It is not well known, but much of this volatility was caused by monster sized position that were built into the market during the bull market from 2002-2007. Traders were betting against a rise in volatility with all kinds of swaps and derivatives plays--hence they were short volatility. When volatility started to go up they were forced to buy volatility to cover their short positions. They then found out they were part of a "herd"--they all had the same positions. The extreme volatility levels we saw in the October-November period were exacerbated by smart investors who understood they could take advantage of the situation by buying volatility in front of these traders-- as the traders were trying to cover and exit their short positions. This explains, in part, the extremes we saw in the VIX.
The VIX indicator, which acts as a reflection of the expectation for market swings in the future stood at 42.91 on January 30. This is down from peaks around 80 during October and November.
The big question now: is volatility high or low and how to play it?
Betting Against the Doomsday Scenario
Posted By David Gaffen On January 30, 2009
Rob Curran reports:
If you scoff at pundits and journalists pontificating on the possibilities of a second Great Depression, Credit Suisse says there’s a way you can put your money where your mouth is.
Comparing the volatility implied by S&P 500 equity derivatives for the next ten years with other miserable economies, Credit Suisse strategist Edward Tom said the current scenario priced in is considerably worse than the “lost decade” of 1990s Japan. The current risk expectations on long-term equity derivatives line up with the realized volatility on the stock market during the “entire ten-year span following the Oct. 28th crash of 1929,” Mr. Tom says.
In other words, you could bet against long-term volatility and have a U.S. economy as bad as Japan’s for ten years, and still win the bet. That’s because volatility has been so high that expectations in turn are also very high, much higher than the norm. The Chicago Board Options Exchange volatility index, which reflects expectations for market swings in the coming month, is still trading at 42.91, which, excluding 2008, would be the highest expectations for swings in the S&P 500 since the depth of the tech bear market. Longer-term volatility — looking at futures contracts — remains even higher.
In the go-slow days of the 2002-2007 creeping bull market, one popular trade was to go short volatility. Traders bet against volatility using “variance swaps” or other derivatives , in the expectation that just about any increase in volatility was a short-term one, and that the market would remain quiet.
In the last several months, however, volatility has been off the charts. The realized volatility in the fourth quarter of 2008 was 64.9%, according to Credit Suisse. And so betting against long-term volatility need not even be a bet on a return to the staid trading of 2002 to 2007, but it’s just a way to bet against the doomsday scenario.
Credit Suisse recommends short-selling long-term volatility as part of a more nuanced hedging around stock positions. But some may be tempted to make an outright bet.
”The idea of shorting long-term vol is very compelling since it has basically never been this high, and quants keep getting excited about the fact that ‘the market can’t keep moving every day of the next 5 years as it has done in the last 5 months,’” said Lorenzo Di Mattia, manager of hedge fund Sibilla Global Fund. “One problem: the assumption is that the USA is going to be the same country as we know it.”
That’s the doomsday scenario. If there is a second Great Depression, Mr. Di Mattia says, all bets are off. And many of the assumptions built into financial markets during the last fifty years could be swept away. Of course, in that case, investors will have a few more problems than a volatility bet that didn’t work out.
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