By Tim Dooling
Ever
notice how people love to use the word “Volatility?” Often used in conjunction with a greek
letter or two in an effort to dazzle the
recipient into a state of awed confusion.
The reality is that the word “Volatility” means very little by itself,
and in my experience 90% of the people who use the word could not stop and
define what they mean by volatility in any meaningful way.
Common foibles :
“This is a volatile
market” correctly stated is “I
measured the last few day’s price changes and they are larger than the others I
generally experience.”
“Volatility is killing
me…” what they mean to say is “I
react poorly to uncertainty.”
“Should I sell this
thing?” actually means “I am in a
weak position and am being impacted by emotion, can you please take my money?”
Conceptually Speaking.
Volatility is a
concept conceived by humans to measure and describe uncertainty and quantify
how different something is from our expectations. It can also be used to describe the path a
series takes between
two points.
It is
not a commodity or any kind of tangible thing, although specific types of volatility
can be calculated with precision and traded, and actual historical volatility
encountered is perfectly calculable.
In
fact all types and descriptions of volatility can be calculated, what makes the
world go around is the
difference in two party’s
perceptions of volatility and different implications of
volatility in different situations.
These differences in perception and value give rise to transactions.
A
measure of volatility is implicit in every conceivable price of every financial
instrument that exists; people understand volatility except when they are
confronted with it by someone who is intent on confusing them. Anyone operating in an economy deals with
volatility daily. From a grandmother
with a checking account to the guy in the funny jacket trading futures,
everyone understands volatility because they price it constantly by the actions
they take. The concept is very
understandable, however describing and measuring it can make it sound
confusing.
Whether
they realize it or not, any rational person with complete information who sells
a security is implicitly making the declaration that “I believe there is more uncertainty around the expectation of future
price than this price will reward me for.”
This is the essence of it all; there may be uncertainty around the
future profitability of a business, or uncertainty around the shareholders
ability to sell it in the future.
Any element of uncertainty that drives a buy/sell decision
at it’s core it can be referred to as volatility.
Practically Speaking
Practitioners
realize the time-dependency of any volatility measurement and a lexicon has developed which takes the generic
term and makes it meaningful in a particular situation. Things like “S&P 30 day Implied
Volatility” (aka the “VIX”) or “the October IBM volatility smile” or the
dazzling “Volatility Surface” each refer to a number (or series) that can be observed,
calculated and traded. What makes it
interesting is when two peoples views of the future are different, which gives
rise to a transaction between them.
Wikipedia
calls volatility: “a measure for variation of price of a financial instrument over
time.” Sounds easy enough, but what if I
told grandma that volatility was “The standard deviation of returns times the square root of time.” She might get confused about what really is a
simple concept. She might even empty
her checking account and go dig a hole somewhere.
Play Easy Games
Stocks go up and down, that is
what they do, it is part of what makes a stock a stock. Uncertainty is inherent in their nature, so
why is there an entire edifice of sophisticated industry aimed at predicting the
next tick of a randomly changing price?
The answer is because it is easy for financial people to profit from the
fear/ignorance of the public.
Consider
the frisky New Yorker walks in and says “You gotta buy this piece of paper I’m
selling because it’s a theta-neutral Vega-grazer.” This is doublespeak for “I will get paid if I
can make you think I found the Holy Grail.”
The concept of volatility lends itself particularly well to feed the
beast of the financial edifice, because it makes the game easier for the
predator.
The reality we
encounter every day requires us to deal with many levels of uncertainty.
Thankfully our evolutionary success has given
us many tools to deal with it with relative ease.
Without a smartypants financial guru to
confuse us with the paralytic analysis about all the possible consequences of
getting out of bed in the morning, we still do it every day.
If you owned every stock on the
planet and held them for an infinite time frame, you are more than 99.9%
certain to enjoy a positive outcome.
Contrarily, if you buy one stock and hold it for a nanosecond you are
nearly certain to lose money, and even if there was no fees/commissions/spreads
to deal with, you are still looking at even money in a best case scenario…..
which would you rather do?
So when stock markets get volatile
people tend to seek advice of someone they think will provide them with an
answer they want to hear. Too often the
prey (the investor) will seek the advice of the predator (the broker). This rarely results in a wealthier investor.
Oh the humanity:
We cannot put the blame on
volatility for harming us. It is not the
volatility that hurts, it is our reaction to it that causes the pain. The good news is that ever since Adam ate
the apple, there have been people around who are more than willing to pander to
our fear and greed.
Sounds like a job for the ETF creators:
Volatility is a multidimensional
concept the most important of which is time.
No security has one number that defines it’s volatility, any definition
must specify the time interval over which it will be measured or forecast. Futures do a decent job of standardizing
this, with VIX futures contracts available for each month of the year. But that is only half the story. The underlying deliverable of the monthly VIX
future is the 30 day implied volatility
of the S&P 500. The trouble is that
the stuff that the VIX is calculated from changes every day, and the stuff that
the VIX future is calculated from changes only once a month Another way to
think about it is that at the expiry of a VIX future, the holder will receive
the value of $1000 multiplied by the weighted average of the next 30 day
implied volatility of the S&P 500.
So on the last day of trading for any particular contract looks forward
another 30 days and derives it’s value from 1 month forward expectations of
volatility levels.
The
point is that tracking the VIX index is a cumbersome and potentially costly
thing to accomplish. So the good folks
at the ETF companies have created products which do all this logistics for
you. The only problem is that they make
very sure that they are well compensated for doing it. They are playing the easy game.
Over a year, or a day (the two
graphs below) take your pick, you will
not get what you think you are, in fact you will miss rather dramatically.
1 Year
VIX (Blue Line) and S&P 500 VIX Short-Term Futures ETN (Green Line)
1 Day price change for same two series:
It is a pretty common
misconception that the VXX and other “Volatility Index Related” ETN’s actually
track the VIX. The companies which
create these products do not go out of their way to clear up this
subtlety. In fact the names they give
the funds are a case study in vaguery.
If the truth be told, despite the name “VIX Short Term Futures”, it is
not intended to track the common VIX index, instead it is designed to have a “constant
maturity” of 30 days, which accounts for much of the discrepancy in the graphs
above.
It’s the difference that matters:
The
message of this note is not the volatility that matters at all, it is
the difference between our individual reactions to it and how we value
certainty that is important.
Suppose some dapper gent calls and
says “Of course volatility is important because it is what determines my
ability to hedge and manage risk.” My
response would be “No it doesn’t”. The
reason is that if someone has a particular tolerance for (or view of) the path that an asset price is likely to
take they can take advantage of that view, or remain within their tolerances if
someone else has a different view or tolerance, that is what makes a market a
market. If your livelihood depends on
certain outcomes, then you should buy lots of insurance. If you have low liquidity requirements and a
long-term horizon, you should sell lots of insurance.
How
to do it you ask? In a financial context
insurance takes many forms, options, futures, swaps all are essentially
insurance products, yet nearly all of them can be replicated by buying/selling
some changing fraction of the underlying , except one…..
Ye Olde Variance Swap
The good folks
in academia devised an incredibly useful mechanism for trading expectations of
uncertainty called a Variance Swap, the only problem being that they took it to
Wall Street to price it. A Variance Swap
is a confusing thing so I’m going to punt on any explanation of it to the good
folks here: http://www.ivolatility.com/doc/VarianceSwaps.pdf. (but brush up on your greek before attempting
it)
Suffice to say that a Variance Swap is simply that it is a mechanism for
people to price their views/tolerances of volatility. Think about it as an insurance product where the
thing you are insuring is an intangible concept that exists in a parallel
(Vega) universe (Variance).
The point is that mechanisms exist to
transfer exposure to uncertainty, so instead of worrying about it, my advice is
to understand how much of it you want to have and be content with it. Do not let some Wall Street Jabberwocky sell
you the Holy Grail, because take it from me, he does not have it……If he did it
would not be for sale.
