Volatility Paradox Hits Markets

Volatility is once again unpredictable. The VIX index of expected US stock market turbulence has averaged about 11 points this year, as opposed to nearly 16 last year. It's long-term average of almost 20 points.

The equivalent volatility gauges for treasuries and currencies are also less volatile. This is often referred to as the volatility paradox.

The tranquillity of "fair indices" compared to the heightened post-crisis uncertainty, is a poignant change in the trading landscape.

Implied volatility has mostly been low, due to actual realized volatility also being unusually constrained. Many attribute this to the impact of central bank monetary policy. However, that argument looks weaker at the moment.

The ECB appears to be adopting a more hawkish perspective on the market. Ostensibly there is something going on with volatility, which has evolved from a statistic to an actual asset that banks and investors can trade.

There are now several big exchange traded funds that retail investors use to bet on the VIX index rising. Looking at the other side of the ETF, more sophisticated hedge funds which systematically bet on "volatilities mean reversion",  effectively contribute towards reducing VIX. Many traders describe this as "picking up pennies in front of a steamroller."

When turbulence does erupt, the losses are painful and immediate. But over time those that have held short positions have been extremely profitable, with the VIX persistently trending downwards. Indeed, betting on falling volatility through a "VIX" ETF would have netted investors almost 32% annually, since the start of 2011. And on the other hand, long volatility ETFs have been simply phenomenal wealth destroyers. Over $16 billion that has flowed into those ETF's since 2010, have incurred an incredible 14 billion in losses.

In the past many traders have used volatility or mean reversion to their advantage. Similarly, Gad Grieve, a well know option trader used a volatility to his advantage (prior to 2008), extracting the premium or "cream" on an equity option to profit an option portfolio. The strategy entailed identifying stocks which had upside potential and selling or writing, out-of-the-money put options, with the expectation that the underling stocks would rise. To hedge against a pull back in the market, Trader, Gad Grieve bought long puts against the S&P 500.  Today, given the low level of volatility in markets, his strategy would be almost obsolete.

Gad Grieve and many of his ilk retired from trading with the 2008 financial crash. Few have returned.

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