Schaeffer's Trading Floor Blog

What's Next On the Volatility Front?

The issues with being overly prepared

by 5/7/2014 7:27 AM
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So, what's next on the volatility front? Minyanville's Todd Harrison has these thoughts in his latest missive:

One last thought on volatility, which has seemingly compressed across asset classes. I don't think this is a coincidence: In our interconnected world, global asset classes are tied together in some way, shape, or form. It stands to reason that as volatility in one complex is muted, it transcends others.

Conversely, when we see volatility pick up -- and that could happen at any time -- we'll see that spread like wildfire around the world. The time to prepare for that is before it happens, via right-sized risk and particular discipline in your approach.

I agree with Todd's basic point, I'd just warn there are risks with preparing a bit too much.

Volatility across asset classes gets more interconnected by the day. A blip in credit markets across the globe will slosh over to our markets faster than I can type this paragraph. Especially now that we're hearing credit players directly hedge with CBOE Volatility Index (VIX) paper.

And volatility can blip up at any moment for any reason. And those blips can go further and last longer than we might think at first.

Always keep in mind that when options and/or volatility exchange-traded notes (ETNs) are in the mix, time is literally money. Basic put options decay over time. So do VIX calls. VIX ETNs virtually always decline over time thanks to the standard contango in the VIX futures term structure. And VIX futures themselves already price in a rise in VIX over time.

So, no matter where you turn, there's a cost associated with hedging against future volatility pops. That's fine and understood, but the problem lies with going to that well too often, i.e., rolling any of these instruments. It's nice to own some protection when the next storm comes, but the issue is more how much did it really cost net-net to own that protection. And if it takes a while to play out, it's possible you were better off missing the bottom in volatility, and then chasing it after the pop has already started.

The devil is always in the details. And everyone has a different risk tolerance. Volatility pops do happen, probably about three times a year or so, but at irregular intervals. All I'm really saying here is that it can get quite costly to pre-anticipate those pops.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.

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