Diary of a Financier

Waiting to Buy Volatility as Social Unrest Goes Viral

In Politics on Tue 22 Feb 2011 at 10:55
  • Social unrest spilling across boarders & now affecting international economies/markets, as evidence in Italy & copper-oil divergence.
  • The VIX-KCJ divergence says that this is a false alarm for markets, so we’ll wait to go long vol when premiums come back down.
  • Cycle of Psychology deep into “Confidence” territory; “Enthusiasm” phase is near.

With protests in Libya getting down-right scary, the social unrest that began in Tunisia in 2010 has now gone viral: Yemen, Egypt, Libya, Saudi Arabia, Algeria, Bahrain, Iran, Wisconsin, and Ohio.  From North Africa to the Middle East–now even the sheeple of America–the populi are trying to overhaul the political institutions that have misrepresented them.
With all of this insurrection across the globe, Libya is now the first instance that’s spilled over to infect international markets with an encompassing contagion of fear.  For example:

The Italian index dropped 3.6% yesterday and Borsa Italiana is shut today due to a technical glitch. The country is being slammed by unrest in Libya with investors looking to sell Libya-related stocks.

FinViz offers a nice visualization of the damage:

PragCap noticed the alarming divergence between copper & oil, which signals the global economic consequences of these civil upheavals:

One distinct aspect of tonight’s market action is the divergence between copper and oil prices. As oil surges almost 8% higher copper is dropping 1%.  This is a clear sign that the rise in oil prices is causing fears of a global economic slow-down.  The risk of turmoil in the Middle East has the potential to have a very real impact on the global economy.  Weak developed markets likely can’t handle a sustained shock from higher oil prices.  Tonight’s decline in copper prices appears to be reflecting this belief.

We’re not panicking right now, and we’re not going to jump headlong into a long vol trade.  But, per my note on Friday, I spent some time reviewing different vehicles to hedge tail risk and/or go long vol.  Such insurance is “cheap,” as I described it, so I found the opportunity ripe for the picking.
For example, I found the chart of the VIX ETN (VXX) attractive:

VXX daily- MACD bull divergence building & breaking resistance, along with MFI. While the Stochastic is also pointing up, I’d like to see MACD enter positive territory & MFI break through 60, because the price trend is so strongly bearish.

I’m not ready to buy equity vol yet though.  First, I’m not looking at where the puck is now, but where it’s going to be.  The smart money isn’t panicking here.  The VIX has spiked today as of the open, but look at the lag in implied correlation (KCJ), which tells me that trader’s and institutions aren’t worried about collapse:

VIX +17%

 

KCJ +0.74%

Thus, we’ll wait for premiums to come back down in the wake of today’s [or this week/month’s] activity.  Per my beloved Cycle of Psychology, we’re still in the bullish phase known as “Confidence,” which culminates with the herd participating under the mantra “Buy on Dips.”

From one of my Seeking Alpha articles in September 2009:

We’re accelerating from Caution to Confidence as popular Bears turn Bull, CNBC celebrates, and analysts come out targeting Dow 10,500.  We’ll probably see another jump up to Enthusiasm as consumerless Inventories are rebuilt to pad GDP.  We can quickly gap up to Greed/Conviction when banks report loan growth, whilst Obama & Bernanke light a cigar.  The USD will have reached support in advance of that day, and Fed Funds rate futures will price a 60-something percent chance of a hike.  Then we’ll realize that we’ve just churned our economy after devaluing it.

…It’s all happened or happening.  The jump to Enthusiasm will occur at Dow 14000, when Equity inflows gain steam.

–Romeo

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