The connections between risk, human psychology, volatility and the Vix

The last week or so has seen something of a change in financial markets. The falls in Bitcoin have continued but in addition equity markets have hit rough water including quite a storm as they plunged yesterday. The falling over 1000 points club was started by the Dow Jones Industrial Average in the United States and then joined by the Nikkei 225 equity index in Japan. An irony in the situation can be found in the way that one of the possible factors causing this has seen its drop stop and be replaced by a bounce. By this I mean bond prices as for example the yield on the ten-year Treasury Note has fallen from the 2.88% it rose to on Friday – in response to a stronger average hourly earnings reading – to 2.72% now. So happy days for those who have some bonds ( yet again) although I caution against the phrase “flight to quality” as neither yield seems to offer much protection against risk to me. The truth is that it has become something of automatic reflex to mark bonds higher when equities plunge.

However after a period of relative stability we have some action and this brings us into a few spheres involving risk, human psychology and the concept of volatility. As an aside one of the markers may be in play. From Vivienne Nunis of the BBC.

As markets in Europe fall after tumbles in Wall St and Asia, most economists are staying calm, calling it a correction and pointing out fundamentals of the US economy are still strong..

They always say that as after all like Ratings Agencies even if it all goes wrong they are likely to be even more in demand in a clear example of perverse behaviour that questions our rationality as a species. Meanwhile this probably wasn’t a cause but who knows?

Plus, the Berlin Wall has now been down for longer than it was actually up. Professor Axel Klausmeier of the Berlin Wall Foundation tells us how the wall still makes its presence felt, almost 30 years since it crumbled. ( BBC)

Hard to believe isn’t it? For younger readers it was a really really big deal at the time.

Risk

This is on its own a simple concept but hard to quantify. Many have claimed to have mastered it but this has often turned to arrogance as we discovered in the mid-1990s when a fund called Long Term Capital Management blew up. I guess we should have been warned by the name! The list of luminaries was long including Myron Scholes who was jointly responsible for an options pricing model used by many including me. There was one lesson in risk which is if you are big enough especially in the derivatives world you get bailed out as the US Federal Reserve stepped in. Also there was a curiosity in the timing as Myron won his Nobel ( strictly Riksbank) prize in 1997 which was just in time for LTCM to collapse in 1998.

Derivatives and risk squared and cubed

If everyone simply bought and sold then financial risk would be relatively limited and mostly related to the currency markets. But derivatives add two types of risk. Firstly you can sell as an opening trade and secondly that you can trade on margin meaning that if you wish you can increase your exposure for the same expense. So if your margin is 10% you could have 10 times as much exposure which is what is meant by gearing. Here is a catch though if you gear up like that then you can be caught out simply by the margin required increasing.

Should such a thing go wrong then it accelerates for the reasons described above. In other words you pay for your greed. An example of this was Nick Leeson of Baring Securities whose enormous bets in Japanese equity derivatives broke not only the company but its owner Barings Bank. Such a large blow-up has another problem which is that other market players figure out what is happening as matters escalate and move prices away from the fund/player in distress.

Volatility

This is a simple concept of out of the ordinary market moves which is harder like so many things in practice than reality. The mathematics comes around  the concept of a standard deviation. Here is the FT definition.

In a series of variables, a way of measuring the extent to which any one of those variables approaches the average of that series.

Don’t worry if that does not help. It tries to calculate an idea of dispersion. So things that might look like volatility aren’t really as for example the equity market rallies of last year had a mean you could plot reducing the volatility. The current move generates volatility in essence because a reversal is against the mean especially if it is a sharp one.

The next issue is that we can calculate what volatility was but we do not know what it will be. The two concepts are sadly often merged but volatility from option prices should be called implied volatility as market makers and participants – including me – do not know what it will be. If there has been someone who does know then they have had the good sense to keep very quiet about it!

Human psychology

Here is a real problem which is that it seems safest when nothing is happening. Except of course periods of stability do end and if you let yourself fall prey to that line of thought you will be selling risk just as it is about to blow. So human psychology leads to the temptation to sell risk for the least premium. This is another way how things can go wrong in a leveraged world,

The Vix Index

This is a way of attempting to capture much of what I have described above. Here is the FT Lexicon.

The Vix index is an index of expected future price volatility implied by options contract prices.  It is often called a fear index because its value rises when investors are concerned about future volatility.

Actually more recently it has been something of a greed index as developments of it became seen as easy money.

 A few years ago, the CBOE began to list derivatives on the Vix, a market that has grown considerably.

At this point the USS Enterprise is on yellow alert. Before we get to the type of risk that is being squared let me add that the bit below underplays things in my opinion.

 the Vix may not truly mean what it is conventionally assumed to mean (expected volatility), and therefore we would be allowing an undecipherable ghost to move markets

The Vix does not mean what many people think it does and here is another issue it will suck you in as it will seem most right when it is about to go most wrong.

Imagine you have a geared position in the Vix index as you look at the chart below.

 

As you can see selling derivatives on this would have looked better and better ( tempting you to increase your exposure) and even the language does not help as the word carry implies you are getting a type of interest. Of course we have seen “carry trades” both implode and explode in the currency markets before. The new situation is explained well below.

Comment

At this stage we wait to see if this is a correction or something more. But the environment may already have changed even if it is the former. This is because things got ever more highly geared as the lack of volatility made people think that it was ever less likely to return. Some today will be mulling this. From George Pearkes.

prospectus. Right but not obligation to accelerate on an 80% decline based on intraday index price. The question: did we get there after-hours, and do after-hours values count as part of an index day? Anyhow, good luck folks.

There were exchange traded notes or ETNs on this as we wonder if they do still exist which only adds to the issue of how you hedge something which may or may not still exist?! How much might be involved in the short volatility game well this on FT Alphaville tries to quantify it.

Now, there could be as much as $100bn of outflows from funds that trade using those types of strategies, says Kolanovic. He thinks the outflows could affect CTAs, along with funds that bet on low volatility, target volatility levels, or follow risk parity strategies.

Along the way such funds if they tried to hedge their position would have added to the drop that was hurting them. Should they do so and the market rallies then they would be hit both ways. Their response to the Vix going over 45 as it has as I have been typing this would be if we exclude the likely profanity to sing along with Kate Bush.

Wow! Wow! Wow! Wow! Wow! Wow!
Unbelievable!
Wow! Wow! Wow! Wow! Wow! Wow!
Unbelievable!

Meanwhile if we return to monetary policy imagine you were the incoming Chair of the US Federal Reserve and you stand to wonder if your first move might be to introduce QE4?

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18 thoughts on “The connections between risk, human psychology, volatility and the Vix

  1. When he does introduce QE4 it’ll be more blatant than ever its to sponsor rich peoples bad financial bets. They’ve effectively bet on central banks giving themselves free money for longer and workers continuing to get next to no pay rise and when there is a glimmer of possibility this isn’t the case there is a hissy fit.

    DOW is merely down to the level it was on December 11 2017.

    • Hi Arthur

      There were signals during the day that central banks were getting ready in case things continued. Odd as you say with the fall heavy for one day but only taking us back a couple of months or so. From @NicTrades

      “Sources “ECB said to be in contact with market participants amid market rout”

      Since when was the stock market price the ECB’s job? And why are m̶a̶r̶k̶e̶t̶ ̶p̶a̶r̶t̶i̶c̶i̶p̶a̶n̶t̶s̶ banks getting special treatment from them?”

      Of course the ECB has a track record of leaking to the major hedge funds which should have been more of a scandal than it was made out to be.

  2. Hi Shaun
    That is a lot of info for a layman to absorb, so like
    a brief history in time I have re-read it. (:o
    Zero hedge are suggesting that credit suisse and
    probably others have been hit, I wonder what will happen
    before and during thursday’s B of E meeting, for Carney june
    2019 is a longer road than he had thought!

    JRH

    • Hi JRH

      Well Credit Suisse were very quick to issue a denial and we know what that usually means!

      ““In response to certain media enquires, Credit Suisse confirms that it has experienced no trading losses from Velocity Shares Daily Inverse VIX Short Term ETNs due December 4, 2030,””

      A few hours later we heard this according to Bloomberg.

      “Credit Suisse said it will buy back the VelocityShares Daily Inverse VIX Short-Term ETN, which it issued and is known by its trading symbol XIV. The fund’s market value topped $2 billion in late January; it was down 93 percent as of 4 p.m. Tuesday after being halted for most of the morning. The bank said it’s redeeming early because the indicative value on Feb. 5 was equal to or less than 20 percent of the prior day’s closing indicative value.”

      Only time will tell and of course it could easily end up in the courts.

  3. The bet on a steady VIX is well rooted in economics, people are Rational Actors and markets tend to equillibrium. The slight flaw in this cunning plan is that people (especially in the City and Wall St.) are raving lunatics and markets tend to chaos. Other than that…

    Money has been cannibalised by financialisation all the money created by leverage and gearing doesn’t exist even if it is real in that it is a promise to pay. All this activity serves no useful purpose whatsoever and certainly has no social goal most of it should be banned.

    The c lean up that should have happened after 2008 will have to happen one day.

  4. When you bet on a ‘sure thing’…….especially when its with someone else’s money….!
    Unlikely to stop the upward march of US rates.

    • Hi jim

      It is something I used to see fairly regularly in the City. Some silly ideas were put forwards but as long as they lasted for a while everyone got paid for that length of time and if by some chance it worked they got large bonuses. However those putting up the money had a much worse risk/reward ratio.

  5. Those clowns on cnbc and Bloomberg were trying to work out what caused the crash…..when the question should have been how the hell did the Trump rally raise the Dow over 7000 points in 14 months?
    The fundamentals of the US economy are rotten to the core national debt racing towards $21T and Trump is cutting taxes,….they claim to have 8000 tons of Gold in Fort Knox yet have refused every attempt to audit it since1954 methinks Auric Goldfinger would be very disappointed if he tried to get his hands on it now…..40% of the population is not in employment yet unemployment figures are the best for decades.
    Tesla is a stellar stock yet burns through cash faster than the next new fantastic idea can com from Elon’s mouth.
    When thosebond yields hit 4% there will be massive problems this situation could escalate into a crisis very quickly,it doesn’t take much to start an avalanche.

    • Shaun, I am glad you are watching the show. I think Forbin may have over-eaten on his pop-corn, not seen his commentry this week. I’ve been watching the “volatility” since Friday. Lots of punditry about but not much firmness on the cause. It still seemd that 3-5% falls are of little beer when you consider the 20-40% rises in markets the past couple of years.

      I think probably whats more concerning is that folk mainly know its QE cash sloshing around making these inflated asset values, and deep down since the money was magic’ed into existence rather than earned through productivity or real output then it can all be magic’ed away just as easily in a concerted fall of all asset values.

      Here is a nice little cartoon, the animation is colourful and effective. It gives a slightly more believable storyline to the Trump boom in the USA.

      Tell me what you think. Kind regards Paul

  6. Ah, the summer of 1989 – in June, I let the most wonderful woman I have ever met slip through my fingers and in August, I was playing in an improvised game of volleyball on the Czech-Austrian border as a helicopter gunship flew over – 3 months later, the Wall came down. One song caught the mood of those heady days https://www.youtube.com/watch?v=rMUX_4B-Hr4 Of course, it was already two years after Black Monday in October 87, which was one of those corrections, which happened for no obvious reason – although a quick look at the money supply figures told you there was too much cheap money washing about. With derivatives and printed money, the bubbles and busts are just all the more spectacular.

    As the Scorpions sang:
    “The wind of change blows straight
    Into the face of time”.

    A correction has been on the cards for a while now after all the “irrational exuberance” caused by cheap money – it all began with the AQ attacks in Sept 2001, when rates were cut significantly and held below liquidity trap levels thereafter. So, really, we have had 16 years of it and as the various canaries have sung, car finance being the last, the markets have ignored them. The markets have moved so far from the overall mean returns that divi returns average 2.5% on the Dow, so capital growth has had to take up the slack even to meet the historic overall return of about 6.5%. But as the capital value rises, so the divi yield will fall and that can only mean that the bubble will burst when the cheap money runs out to finance the share buying. The problem is that borrowing costs are rising and so, looking about 18 months ahead, these markets really should be adjusting quite significantly soon.

    Then what happens to the rest of the credit-fuelled economy?

  7. In contradiction to the IMF etc my model in 2016, said 2017 would be reasonable global growth when the global economic authorities predicted weakness/no growth. We can see how that played out and as a result there was a market boom last year as investors caught up with the reality my model; predicted.

    Yet again, in contradiction to the IMF et al my model in 2017 said and still says 2018 will be a tough year due to rising global inflation, the Kitchin cycle due to enter it’s normal downswing phase and collapsing narrow money growth globally pointing to a liquidity squeeze arriving in March/April.

    As markets never do well in liquidity squeezes expect further falls throughout the year as more investors begin to realise the authorities were wrong…yet again..

    Japan and Switzerland would be the best bet this year despite recent falls followed, bizarrely, by the UK despite Brexit fears.

    The US $ weakening cycle started 3/4 months earlier than my model predicted but the weak phase is here to stay which should hopefully help the US export economy as Trumps tax cuts will only manage to ameliorate my expected fall in US growth due to the dual headwinds his tax cuts will experience from the narrow money growth collapse and the downward phase of the Kitchin cycle which has probably already started.

    I positioned defensively last month.

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