March 13, 2013

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.

But why? The florescence of Greek and Euro distress has faded for now. Current withered volatility levels have been seen only twice in the history of the VIX dating to 1990. In January 1994, the VIX traded at 10.63 before a surreal bull market ran the Nasdaq to heights in 2000 not since assailed. The all-time VIX low of 10.42 came in January 2007. The record high? Near 80, in October 2008.

Uncertainty lingers, yes. Traders Magazine says everyone from proprietary traders to long-only money and insurance companies looking to offload risk or profit on spreads is using VIX options and futures. They can buy the index now and sell its future volatility and sit in a demilitarized zone if the world potentially writhes.

But there’s more here than meets the eye, we think. Your core holders may be driving some demand. You won’t see it in your 13fs. In the madding millisecond crowd where shares trade thousands of times in a second on spreads of pennies or less, money may be swinging by with VIX futures as a rope.

An aside: don’t miss IR Magazine’s West Coast Think Tank April 4 in Palo Alto. The track we’re sponsoring is about the practical implications of market structure to IR. (Ask us for a demo of you’d like to see how to apply data to your IR program.)

Anyway, if we zoom way back from markets, something comes smartly into focus. There’s extraordinary volatility – at a distance. If a stock trades 41,000 times each day, in a month that’s 820,000 prices. Instability. Sure, many could be the same. But imagine if it happened at the grocery store.

Internally, we track Total Intramonth Volatility (TIV). It’s the high and low prices every day, added up over a month. Your typical stock’s TIV is 40%. Some are 100% — the total market cap turned over each month.

Sure, megacaps are lower. Yet opportunity for return at little risk is compelling. Take ExxonMobil (XOM). With TIV of 21%, half the market average, that’s still $18.93 the last 20 days for money seeking nearly risk-free profit. How? We’re coming to that.

Ironically (or paradoxically), short volume averages about 40% too, but each day in a given stock. In XOM, it’s 36.5%. An XOM holder could go long VIX futures and short XOM, and use these hedged proceeds raised from short sales to trade and capture as much of that $18.93 each month as possible, slowly covering short exposure on trading ranges.

Each month at options expirations, accounts are settled. The aim in shorting isn’t betting the stock will go down. It’s raising money for trading that’s fully hedged by VIX futures in placid markets. It’s almost the proverbial “no brainer.”

We can’t prove it. And we’re oversimplifying I’m sure. But if we can figure this out as mathematicians and data analysts, folks smarter than us have known awhile.

Stock options expire Mar 14-15 and S&P indexes rebalance then too. VIX futures and options expire Mar 20. That’s arbitrage opportunity for your holders trading around their positions.

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