Option traders implicitly believe that when the stock market goes up, volatility falls, and when the stock marketfalls, volatility rises. This assumption, which is based on years of empirical data, is implicit in many of the volatility-based strategies that have become common place today. To mention a few: volatility targeting, risk parity, dynamic rebalancing.
The breathtaking month-long rally in the Japanese stock market is now calling this assumption into question. Since Abe’s landslide win last month, the Nikkei has rallied over 10% in a month.
Investors had almost given up on Japan, but a confluence of positive factors has woken the sleeping giant, and the Japanese stock market has literally exploded up. Pundits are now calling for a doubling of the Japanese stock market, up to the highs of the 80s and the legendary bubble and bust.
Just a month ago a 10% out of the money call option on the Nikkei index could have been had for 0.25% of premium. The same option today is worth 4.25%! In other words, a more than 16 fold return on investment. Clearly a fat “right tail” event. What is more amazing, however, is that as the market rallied, suddenly there was panic – to the upside. Not a meltdown fear, but a melt-up fear. Spot (equity market level) is up, and so is volatility in Nikkei. Implied volatility a month ago as measured by the VNKY (VNKY is to the Nikkei options market what (VIX is to the S&P 500 options market) has surged from 14.5% last month to over 19% today, even as the market has rallied. The assumption of spot up / volatility down is breaking down. This is not the first time we have seen this dynamic. A similar event occurred in the Chinese stock market a few years ago.
The main reason this is relevant for us today is because of what the breakdown of spot up/vol down, along with another sacred correlation assumption (between yields and stock market returns), could mean for larger markets like the S&P 500 and strategies that rely on volatility as an indicator for risk balancing. There are large quantities of sold call options in the US market from yield enhancing investors. They like to systematically sell option “strangles” i.e. puts and calls, so at inception there is no “delta” or direct market exposure.
Since the volatility of calls is lower than that of puts, they balance the call and put side in terms of premium either by selling more calls than puts, or selling calls that are closer to the money than puts. A spot up/vol up environment is obviously very bad for either setup. A spot up/ volatility up environment here in the US, for instance due to a tax plan that goes through Congress smoothly, could create global melt-up mayhem. The short gamma position that an option seller inherits for yield can create an enormous need for hedges, i.e. by buying the underlying, that can completely overwhelm the liquidity of the markets on the upside. For dynamic risk balancing strategies, spot up/vol up means that as spot rises, the models require de-risking rather than increasing risk, which creates more volatility and potentially a feedback effect.
History does not repeat, it rhymes, and sometimes backwards. While everyone is expecting volatility to rise with markets falling, they might be shocked to find out that this time volatility spikes not because of markets melting down, but because they melt-up, and the need for hedges amplifies the melt-up! And to make matters complicated, participants’ behavior is systematically opposite to what is expected, creating more uncertainty.
What is an investor to do? The first thing is to take the blinders off and to realize that at current prices, those selling upside lottery tickets are doing so nearly for free. Yes, in the long run selling lottery tickets is a positive expected return trade. But in the short run, to sell insurance, upside or downside, without reference to the price or the risk inherited can prove to be very expensive indeed. The second obvious thing is to question both core correlation assumptions (between the market and volatility, and between the equity market and the bond markets), and see where they can fail us in a big way. And yes, finally, even though the market is high, volatility and call options are still very cheap.
Vineer Bhansali, Ph.D. is the Founder and Chief Investment Officer of LongTail Alpha, LLC, a California-registered investment adviser and a CFTC-registered CTA and CPO. Any opinions or views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the opinions or views of LongTail Alpha, LLC or any of its affiliates (collectively, “LongTail Alpha”), or any other associated persons of LongTail Alpha. You should not treat any opinion expressed by Dr. Bhansali as investment advice or as a recommendation to make an investment in any particular investment strategy or investment product. Dr. Bhansali’s opinions and commentaries are based upon information he considers credible, but which may not constitute research by LongTail Alpha. Dr. Bhansali does not warrant the completeness or accuracy of the information upon which his opinions or commentaries are based.