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Tuesday, July 01, 2014

Low Volatility Dilemma

Recently “low vol” becomes an obsession for every market observer or participant, whether he is a vol trader or not.  It even catches the attention of the financial news media.  Low vol, not surprisingly, is the result of the recent amazing bull market driven by the Fed’s easy money policy.  The concern of “low vol” is not about the volatility itself, but more on the worry that such low vol portents a reversal of the market.  For us, the obvious question is, as vol traders, can we still be profitable in this low vol environment?

First of all,  this is not the lowest vol environment we have ever seen – we saw sub-10 VIX in January 2007, right at the beginning of the subprime crisis, while VIX around 10 or below was the norm in the 90s – Currently VIX is around 11-12 in the recent month (touching 10.61 in 6/18).  On the other hand, the realized vol of SPY drops to 6.5 for weekly or monthly.

There are 2 common beliefs about volatility: 1) Implied vol tends to converge with realized vol; 2) Implied vol tends to mean-revert.  In the first part, VIX is still too high if it is relative to realized vol, while in the second, VIX is low from historical perspective.  In other words, the current “low vol” is not really extreme or surprising; its rationale can be justified in either way.

For volatility strategy, prolonged low vol environment can be opportunities – the most obvious one is you can cheaply buy into convexity -- with some potential pitfalls: 1) believing too much in mean-reversion of implied vol may end up enticing the trader to be too long in vol, which can be painful even when the implied vol holds, but stock movements not realizing (which is typically the case in most environments, high or low vol); 2) If focusing too much on the low realized vol and end-up shorting too much Vega believing implied vol will converge to realized vol, the risk is obvious: a spike in vol, or a long period of divergence of implied vol and realized vol can cause damaging mark-to-market loss in the portfolio.

Nevertheless, we weather this low vol environment pretty well -- every vol trader should take this as a required course: one needs to experience both the high vol and low vol environment to mature.  Here are several areas in which we thrive:  

1) Trade the relativity. While most people fixate on VIX and S&P vol, in the single name space, there is still much divergence in vol, not all of which are low. There are still tremendous opportunities on the relative vol on the vol surface (intra-name), or among single names (inter-name).  For example, though VIX has a very low reading, it represents only the very short term vol.  On the SPY vol surface, we still see a lot of long/short opportunities on the term structure (Currently SPY is at the steepest term structure in recent years), skew and vol spreads capturing expected macro event.  There are much more similar vol surface opportunities in active single names like AAPL, FB, TSLA, NFLX, etc.

2) Controlling the decay.  One of the pitfalls of low vol is that it entices the trader to hold onto too much short term options, where Theta overtaking Vega.  An extended period of low realized vol can cause frustrating loss from factor that traders cannot control (time).  This requires an active balancing management of decay, while understand that low vol can give us huge leverage.

3) Be nimble, trade actively and be willing to take in small profits while keeping the portfolio relatively light in Vega and Theta risk.  Low vol can cause traders to speculate too much either on the emergence of big macro events, or be lulled into complacency.  Either way can cause positions to build up too much.  

Two observations from a vol trader who has been through some different faces of the market: First, low vol is actually the norm (while high vol period cannot sustain for a long period of time).  Secondly, vol always spikes, except you don’t know when, so be prepared for spikes, but not to position waiting for them.

So low vol is really nothing to complain about.  It’s an opportunity. Just need to trade more and focus on the relativity.

 Derek Wang, CEO, Bell Curve Capital LP - dwang at

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