Why Traders Love Volatility Except When It Bites Back: QuickTake

(Bloomberg) -- Mom and pop investors fear it. Traders by and large love it, and normally miss it when it’s gone. Volatility was absent from the financial markets for an unusually long time before rushing back. It’s now on everyone’s radar screen, and likely to stay that way in the months ahead. Volatility not only affects investments; investing in volatility has become something of a cottage industry.

1. What is volatility?

Basically, the up-and-down movement of the market. Downward moves tend to get more attention and be more associated with volatility, as they also tend to fuel concern about what’s coming next.

2. How is it measured?

The most prominent tracker is the Cboe Volatility Index, or VIX, a stock-volatility index that is sometimes referred to as the “fear gauge” because it tends to rise when stocks go down. It’s a market estimate of future volatility.

3. How does the VIX capture fear?

It’s compiled based on how much traders are willing to pay for options on the S&P 500 Index. Options are contracts that give the holder the right, not the obligation, to buy securities at set prices when the underlying asset reaches set levels; traders often use options and other derivatives as insurance policies against market fluctuations or to bet on the moves themselves. The higher the price of the option, the bigger the fixed cost, and therefore the larger the move needed to generate a return that will make it pay off. So option prices reflect the size of the swings -- the volatility -- traders expect. Say a trader pays $5,000 for an option betting on yen moves, and say that contract shows implied volatility is about 8 percent. If some other investor pays $10,000 for the exact same option, then the implied volatility level jumps to about 10 percent.

4. What’s ‘normal’ for stock volatility?

The long-term average for the VIX is about 19.4, with its lowest levels being in the 8-10 range. Its intraday record high is 89.53, set on Oct. 24, 2008, at the height of the global financial crisis. After spending most of 2017 around 10, the VIX spiked to 38 on Feb. 5 and more recently has been in the 15-18 range. Some refer to the VIX as “mean-reverting" -- it tends to go back to about its average over time rather than staying at high or low extremes.

5. How do people invest in the VIX?

They can’t invest directly in the VIX, which is just a number, but can make bets on which way the VIX will go by using futures, options or VIX-based exchange-traded products. In fact, the emergence of a whole crop of products tied to the VIX in recent years has led to questions about whether VIX trading is itself influencing the index or market volatility as a whole.

6. Are there other volatility gauges?

Yes. They’ve proliferated widely in recent years, in no small part due to the success of the VIX. They exist for indexes like the Russell 2000 (RVX Index), the Euro Stoxx 50 (V2X Index) and India’s Nifty 50 (INVIXN Index). They also exist in other asset classes. The Merrill Option Volatility Estimate (MOVE Index) looks at implied volatility of one-month Treasury options. The JPMorgan Global FX Volatility Index (JPMVXYGL Index) keeps track of currency volatility. There’s even volatility of volatility –- the Cboe VVIX (VVIX Index) measures the expected volatility of the 30-day forward price of the VIX.

7. Is trading volatility like trading stocks?

They have similarities, including the ability to go short or long. “Short volatility” is a bet that volatility will continue to go down, or at least stay at very low levels. “Long volatility” is the opposite, a bet that volatility will increase. With the VIX falling for a third year in 2017, shorting volatility became very popular: A Bank of America Corp. survey in early January found that the strategy had become the most-crowded trade in the markets.

8. How’d that work out?

When uncertainty over the impact of rising Treasury yields hit the stock market and volatility jumped earlier this year, it caught some investors off guard. Volatility had been unusually low for an unusually long period of time, and many people had gotten used to that. So they were making bets that the situation would stay the same. Some of them weren’t paying enough attention to the risks, or didn’t hedge their bets to the extent they might have needed to. In addition, some securities, such as VIX-based exchange-traded notes, ran into trouble because their designs weren’t conducive to surviving a big market turn like that. (Some of these products went through structural changes to make them less risky in the future.)

9. Can the VIX be gamed?

The VIX has had some wild moves on settlement days, raising concern among academics and some traders that it can be manipulated. The price critical to holders of futures tied to the volatility index gets determined in an auction every Wednesday that’s based on market makers’ S&P 500 options trades (while the VIX itself is calculated using options quotes). Cboe, which maintains that allegations of manipulation are “without merit,” said it’s working to improve the settlement process.

The Reference Shelf

• Volatility’s comeback has unleashed the best returns of 2018.
• Volatility Inc.: A look inside Wall Street’s $8 billion time bomb.
• JPMorgan’s Kolanovic warns of liquidity snarls but stays bullish.
• A simple investment strategy, doomed by a one-direction market.
• Out-of-whack volatility gives strategists hope for calm ahead.
• An odd spike in Wall Street’s "fear gauge" awakens the manipulation debate.

--With assistance from Garfield Reynolds.

To contact the reporters on this story: Joanna Ossinger in New York at jossinger@bloomberg.net;Cecile Vannucci in London at cvannucci1@bloomberg.net

To contact the editors responsible for this story: Tracy Alloway at talloway@bloomberg.net, John O'Neil

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