Diary of a Financier

Progression of Our Volatility Trade & Where the Fear Is Manifest

In Capital Markets on Wed 20 Apr 2011 at 10:57
  • When volatility spikes off its lows, I’ll exchange VXZ for TLT.
  • As a mainstream, short-term, coincident indicator, VIX is rendered useless as a volatility forecaster.
  • I prefer to look at Bonds–which look bullish–and SKEW–which indicates a high-probability of tail-risk.

Looking at the overlay of VXZ v TLT, I almost wish I had initiated my long volatility hedge by going long, long-dated Treasuries:

TLT v VXZ- daily price overlay.

It’s the same negative correlation, long volatility trade as buying the VIX, except it bears interest (TLT yields 4.27%).

Despite the tracking error and the contango erosion in ETNs like VXX & VXZ, they’re remarkably fruitful vehicles for capturing price spikes in the underlying indices.  So reevaluating this hedge in retrospect, I suppose I’d still choose VXZ over TLT in the near term.

Leo Kolivatis over at Pension Pulse had a discussion with a friend who manages a large Canadian pension.  The PM commented:

…the biggest anomaly is still long term volatility, which is sitting at 30. The past 5 years realized vol on spx is at 28. Unless you think we will have another banking crisis it will be very difficult for vol to realize this level. Interest rate curves are steep and the Fed hasn’t yet increased short term interest rate.

Essentially, he argues that given the steep yield curve (low short-term rates), it’s historically unlikely for volatility to surge in the coming months.  That’s a stern case for lower realized volatility than the VIX already forecasts and even lower than medium-term VIX (like my VXZ).

But, I’ve always held that the VIX is an inaccurate gauge of volatility.  Philosophically, I’d have to ascribe that to the reflexive feedback loop wrought from its mainstream acceptance.  I often opt for Implied Correlation (KCJ), but even that has gained wider acceptance and therefore eroded predictive powers.

Cullen Roche mentioned that while volatility resides well below its 20-year average of 19, the downside is its historic bottom at 10.  Mr. Roche still cites complacency (i.e. the Bernanke Put) as the biggest contributor to today’s low VIX, and complacency always signals the greatest of risks ahead.

With VIX & KCJ giving the “all clear,” you may be complacent, but I don’t feel all that comfortable.  The money is still flowing into “risk-on” trades, so where should my eyes be focused to read this market’s bluff (if one exists)?

First, I mentioned last week that bonds are the true masters of the universe:

Jeff Gunlatch is quite right about the correlation between QE and rising 10-year rates.  But as for what the bond market says: QE1 had little net effect on AGG, which inched up only +0.62% over the 15 month QE1 purchasing period.  Similarly, AGG has lost -0.95% to date since the QE2 purchasing began.   QE has had little effect upon bonds–if anything, it seems to have faintly hindered them–although it’s hard to say what would’ve happened void of the stimulus…

The real reaction can be found in equities, where QE’s effect is powerfully effective and where I expect the absence of QE to be most noticeable.  It’s also hard for me to negate a pro-bond outlook, given all I’ve discussed.

Since that entry of mine, bonds have technically set-up for a classical bull run:

AGG daily- bullish trend confirmed with 1st resistance at $106 and a gap to fill up to $107.40. An ugly weekly chart is trying to turnaround, but the monthly still looks bullish.

Tyler Durden draws us to the CBOE SKEW Index, another indicator to find the fear where nobody’s looking:

But as everyone who has done even a little work in option vol, the only index that matters these days, at least for equities now that precious metals and certain currencies (CHF) are the true flight to safety, is the SKEW. As we have disclosed many times in the past, SKEW is how the pros play vol, while VIX is what is left for the peasantry and CNBC. Basically, VIX shows riskiness as implied by ATM options, while SKEW demonstrates the difference between ATM and OTM options. And as the chart below shows, there is a rather dramatic difference when looking between the VIX and SKEW indices. In essence what is happening is that everyone is selling ATM short-dated vol and buying mid-term Out of the Money vol as expressed by the SKEW, in a confirmation that the protection cost in the wings is actually much higher than one would assume.

One… potential way to think of this is that the skew better represents the real market value of the Bernanke Put (i.e. how much is the market pricing in the never-ending story of a Fed-provided safety net) – perhaps notable that the SKEW began to rise very shortly after Jackson Hole and the QE2 plan came online.

Since SKEW prints 129.40 as of today, I’ll leave it to the CBOE’s own analysis to interpret what SKEW is forecasting:

The probability of a return two standard deviations below the mean gradually increases from 2.3% to 14.45% as SKEW increases from 100 to 145. The probability of a return three standard deviations below the mean increases from .15% to .45% as SKEW increases from 100 to 105 and increases to 2.81% when SKEW reaches 145.

So SKEW is assigning ~10% probability of a 2-sigma downside  in the SPX over the next 30-days, and ~1.8% chance of a 3-sigma fall.  To put today’s reading of 129.40 into context, the index averages around 115.50, only  trending this high as little as 2.5% of the time since 1990.

Given a heightened SKEW reading, I’m happy to pick up cheap vol protection via VXZ, because the VIX is much more of a short-term, coincident fear gauge.

–Romeo (hattip Tyler Durden)

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