights but not obligations, ways to pursue changing prices, the more heightened the risk of sudden lurches.

Why? All layers of options and futures are forms of implied supply or demand.  But the moment prices move, those layers become ethereal, dissolving in an instant like those animated transitions you can put in you Powerpoint slide deck.

And the more people pursue the gaps rather than the assets, the greater the assets can be blighted by sudden lurches.  Realize VOLQ is just another clip for the automatic weapons in the Nasdaq’s volatility arsenal that already includes e-Minis and micro e-Minis on the Nasdaq 100.

The first e-Mini S&P 500 futures contract began trading in 1997 and was 20% the size of the standard contract.  Micro e-Minis are a tenth of the e-Mini, 2% of the original contract.  And you can trade options on Micro e-Mini futures too.  We wrote about them in August.

Markets keep migrating away from size, away from the core asset, toward tiny, uncommitted bets and hedges comprised of multi-layered derivatives.

It’s great for the firms selling the products.  But it makes volatility accessible to the masses.  And the masses don’t understand it. And the more the masses are exposed to things that vanish, the more given to wild swings become the underlying assets.

Sure, derivatives can work well.  VOLQ was the right play today.  Traders can hedge exposure to sudden market moves, play the probability of profits in snap swings.

But the consequence is a market that cannot be trusted.

Market Structure Analytics help one survive it. Everybody should have baseline market-structure metrics.

The market is likely to rebound, data say. But this lurch manifested a week ago – much of implied volatility is predicated on weekly options – when the sector data looked ragged to us.  Sure enough it was.  Blame volatility and its instruments. Cue the exit music.

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