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The Great Volatility Crash | The Mesh Report

The Great Volatility Crash

John Thomas May 10, 2017 Comments Off on The Great Volatility Crash

Short term traders are amazed, aghast, and gob smacked to see the Volatility Index (VIX) trading at a new decade low of $9.70.

To show you how insanely low this is, a $9.70 VIX means that the S&P 500 is unlikely to move 67 points up or down in the next 30 days.

And it has to stay within that range in a world full of booby traps and stock valuation at a 19.50 earnings multiple, a 17-year high.

Yet, when I tried to bet against this highly unlikely scenario, I got my head handed to me.

It is a classic case of a market staying irrational longer that I can stay illiquid.

This will all end in tears.

And my hard and fast rule of keeping stop losses at 2% of capital at all times reigns supreme.

It could be that algorithms have finally and completely taken aver the market.

Even the smallest amount of selling meets a wall of algorithmic buying headed in the opposite direction.

In other words, the stock market has become perfect.

It might get even more perfect.

For $9.70 is not the all time low for the VIX. For that you would have to get down to the $8 handle we saw in 1998.

That’s when Long Term Capital Management (LTCM), a hedge fund advised by two Nobel Prize winners, was selling short all of the volatility on the planet in massive size.

When the Russian Debt Crisis hit, they were forced to cover at a loss.

But market liquidity vaporized. LTCM lost $125 million in two weeks and went bankrupt.

The VIX shot up to $40 and stayed there for two years. I know because I was heavily involved in the unwind.

For more on the LTCM fiasco read “When Genius Failed” by Roger Lowenstein click here for the link at https://www.amazon.com/When-Genius-Failed-Long-Term-Management/dp/0375758259/ref=sr_1_1?ie=UTF8&qid=1494350304&sr=8-1&keywords=long+term+capital+management ).

The VIX and its cousin the VXX have been one of our most reliable source of trading profits since the inception of the Diary of a Mad Hedge Fund Trader a decade ago.

We have been playing the VIX largely from the short side ever since it topped at $89 in 2009.

Perhaps it is because I am one of those cheapskates who buys Christmas ornaments by the bucket load from Costco in January for ten cents on the dollar, because my eleven month theoretical return on capital comes close to 1,000%.

I also like buying flood insurance in the middle of the summer drought, when the forecast in California is for endless days of sunshine.

That is what we are facing now with the volatility index (VIX) where premiums probed such rock bottom prices.

Yikes!

Get this one right, and the profits you can realize are spectacular.

It gets better. If the bottom in volatility exactly coincides with the peak in the stock market that it measures, volatility could be headed back up to the $20 handle, and maybe more.

I double dare you to look at the charts below and tell me this isn’t happening.

Watch carefully for other confirming trends to affirm this trade is unfolding. Those would include a strong dollar, falling stocks, plunging oil, and a weak Japanese yen, Euro, and fixed income instruments of any kind.

Notice that almost every one of these is happening this week!

Reversion to the mean, anyone?

You may know of this from the many clueless talking heads, beginners, and newbies who call the VIX the “Fear Index”.

Long-term followers of my Trade Alert Service profited handsomely after I urged them to sell short this index three times since January. Shorting every spike up has worked like a charm.

For those of you who have a PhD in higher mathematics from MIT, the VIX is simply a weighted blend of prices for a range of options on the S&P 500 index.

The formula uses a kernel smoothed estimator that takes as inputs the current market prices for all out-of-the-money calls and puts for the front month and second month expirations.

The VIX is the square root of the par variance swap rate for a 30-day term initiated today. To get into the pricing of the individual options, please go look up your handy dandy and ever useful Black-Scholes equation.

You will recall that this is the equation that derives from the Brownian motion of heat transference in metals. Got all that?

For the rest of you who do not possess a PhD in higher mathematics from MIT, and maybe scored a 450 on your math SAT test, or who don’t know what an SAT test is, this is what you need to know.

When the market goes up, the VIX goes down. When the market goes down, the VIX goes up. Period.

End of story. Class dismissed.

The VIX is expressed in terms of the annualized movement in the S&P 500, which today is at $806.06.

So for example, a VIX of $9.70 means that the market expects the index to move 2.80%, or 67.17 S&P 500 points, over the next 30 days.

You get this by calculating $9.70/3.46 = 2.80%, where the square root of 12 months is 3.46.

The volatility index doesn’t really care which way the stock index moves. If the S&P 500 moves more than the projected 4.0%, you make a profit on your long VIX positions.

I am going into this detail because I always get a million questions whenever I raise this subject with volatility deprived investors.

It gets better. Futures contracts began trading on the VIX in 2004, and options on the futures since 2006.

Since then, these instruments have provided a vital means through which hedge funds control risk in their portfolios, thus providing the “hedge” in hedge fund.

If you make money on your VIX trade, it will offset losses on other long positions. This is how the big funds most commonly use it.

No one who buys fire insurance ever complains when their house doesn’t burn down.

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