Monday, December 9, 2019

VIXPlosion 2.0: Is Inevitable

Normally, using the word "inevitable" in conjunction with markets, is begging to look like a fool. Be that as it may, perma-bears are like a stopped watch, we only have to be right once. Because we don't expect this gong show to last forever...

Way back in the summer of 2017, Morgan Stanley posited what would happen to the volatility complex if the VIX explodes. A few months later we found out. Inverse volatility ETFs got obliterated. It was a binary trade, now you see it, now you don't. Inverse ETFs can't trade below $0, however, a short position can move past 100% negative margin - say for example when the VIX gains 300% in two days - The ETFs essentially exploded.


All of which points to a fundamental flaw in the stock market arising due to the Black Scholes Nobel-prize winning options pricing model. The problem with the model in a nutshell is that it uses historical volatility to price future dated options. Unfortunately, historical (realized) volatility tends to decline precipitously at market tops. 

Assumptions of the Black-Scholes model:

The returns on the underlying are normally distributed.

Nevertheless, this pricing anomaly could be offset IF market participants viewed this risk mis-pricing anomaly appropriately and bid up these options to better represent risk at market tops.  

Enter "skew" which is supposed to offset this underlying pricing anomaly:

"The crash of October 1987 sensitized investors to the potential for stock market crashes and forever changed their view of S&P 500 returns. Investors now realize that S&P 500 tail risk - the risk of outlier returns two or more standard deviations below the mean - is significantly greater than under a lognormal distribution"

Basically saying that risk rises as the market goes up in (over) valuation. Something that a PhD Nobel Prize winner couldn't figure out, because it requires too much commonsense. 

The problem with (put) skew is that it's expensive. It reduces money manager P&L and the premium deterioration only gets worse as the market melts-up. Ironically, just as risk is reaching the highest level. 

Which is why it's just cheaper to assume the Fed has a "safety net" beneath this market aka. the "Fed put":

It gets far worse.

Due to the futures market, and the fact that future dated volatility is generally priced higher than spot volatility - the embedded cost of carry condition known as "contango". As the futures approach maturity they generally lose value. Which makes for a short bet that is highly lucrative until it explodes spectacularly.

Here we see the now record VIX short and the decline in volatility into the recent melt-up. What we also see is that the last two times volatility exploded, the VIX futures position was already substantially unwound ahead of time. However, this time it's not. Why? Because it's the end of the year, and everyone knows the market always goes up in December.

March, 2019:


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