Is volatility gone forever?

Is volatility gone forever?

Volatility is a term often bandied about in the financial markets…

But what do we actually mean when we refer to volatility?

And, perhaps more importantly, is the term even relevant any more in today’s world?

In finance, volatility is used to describe an instrument or asset’s propensity for price change.

An asset that is volatile in nature is changing price frequently, often in an erratic fashion, and without an obvious pattern.

The more unpredictable the behaviour of the instrument or asset, the higher the level of volatility we would say it has.

Assets or instruments with low levels of volatility will typically change price with much less frequency and or trade within well-defined ranges that they break out of infrequently.</>

If and when they do move out of a prior range, they are likely to do so slowly, rather than with a bang.

The concept of volatility is taken one step further in both modern portfolio theory and derivatives trading…

In both cases, statistical studies are employed to determine the historical levels of volatility for assets and asset classes.

This data is then used to calculate or imply future levels of volatility.

Looking for the Holy Grail…

Under modern portfolio theory, traders are looking for investments with the ideal combination of excess returns and low volatility – in order to reach what is known as the efficient portfolio frontier.

The “holy grail” here would be an asset that offered those two characteristics (high return and low volatility) as well being uncorrelated to (i.e. does not move in relation to) other asset classes.

You won’t be surprised to learn that investments which meet all of these criteria at once are rare beasts indeed.

After all, risk and reward are inversely proportional and, in essence, volatility is really an attempt to measure or gauge risk.

Therefore, those that are trying to construct highly efficient portfolios are forced to make a trade-off between these competing factors.

Volatility, as we noted above, is an important concept in derivatives trading and valuation as well.

For example, an estimation of volatility levels – that is the likelihood or otherwise of abnormal price action in the future – was a cornerstone of the Nobel Prize winning work of Fischer Black, Robert Merton and Myron Scholes.

Their formula and the models it spawned are credited with creating the growth in options and derivatives trading seen over the last three decades.

However, whilst Merton and Scholes (Black sadly died in 1995) may have felt that they had mastered the concept of volatility…

They and their partners would soon face a rude awakening, when the Hedge Fund they helped create – Long Term Capital Management – imploded in 1998.

The fund collapsed after making losses of US $4.6 billion in just four months, following crises in both Asian and Russian markets that year.

The fund had run very large, highly leveraged positions and, as such, was judged to be systematically important to the wider financial markets.

It was bailed out by a consortium of 16 banks, to the tune of US$3.6 billion, under the supervision of the US Federal Reserve.

In essence, the fund collapsed because the models it employed could not cope with, or conceive of two consecutive financial crises and the sharp gyrations in prices and valuations that they would create.

That degree of volatility had never been seen before, and therefore it was effectively excluded as a possible outcome in the Hedge Fund’s models.

Despite this salutary lesson, markets would paint themselves into a similar corner – with incorrect assumptions about volatility and credit – in 2007/2008. Only this time it was done on a much, much larger scale…

This ultimately led to the subprime mortgage debacle, the credit crunch, the global financial crisis and great recession that followed.

Of course, these failures were not just about the limitations of advanced mathematics and theories.

They were largely about human biases and an inability to learn from what had gone before. Which could be summed upped as a “this time its different attitude”.

Well, fast forward 10 years and this time it really is different…

Because volatility has all but disappeared today. Not as concept, but as a value or input into the market’s price creation mechanism.

In fact, the level of volatility in US equities has rarely, if ever been lower than it is right now.

The chart below is a nine month plot of the CBOE VIX (Volatility Index), which measures the level of volatility within the top 500 US equities or, more specifically, within the options on them.

Click image to enlarge.

Effectively, this index encapsulates the contest between investor’s greed and fear. To put it simply: the lower the index goes, the lower the level of concern or fear of loss there is amongst investors.

To give the chart some context: at the time of writing The VIX index was down more than -25% year-to-date, from what  was already an historically low base before those falls.

You should also note that the VIX peaked just above 79.00 in October 2008.

Should we be worried about
lack of volatility?

Now, you may be thinking: “Why should we be concerned if concerns about major losses are evaporating and volatility is low? After all, equities keep going up and we are making money, so what’s the problem?”

The problem is with human nature…

Once again investors are becoming complacent. Large losses are a distant memory, new all-time highs are much fresher in their minds and, in effect, many traders now believe investing is a one way street.

And who could blame them for thinking that way, because apart from the odd interruption, it’s pretty much been just that way over the last eight or so years.

However, rather perversely, persistently low levels of volatility actually encourage us to take more risk in our trading – simply because we don’t see a downside.

We are encouraged to take a bigger position, use more leverage, have a looser stop loss, or trade in more speculative stock than we otherwise would have done.

Just like the rocket scientists at LTCM in 1998 and the credit traders of the early noughties, we are in danger of completely ignoring the possibility of a downside.

This behaviour will only further reinforce itself in the minds of investors the longer it goes on. And the longer it goes on for, the more unhealthy the end results for the market will be.