FTG Blog - Why Traders Are Worrying About Low Volatility

Why Traders Are Worrying About Low Volatility

Stock markets are a sea of green, punctuated by frothy highs as markets roll past shocks such as U.K. elections, North Korean missiles, Persian Gulf confrontations and tweet-storms from U.S. President Donald Trump. Normally, all that good market news would seem simply good, right? But a growing chorus of strategists, investors and even policy makers is fretting that there should be more downs to go along with those ups. They’re worried that what’s called volatility in the markets is too low — and that the low readings in market measures known as fear gauges could foreshadow a giant disturbance down the road.

1. What, exactly, is volatility?

It’s how much the markets go up and down. More precisely, it’s a way of measuring current or expected price fluctuations relative to the average level of price swings. Historical, or realized, volatility looks at how much a price has fluctuated over a given time. One notable example of volatility came with Brexit. On June 24, 2016, after Britons voted to quit the European Union, the pound swung between $1.3229 and $1.5018 – the sort of range that usually defines its highs and lows for a year. So 24-hour historical volatility for sterling reached a record 100 percent — basically, a year’s price swings in one day.

2. That’s the past. How do investors look ahead?

Nobody knows what the markets will do. But people are making bets all the time based on their guesses, and no one’s more honest about their expectations than somebody putting their money where their mouth is. Certain kinds of guesses can be read as implied volatility — implying how much traders expect a security to fluctuate. That’s the basis for widely traded indexes like the VIX (for the S&P 500 Index) and MOVE (for the U.S. Treasury bond market). They are seen as fear gauges because of the insight they give into traders’ worries.

3. How are those put together?

They’re mathematical constructs calculated from options, which are contracts that give the option holder the right, not the obligation, to buy securities such as the S&P 500 Index, Treasury bonds and currencies at set prices when the underlying asset reaches set levels. Traders often use these derivatives to hedge against market fluctuations. Options show how much they’re willing to pay to be prepared for certain outcomes.

4. How does that work?

The higher the price of the option, the bigger the fixed cost and therefore the larger the move needed to generate a return that will make it pay off. Say I decide to pay $5,000 for an option betting on yen moves, and let’s say that contract shows implied volatility is about 8 percent. If some other investor pays $10,000 for the exact same option, then the implied volatility level jumps to about 10 percent. (As for the way the model calculates volatility, and for why this is measured in percent terms, it relates to a complicated mathematical formula, which you can read about here.)

5. So it’s a fear gauge because it shows the price of worries?

Yes, options get more valuable when markets get more turbulent and the price of the underlying stock, bond, index, currency or commodity is moving. You pay more to hedge in a dangerous market, just like you pay more for car insurance if you are in your early 20s than if you’re 40 with two decades of a spotless driving record.

6. Why do I hear traders using so many Greek terms?

The Greeks? It might be better to ignore them. Part of the mystique of the options world is being able to reference a series of Greek letters: delta, gamma, theta and rho. There’s also vega, which sounds like it should be a Greek letter, but in fact isn’t. These all measure the sensitivity of options to changes in other variables. But if you’re not trading options yourself, don’t worry. Another term that comes up a lot is Black-Scholes. That’s the model used to price options, and therefore to produce the implied volatility that feeds into the VIX and other fear gauges.

7. So what does it mean that fear gauges are all so low?

Remember the Economics 101 lesson about how markets are driven by two opposing forces — fear and greed? The concern about low, or compressed, volatility is that the balance has tipped way over to the greed side. Historically, similar bouts have been followed by sudden turmoil – and a sudden rush to buy the insurance that investors realize they should have already taken out can exacerbate such moves. The VIX recently hit the lowest since 1993, busting through the lows seen in 2007 that were followed by the subprime crisis, Lehman Brothers collapse and the global credit crunch.

8. Does everybody think that?

Obviously the investors who keep making those trading screens light up green don’t. There’s a school of thought that the VIX isn’t necessarily any better at gauging apprehension than Wall Street’s real fear index — the S&P 500. Because options are complicated beasts, they are frequently cited by pundits trying to sound convincing. But 90 percent of the information contained in the VIX is visible in the S&P 500. There are others who think markets in general are going to be calmer. Some think that’s because we’re going back to the “old normal” of more stable global markets that prevailed before the great financial crisis. Others say we’re moving into an era where passive investing and trading done by robots is going to make the human error, and emotion, less of a driver of day-to-day market fluctuations than before.