While some have visions of sugar plums dancing in their heads at
this time of year, quite possibly the result of excess
, I have the vision of a world wherein volatility measures can be
traded independently of price opinion. Maybe in 2014, but I doubt
it: As investors are naturally long stock and not (non-embedded)
call options, they tend to ignore call options on the way up and
buy put options on the way down.
These actions are combined with those of assorted comedians who
have yet to figure out that writing put options is a good way to
lose a lot of money in a hurry, and variance swap traders who put
themselves in the position of "paying floating" on variance and now
have to hedge themselves dynamically by selling ever-increasing
amounts of stock into a falling market to create the spikes in
volatility seen during every market downturn. If this last point
sounds needlessly complex, well, why do you think every financial
crisis in our lifetimes involved people whose actions required
greater underlying intelligence than they were able to provide?
The Euro STOXX 50, the underlying asset for ETFs such as the
SPDR Euro STOXX Equity fund
(NYSEARCA:FEZ ), also underlies a volatility index similar to the
(INDEXCBOE:VIX) , the VSTOXX, and futures thereon. These futures
can be added to STOXX-related investments to reduce overall
portfolio volatility. In addition, they can be traded against the
VIX, if you happen to have a trans-Atlantic volatility trade in
mind, or simply outright.
The forward curve of these futures behaves similarly to the VIX. As
the underlying stock index rises, spot volatility levels fall and
near-term futures decline relative to back-month futures. The
process works in reverse when the stock index falls. The chart
below highlights the ratio of January-April VSTOXX futures to
front-month December VSTOXX futures from late August onwards. The
ratios rose during the September-November rally and declined
quickly with last week's selloff.
The never-ending attempt to classify any volatility as high or low
is meaningless and therefore fully worthy of the human condition.
Implied volatility must be measured against a historic volatility
standard such as a high-low-close volatility that incorporates the
effects of both intraday range and interday change.
The VSTOXX excess volatility, defined here as the ratio of implied
to high-low-close volatility minus 1.00, jumps and jumps quickly
whenever the Euro STOXX 50 index declines. As volatility is bounded
on the downside, the jumps are very asymmetric. This is why even a
small addition of long volatility to an underlying portfolio can
reduce its overall variance of returns.
Finally, please note how far away the Euro STOXX 50 is from its
pre-crisis high; that high was reached in July 2007. The US market,
in contrast, has been making new highs regularly in 2013. As
investors' state of psychological loss is related to the
time-adjusted retracement of gain, a different measure of
psychological anchoring will be required for the VSTOXX. I will
address that in the near future.