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Flattening of the VIX Futures Curve?

Despite a negative 4th quarter GDP print, the equity markets were rather muted during the day.  Apparently the market saw that the majority of the miss was due to military spending and a reduction in inventories, but the consumer was a bull!  (even though consumer confidence fell to the lowest level since the debt ceiling debates in mid 2011…)  Fourth quarter GDP of  -.1% actual versus a concensus of -1.1% seems like a pretty big miss regardless of the construction, but I will let the smarter folks sort that nonsense out.

The more interesting question is whether we are seeing a true breakout in the VIX and volatility in general.  Despite a rather muted downside response on the S&P 500 of about .5%, we saw a pretty significant jump in the front part of the VIX futures curve and in the VIX itself.  This is coming directly on the heels of making multi-year lows on 1 year ATM implied volatility at a measly 15.1%.

Significant parallel shift down since end of 2012, now a possibly breakout to the upside?

I really do not mind rising markets and euphoric price action.  I will even say that equities look incredibly cheap compared to bonds from a relative perspective.  What I never understand is when the market dismisses all possible future risks as if it just had a lobotomy.  If you analyze historic volatility across many different time periods going back as far as you can, you will find a big range in realized volatility, but you will also find that a lot of averages tend to rotate around 16%.  Maybe 16% is normal and a fair price for volatility over the long-term.

I could make an argument that modern financial instruments and players have made markets more volatile rather than less volatile, but I will stick to an economic environment driven approach.  Many moons ago (Dec 2009) I admitted my ignorance in forecasting levels of the market, but thought there was one thing that was nearly certain – more volatility rather than less volatility.  Large monetary and government intervention along with zero to low economic growth and a deflationary undertone creates market volatility.  The two markets that I can point to are the United States following the crash of the great depression and Japan following the burst of the great asset bubble:

Market volatility lulls always, but a consistently higher realized volatility level

Purchasing 1 year option volatility at a 15% level might be a losing trade over this next year, but given the backdrop I think it is reasonable to reassess whether normal volatility relates directly back to the 2005-2006 time period.  A lot of things have changed.

Volatility Trading (Wiley Trading)

In Volatility Trading, Sinclair offers you a quantitative model for measuring volatility in order to gain an edge in your everyday option trading endeavors. With an accessible, straightforward approach. He guides traders through the basics of option pricing, volatility measurement, hedging, money management, and trade evaluation. In addition, Sinclair explains the often-overlooked psychological aspects of trading, revealing both how behavioral psychology can create market conditions traders can take advantage of-and how it can lead them astray. Psychological biases, he asserts, are probably the drivers behind most sources of edge available to a volatility trader.

Your goal, Sinclair explains, must be clearly defined and easily expressed-if you cannot explain it in one sentence, you probably aren’t completely clear about what it is. The same applies to your statistical edge. If you do not know exactly what your edge is, you shouldn’t trade. He shows how, in addition to the numerical evaluation of a potential trade, you should be able to identify and evaluate the reason why implied volatility is priced where it is, that is, why an edge exists. This means it is also necessary to be on top of recent news stories, sector trends, and behavioral psychology. Finally, Sinclair underscores why trades need to be sized correctly, which means that each trade is evaluated according to its projected return and risk in the overall context of your goals.

As the author concludes, while we also need to pay attention to seemingly mundane things like having good execution software, a comfortable office, and getting enough sleep, it is knowledge that is the ultimate source of edge. So, all else being equal, the trader with the greater knowledge will be the more successful. This book, and its companion CD-ROM, will provide that knowledge. The CD-ROM includes spreadsheets designed to help you forecast volatility and evaluate trades together with simulation engines.In Volatility Trading, Sinclair offers you a quantitative model for measuring volatility in order to gain an edge in your everyday option trading endeavors. With an accessible, straightforward approach. He guides traders through the basics of option pricing, volatility measurement, hedging, money management, and trade evaluation. In addition, Sinclair explains the often-overlooked psychological aspects of trading, revealing both how behavioral psychology can create market conditions traders can take advantage of-and how it can lead them astray. Psychological biases, he asserts, are probably the drivers behind most sources of edge available to a volatility trader.

Your goal, Sinclair explains, must be clearly defined and easily expressed-if you cannot explain it in one sentence, you probably aren’t completely clear about what it is. The same applies to your statistical edge. If you do not know exactly what your edge is, you shouldn’t trade. He shows how, in addition to the numerical evaluation of a potential trade, you should be able to identify and evaluate the reason why implied volatility is priced where it is, that is, why an edge exists. This means it is also necessary to be on top of recent news stories, sector trends, and behavioral psychology. Finally, Sinclair underscores why trades need to be sized correctly, which means that each trade is evaluated according to its projected return and risk in the overall context of your goals.

As the author concludes, while we also need to pay attention to seemingly mundane things like having good execution software, a comfortable office, and getting enough sleep, it is knowledge that is the ultimate source of edge. So, all else being equal, the trader with the greater knowledge will be the more successful. This book, and its companion CD-ROM, will provide that knowledge. The CD-ROM includes spreadsheets designed to help you forecast volatility and evaluate trades together with simulation engines.

 

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