"Most of the time, your risk management works. With a systemic event such as the recent shocks following the collapse of Lehman Brothers, obviously the risk-management system of any one bank appears, after the fact, to be incomplete. We ended up where banks couldn't liquidate their risk, and the system tended to freeze up." -Myron Scholes
There are quantitative and qualitative approaches to measuring and talking about volatility. Some people have cool cars and other cool material things. I have a cool VIX theory that I used to correctly predict a prolonged period of extended gains and low volatility in the stock market. I used the theory paired with fundamental analysis several times to generate high-alpha, winning trades with returns that dramatically exceed the typical idea:
On May 15th, I introduced a multi-faceted theory on why I believed the VIX was relatively subdued in the post-COVID cycle.
On June 22nd, after my VIX call paid off quite handsomely, I did another piece on why I thought volatility would remain subdued.
On October 10th, I wrote an article urging my readers to short the VIX despite the vicious Hamas attacks that drove levels of fear to a fever pitch.
In that article I recommended the December 20 $17 put options which paid $4.69 (entry $1.42) per contract on the date of settlement, and the December 20 $16 put options paid $3.69 (entry $0.91). This means they experienced a respective price gain of 230% and 327% in less than three months.
Next, I recommended that folks short the VIX despite some climbs associated with building geopolitical risk as Israel and Iran engaged in saber rattling. I recommended using the June 18th $14 put options to short volatility. I recommended them at $0.52, and they printed on 6/18 at $1.61. That is a price gain of 210%.
I will be launching an invite-only trading service very soon called Punk Rock Traders. We will aim to repeat trades like this in order to provide investors with more opportunities for wealth augmentation. Most of Wall Street is oriented toward wealth preservation, and we aim to serve a more niche market that is focused on dramatic outperformance over short time periods.
Given what has happened in the past two days fears are running very high, and while much of the volatility has already collapsed, I am convinced there is still money to be made over the next quarter in postulating that the true mean of the $VIX is lower than where it is currently trading. The three reasons I feel comfortable shorting volatility are:
It is unlikely that we are in a recession. While we are slowing down relative to previous levels of higher-than-average growth, the economy seems impressively resilient. Part of this seems to me to be a natural consequence of the culling of commercial entities that happened during the pandemic. Companies that emerged after the pandemic were stronger and more resilient and cleared a lot of dead wood to increase earnings power. When we get further economic data to confirm the economy is on stronger footing than the last jobs report would indicate, volatility should stabilize at lower levels.
If we do come into recession, several factors will moderate the overall adverse economic impact of it. The Fed has plenty of room to cut and to bring instant relief to the economy, so the Fed put is back. Andrew Goolsby
Recession fears, in this case, have actually made recession less likely. Mortgage rates and oil prices have dropped. And if we continue to get bad news they will continue to drop. These crucial inputs in the consumer wallet should alleviate the adversity of economic weakness, and the overall consumer balance sheet, default rates, and continuing ability to access credit are all encouraging from a standpoint of supporting the strength of economic activity. The recent fears also play well into the rising odds, and rising expected magnitude, of coming Fed cuts.
There has been a lot of fortunes already made trading Monday's volatility given the magnitude of that move. Volatility spiked to an intraday high percentage gain north of 170% well into the $60 handle. This was a level of volatility not experienced since COVID-19. Already, the curve has become to dramatically level off from the intense levels of fear yesterday. Many participants assumed we were in the midst of a soft landing, and then thew jobs info cast doubt on that narrative. But already, those doubts are subsiding.
Now given the high levels of uncertainty associated with COVID-19 and the daily volatility introduced into markets by numbers of infections and contagiousness of new strains, the volatility curve stayed elevated for many months after the initial catalyst.
We will get more clarity on whether or not we are entering a recession very soon, and I believe the bunk jobs report was an anomaly rather than a watershed moment in this cycle. The qualitative fact that the inversion has already started to materially collapse means that this risk is in a different breed compared to what happened after COVID, it was a volatility blow-off, not a source of persistent uncertainty.
Now there's a lot of fancy ways to discuss volatility, but I think putting a very simple qualitative hat and asking a very simple question will help orient any objective investor: are the problems and uncertainties facing the economy anywhere near the level of severity experienced during COVID-19? The answer is clearly no if you remain grounded in the data instead of in the lower part of your brain.
What Caused the Volatility Spikes on Friday and Monday?
My theory on why the VIX was hanging around lows given the copious and serious risks facing the market has a lot to do with the evolution of markets. In the introductory quote Myron Scholes elaborates how risks are magnified when financial infrastructure is gummed up. The lack of liquidity and financial resolution causes volatility to spike, and the uncertainty associated it with it causes the demand of VIX calls to dramatically exceed those of VIX puts.
I want you to do something for me. When you think what caused the volatility spike I want you to do a little trick with me. The same thing always causes the volatility spike, an absence of buyers. Most shots on goal, in terms of risks stalking markets, do not cause a shortage of buyers. One thing that does cause a shortage of buyers is forced liquidation. This is why a low-risk, boring trade used by a lot of institutional investors to borrow in Yen, the carry trade, has caused far more damage to markets than the prospect of an unprecedented escalating regional war in the Middle East.
Which risk is scarier and more emotionally upsetting? Clearly the latter one, but the former one is what caused market volatility to spike so rapidly and precipitously. Forced liquidation is always the cause in one way or another of a VIX spike as high as we saw yesterday. Disregard the story about catalysts and realize that anything that causes sellers to dramatically outnumber buyers will cause volatility to spike, but as we can see today, that balance is being restored.
One of the anchors of my theory for why the VIX is suppressed is that markets have evolved since the great VIX spikes we all remember. They are more stable, the circuit breakers work, and for the time being there is nothing that appears it will cause the type of unforeseen systemic risk, like Lehman Brothers or COVID, that will lead to an extended period of forced liquidation. The guard rails are still on the economy and the market, and that favors volatility continuing to hang out in the low twenties or high teens instead of reverting toward the highs experienced Monday.
I think a period of 100 days or so is a good time period to take advantage of falling volatility. I think the true mean of the $VIX is below $23 dollars. I think a good contract is Nov 20 $VIX put options at $23 dollars. If you are worried about short-term volatility you could compliment this trade with far OTM VIX calls of a shorter duration. I think September 18th calls around $35 dollars should do the trick nicely for insurance, given the range of the $VIX in the past few days. If volatility explodes upwards again, these should be at a price point that will take the pain of being short away partially or completely, depending on the size of any future spikes.
