Volatility: the tail that became smarter than the dog — a data-driven visual essay
In the 1990 film “Goodfellas”, one of the most memorable scene is the one where Henry Hill (Ray Liotta) and Tommy DeVito (Joe Pesci) get into a tense exchange in which Pesci asks: “Funny how?”
The feeling of unease is not unlike what an investor can experience in the stock market, watching his portfolio go up and down in value rapidly. The Oscar winning performance from Pesci, while it can’t be measured is the epitome of a volatile character.
Unlike other financial concepts, with volatility you can be clueless about mathematics or finance but still perceive it very clearly. In fact you can feel it if you are invested in the markets, or in your daily life.
The concept of volatility is both familiar and abstract, however in financial markets it has also acquired physical presence. Over the years, volatility has evolved from a proxy for risk, to an actively traded instruments, to a physical impact on the markets it was measuring (a tail that wags the dog).
Below is a brief timeline of how this evolution occurred and how volatility’s presence grew.
1950s: Maths enter the financial world
As the Dow soared to 500 people started getting excited about investing (today it’s at 24,000 and on 2 march 2018 the dow moved by over 500 points).
At the same time future Nobel prize winner Markowitz introduces volatility as a proxy of risk in his Modern Portfolio Theory. Based on its historical moves the more volatile a stock is, the riskier it is meant to be.
With diversification, you can get better return for the same risk or same return with lower risk. Thus a portfolio manager would have to look at how the different components would behave together.
Investment was no longer just about picking the right stocks, instead it became about finding a combination of stocks and other assets that would place the portfolio on the elusive “Efficient Frontier”.
In terms of risk adjusted return the Efficient Frontier would outperform all other combinations.
If it was a cyclist the portfolio would go as fast or faster for the same effort:
This new idea proves so successful that it changed the way we approach the stock market forever.
1973: Theory becomes practice with the Black Scholes Merton model
Three academics introduced a way to price options with a formula based on volatility, derived from Brownian motion which is used for particle physics.
Volatility is a key component of the formula. However it was no longer the observed volatility, instead it was looking into the future. In other words it evolved from something measurable, historical to something forward looking, hypothetical. It is called implied volatility but I will use “volatility of the future” just for the purpose of this write-up.
The model was a perfect blend of theory and practice which provided a theoretical basis for the boom in options trading and derivatives that was about to follow.
The same Black and Scholes went on to become directors into a new company that launched in 1994 to apply the cutting edge mathematical approach to finance they had introduced to the world: LTCM
In 1997 they received the Nobel Prize.
In 1998 LTCM crashed spectacularly.
However that didn’t stop the derivatives market to continue their spectacular growth.
1992: Volatility becomes visible with the VIX
Implied volatility is useful to investors, as it gives them a way to gauge the market environment, yet it was not easy to follow it until the introduction of the VIX by the Chicago Board Options Exchange (CBOE).
Suddenly volatility appeared, like a lightsaber.
The VIX was constantly referred to and earned the nickname of “fear index”. Yet it was just that, an index, a calculation.
There were no “pure” volatility contracts that investors could trade.
2004: Volatility becomes tradable with VIX Futures
Until someone who wasn’t from a finance background but asked Goldman Sachs if it could be done. That person was newly minted billionaire Mark Cuban, who apparently doesn’t mind risk.
The investment banks invariably find a way and VIX Futures were developed at Goldman Sachs by Sandy Rattray.
In other words, a derivative on the volatility of the future was now available. In a different world the VIX Futures pitch may have gone a bit like that:
But in the financial world it was a tremendous success:
The 2008 financial crisis slowed the growth of derivatives but it was just a pause. In fact the VIX was about to see another major development.
2009: VIX for everyone
With the launch of VIX Exchange Traded Notes (ETNs), everyone could trade the underlying as simply as funds and shares, with products such as VXX. What was marketed “as access to the VIX” was available for mass distribution.
Was that such a good idea? Now we just need to take a moment to consider how those products work.
- Futures are not the spot and the same thing so the tracking error is huge.
2. The VXX underperforms the VIX because the futures are higher than the spot so it’s a case of buy high sell low
In turn this characteristic prompted to create Inverse VIX products such as the XIV, which performed well until it collapsed.
3. The reason for the collapse is that by nature volatility can vary greatly by 100% in a day compared to a few percentage for the equity market. When the VIX spiked in February 2018 it wiped out the XIV.
2018: The tail that became smarter than the dog
Why does a dog wag its tail?
Because a dog is smarter than its tail.
If the tail was smarter, the tail would wag the dog.
As the activity increased on the VIX, market makers ultimately have to hedge dynamically on the equity markets. This is how volatility itself started moving the markets. Or in the words of VIX Futures inventor himself in an FT article from February 2018.
If the tail was wagging the dog before, you didn’t notice very it much. What happened on Monday was the tail grabbed the dog and gave it a swing around the room.
This new market regime has prompted some industry veterans like Carl Icahn to wonder if this is the most volatile markets ever observed (Answer: it’s not really, but it still feels like something has changed).
What is the future of the volatility of the future?
The latest developments pale in comparison to the previous volatility-related crisis, LTCM or the global meltdown of 2008. However it could be the first example of volatility-induced effect on the market. As the volatility tail became more accessible, it also became more complex — or smarter — and more impactful on the markets.
After the global financial crisis of 2008, financial engineering and innovation had to take a step back. Now banks are back in profit and finance is also back in its innovative ways (Bitcoin futures have launched and there are talks of Bitcoin volatility). There are also increasing talks of regulation but not from the main players.
This could be exciting to watch, from the sidelines.
