Market Volatility: "The reports of my death are greatly exaggerated."

I started drafting this piece a week or so back when the VIX first closed in the single digits. When CNBC and Bloomberg TV, cover on a daily basis the phenomenon of volatility being low, we are probably close to the end rather than the beginning.

Why has VIX been so low? Should it be this low? Will it stay there?

The VIX is calculated using a "formula to derive expected volatility by averaging the weighted prices of out-of-the-money puts and calls." There's a pretty complicated paper on the exact calculation (read it here).

There are a couple of ways I personally think about the VIX - we can talk about whether that's right or wrong in the comments below (would love some feedback - I do not profess to be an expert).

To me, it measures fear and greed (and with greed, comes complacency). In addition, the VIX is a numerical representation of supply and demand levels for S&P options.  From where I'm sitting, there looks like there are a lot of option selling.

I was just speaking with a fund that has done well enough in the discretionary macro space, and all of a sudden, they want to get involved in selling vol. Obviously, retail is in on this as well, evinced by the myriad of short VIX ETFs in existence. I know, I know. Anecdotal signs. But to me, they point to one thing:


Contributor James posted on Macro Man a few months back with some insights on the VIX, looking at various rolling correlations and momentum numbers - I don't know if looking at momentum and price dislocations, etc. for the VIX makes particular sense. With that said, there are definitely some points of insight and interests in his post. Go ahead and check it out.

I wanted to think about what could be contributing to the drop in market volatility.

Two factors in play, contributing to the suppression of volatility and its subsequent unwind are the following.

Passive investment/Indexing:

It's well documented that there has been huge flow into passive investment in favor of its active counterpart. However, the performance and subsequent investment flow from active to passive follow a clear cyclical pattern, as you can see in the picture below.

It's been well documented that we are currently in the midst of a historical shift towards passive buy and hold investment.

This is where are we now looking at relative performance:

I have noticed some reflexivity (à la George Soros) characteristics in this shift:

As volatility drifts lower, the more passive investment out performance, as passive investment out performance, money flows out of active management to passive investment, thus helping to suppress volatility.

Reflexivity is dual sided. This positive feedback loop that has helped quell volatility, can easily be unwound in the other direction as well in violent fashion (selling begets selling).


Risk Parity Funds/General Vol Targeting Funds:

Another factor that could lead to large increases in equity and fixed income is the rise of the myriad of risk parity funds.

These are just a portion of the risk parity funds that currently exist in the market


Without going into a deep dive of risk parity funds (maybe we'll save the fun for some other time), I just want to highlight a couple of risk parity funds' characteristics that can lead to a unusual large sell off in the assets these funds own.

First, there are a lot of money implementing the same strategy. Doesn't take a genius to figure out that things can go bad quickly if everyone is trying to escape a burning theater at the same time.

But what can lead to such an exodus? These funds are volatility targeted and implement similar draw-down types of risk controls.

What are draw-downs? Think stop-loss but on an entire fund level instead of one particular position. When are draw-downs implemented? When the fund volatility exceeds a certain preset level (fund volatility roughly calculated via the volatility of the composite assets). With that said, it's to see how a large enough exogenous shock to a specific market, can lead to a large continual spike in volatility and draw down in a number of markets.

In addition to risk parity funds, there are also a lot of smart beta funds and other quantitative investment funds that have specific hard volatility targets. Again, they are bound to sell if volatility hits a specific number; their backtests are skewed to the low end of volatility as the recency of the current low volatility environment unrealistically skews their data towards underestimation.

Should volatility be this low?  Will it stay here?

Should it be this low? Probably.

All the reasons, I've mentioned above probably shows you why volatility should be this low. However, as speculators, we are worried about the world in the future, not in the present.

So what about the future?

We have a deterioration of some of the US macro data, the Fed continuing marching on in terms of hikes, the geopolitical risks in terms ofSyria and North Korea, and the circling of political vultures over the Donald Trump's scandals du jour.

There is a copious amount of risks simmering under this low volatility market surface, that can trigger be the exogenous shock.

A conjecture on how this ends:



Oh, the humanity!

Pretty sure most of us know this, just a question of when.

I can't predict when, I can only advocate insurance.

If you own a house, that's your asset, you buy insurance on it. If you own a portfolio, that's an asset, why don't you buy insurance on it? Besides, insurance is cheap.

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HH
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May 24, 2017 at 10:32 PM × This comment has been removed by a blog administrator.
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abee crombie
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May 25, 2017 at 6:04 AM ×

Great post. shorting vol has been one of the best trades for a while. great sharp ratio. Which I am sure has encouraged crowding. So far its the trade that keeps on giving. Have to see that really change first, IMO

But I do like puts here. That said I have been a bit too bearish and capitalized very little on a spectacular tech rally. Thats what is driving the market, low vol is just the result.

Which comes first. Goog/AMZN at $1000 or bitcoin hitting $3,000. This is becoming a nice blow off move. Just be careful to no get run over if you are playing.

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Detroit Red
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May 25, 2017 at 6:25 AM × This comment has been removed by the author.
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checkmate
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May 25, 2017 at 11:49 AM ×

"UK economic growth surprisingly revised down to 0.2%"
"Banks report approving fewer mortgages"
No surprise to me at all. I've been watching property transactional volumes and market conditions closely. Also watching some of the rates on offer via a couple of platforms which are useful indications of current credit conditions and future expectations of the economic conditions expected. I would say with some confidence that the UK will by the end of the year be registering a growth trend (not just one data point) that is so low it feels like a small recession even if the data don't strictly qualify it as such by rigorous definitions of same. Looking at UK risk assets that isn't even on the radar yet. Indeed, the UK's answer to an investor 'god' Neil W just disclosed his holdings in his latest fund launch and it is peppered with the cyclical growth stocks he as steadfastly avoided in recent years. So , someone is going to be wrong here. Either I have no idea what I am talking about or Neil W just jumped onto the wrong horse. I will never give you a better straight man opportunity to blow a big one my way.
However, let one particular visitor understand the difference between being willing to post one's views or trades up front and those who pop up retrospectively playing the market hero.

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Unknown
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May 25, 2017 at 12:15 PM ×

Great summary of the factors driving low vol. Interested to hear what you think about this chart from Credit Suisse showing flow back into active funds. Could this be a driving force behind higher vol?

[img]http://si.wsj.net/public/resources/images/BN-TL675_Dshot_NS_20170515230833.png[/img]

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johno
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May 25, 2017 at 1:34 PM ×

@checkmate: "let one particular visitor understand the difference between being willing to post one's views or trades up front and those who pop up retrospectively playing the market hero."

Yeah, when the market sold off last week, I had added comfort to JBTFD because that particular visitor went silent. Hiding under his desk, though he will of course protest otherwise. Whatever. The guy is total bull sh1t. So afraid of being seen to be wrong, even once, that he always posts after-the-fact. And another thing, about that 500 contracts trade he reported some weeks ago (after-the-fact, of course), one wonders whether that was for his firm or his PA. If for his PA, what kind of a firm does he work at? Compliance departments at reputable hedge funds I know don't allow tight stop trading of futures for the PA.

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abee crombie
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May 25, 2017 at 1:45 PM ×

Nico, where are you old boy? Even though shorting spoos, most heavily at the beginning of the year, has been a losing trade, had you shorted Russell, XME, transports, Dow, financials and many other sectors/industires (ex Tech) you arent much different vs March 1 and even onside for a few

I always liked hearing your thoughts. Do come back soon as I think you will be proven correct fairly soon

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IPA
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May 25, 2017 at 2:04 PM ×

Shorting the indices for more than a few days has been a loser's game, I have been slapped on the wrist a few times. But select sectors took a beating and may be the best way to short equities. Still holding my XRT and IYT shorts here. I paired them with XLE and XOP longs as I think that energy sector will rally into the second part of the year.

WTI is scared of 52 here, sold off hard. There may be another attempt to regain the level, not sure it comes today though. Support at 50 may hold the decline for now. Looks like profit taking today.

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Mi Pa
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May 25, 2017 at 3:28 PM ×

Well, i closed my ROST short, heading back to 65-66 me thinks.

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IPA
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May 25, 2017 at 3:58 PM ×

Hey Mi Pa, nothing wrong with booking profits. They had a good report but I still think there is another leg down in retail, including ROST. Their margins compressed in Q1. This just shows that even off-price space is not immune to increasing costs and inability to raise prices as online competition heats up. They are still looking to open more stores, I don't get why. The only reason they were not killed is because the comps did not crater. I am going to hold my short for my original targets. Look at TJX as a replacement if you are unsure about ROST.

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abee crombie
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May 25, 2017 at 4:56 PM ×

IPA, on Rost and TJX, do you know where they get all their inventory from? I assume full price like M and specialty stores. But those guys are now right sizing inventory big time. Yes while they are doing it, it creates supply for the off price guys, but my guess is that at some point if full price retail doesnt have excess inventory, where are the off price guys going to get any stock from. Thats always been my main thesis on these guys. But so far it hasnt played out. You see like you know the space, any thoughts.

ROST stores are crap if you have ever been in one. Targeting poorer consumer. 2 biggest Dollar stores not doing well, specialty finance similar. This is about as good as it gets for the lower income US consumer IMO. Initial claims at 40 year lows at 240. If it starts moving higher, watch out

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johno
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May 25, 2017 at 5:35 PM ×

Have gotten long oil during the OPEC press conference. Markets are just being markets. Inventories are going to draw, draw, draw. Press trying to explain the action with "they didn't address the post-cut strategy." Yeah? Why is the CLZ7/CLZ8 timespread selling off then? Just a shakeout.

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dfdsfiol
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May 25, 2017 at 5:38 PM ×

What about the talk of crude sales from US reserves? Probably just noise but markets can be stupid.....

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IPA
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May 25, 2017 at 5:45 PM ×

abee, yes, they get their inventory from same sources but there is always going to be ample supply. M, JCP, DDS, KSS and specialty stores' inventories are so huge that this trend can last for a long while. This being said, online sellers are catching a huge share of mfgs' and wholesalers' attention now. Overstock and Bluefly are going strong. I think ROST and TJX take a hit from that even before M and other full price become lean on inventory.

Are you going to hold your ULTA short through earnings? I ain't budging :)

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Nico G
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May 25, 2017 at 5:47 PM ×

"Nico, where are you old boy?"

abee, I had margin call after losing just over $3.21 million on the ES short. I am done with trading now.

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dfdsfiol
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May 25, 2017 at 5:51 PM ×

Thats okay NICO. You've made enough and Im sure you are smart about your savings. Go enjoy the fruits of your labor on the islands somewhere. No worries mate! Life is short. Go live it up.

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abee crombie
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May 25, 2017 at 6:04 PM ×

yeah I'm holding ULTA, they are starting to lap some very impressive comps, lets see...but tough to bet against. my Momo shorts are hurting me but I suck at getting in once the move happens so holding tight for now.

Nico, sorry to hear, but I'm sure you made more than that before. Wait until the QQQ's start correcting. Parabolic markets dont correct sideways. While FANG are great companies, great earnings stories, way too crowded IMO. Once they go, the whole market is done and you will be able to trade again, somewhat normally...

I've got way too much oil exposure here. Not feeling it. A few more days of this and I'm cutting down a lot

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johno
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May 25, 2017 at 6:08 PM ×

Frankly, I don't have a clue about that. My guess is all the trigger-happy, really speculative longs got cleared out today, and all the guys who wanted the OPEC meeting out-of-the-way to short have been piling in. If you were bullish, you probably already had your position coming into today. That's my theory. But hey, could be wrong. Happens all the time.

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IPA
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May 25, 2017 at 6:14 PM ×

Those who are trying to catch a knife in crude, 50% retracement of the rally comes in at 48-ish. Players will probably front run it, so I am lining up an entry at 48.35

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johno
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May 25, 2017 at 6:33 PM ×

Thanks, IPA. My theory is ... the fast money and algos were selling and the more information-based traders were holding off, waiting until they had the facts in hand. With the press conference finished, those players are probably participating, hence the sideways action now. We'll see. Like the majority of my theories on really short-term price action, it'll probably get invalidated.

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Whammer
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May 25, 2017 at 9:58 PM ×

I don't think that was real Nico....

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SRX
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May 26, 2017 at 12:47 AM ×

As volatility drifts lower, the more passive investment out performance, as passive investment out "performance, money flows out of active management to passive investment, thus helping to suppress volatility. "

I get why low volatility begets passive investment, but why would passive investment cause low volatility?

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IPA
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May 26, 2017 at 4:46 AM ×

Big crude draws are coming:

https://www.reuters.com/article/us-opec-oil-inventories-idUSKBN18L2Q1

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johno
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May 26, 2017 at 4:07 PM ×

Thanks for sharing, IPA. Mostly agree with that analysis, which makes me comfortable being long oil here. The catalyst -- draws -- is right around the corner. You were right about waiting for 48.35 though ;) GS published an interesting note on positioning the other day, which suggested the slow-down reported shale producer hedging since the November OPEC deal and the averaged hedged prices pointing to break-evens around $55 (versus 1-year forwards around $50) point to a slowing rig count before too long too . Maybe. Would be icing on the cake.

Just took off some EURNOK here in low 9.37s as mis-pricing versus oil is less extreme now (and I have more oil exposure through the futures position). I did take off that time spread trade (at a loss) yesterday. Knew I was late-to-the-game so it was very small. I didn't think the Saudi oil minister's rhetoric about living with shale and its rising service costs was especially supportive of that position. Bleeding some more today, so the right decision so far. My tight stop in palladium got triggered. Should have done an option structure in that a while back. Mistake. What do you expect from a commodities newbie like me?

The gift that keeps giving is short USDMYR. I actually have a really good history with MYR, come to think of it. Low-stress money is the best money. Separately, I put on some short SGDTHB last night. I've been looking to get long THB, but 1) there is strong bearish seasonality in April and May, 2) the USD is now cheap on short-to-medium term regressions, 3) the central bank has been a pill and intervened liked crazy. Besides having to worry about the US Treasury changing its definition of currency manipulator and having a persistently strong balance of payments, the recent intervention and sterilization has pushed the Thai central bank's net equity to a negative position. The last couple times that happened, well, if anyone cares, they can graph that versus SGDTHB ...

Back to commodities, anyone looking at sugar? Big surplus coming in 17/18 as Thailand production rebounds and European quotas are lifted. Meanwhile, India isn't lifting import restrictions. So all looks dire, except ... sugar is now getting to levels where Brazilians might turn cane to ethanol rather than crystallize, which will affect the balance. Also, there's the possibility of an El Nino. My sense (not worth much in commodities, except maybe for oil) is that if sugar spends time down at the switching level during this Brazilian harvest, maybe this could be a buy as the surplus turns out to be less than people expect. There are decent-sized shorts here, so there's dry tinder, but they probably have the right position on for now.


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