For those of you interested in the nuts-and-bolts of
financial markets…
It’s been an insane few days at work for me, as I’ve been
trading, with something quite unlike success, the VIX. The VIX is
the CBOE Volatility Index, and you can trade futures or options on
it.
So, stay with me here for a minute:
The Standard and Poor’s 500 index is essentially a derivative,
derived as it is from the capitalization-weighted prices of its 500
underlying stocks.
Options on the S&P 500 are derivatives of the S&P
500.
The VIX index which measures the implied volatility of options
on the S&P 500 is a derivative of those options. However, there
is no way to trade the VIX index directly.
VIX futures and options are derivatives of the VIX index. (There
are also ETFs like the VXX which buy a time-weighted mix of VIX
futures, and are themselves derivatives of VIX futures, and there
are options on those ETFs! I’m trading those a little bit too. VXX
and other VIX-related ETFs have had massive volume in recent days,
with VXX alone trading over 45 million shares on Tuesday…more
than the total number of VXX shares outstanding as the product has
been a popular short-term trading vehicle.)
Therefore, this insane products that I’m trying to trade are
basically a 4th or 5th or 6th derivative of the stock market.
What is particularly crazy about these products is that they
measure current expectations of future expectations of market
volatility. That means that even if the market is calm now, where
you would normally make money selling volatility, if the market
expects turmoil ahead the VIX product will reflect that rather than
the current calmness.
And that’s just what’s happened over roughly the past week: The
VIX has gone up dramatically even though the market itself has been
quite dull.
Take a look at this
chart, and you’ll see a flat line in the S&P 500, but a
huge rise in the VIX. (At least if you look at the chart early on
Wednesday, you’ll see it. I can’t vouch for the trend continuing
for another day or more.)
So why is this happening? Seems like two main things:
First, fears that Greece’s financial situation will end in a
more disorderly way than previous thought, although news late
Tuesday seems to suggest they have the train nearly back on the
rails as far as getting a needed EU bailout.
And second, fears that the stock market may suffer from profit
taking after a 10 percent rally in the last two months.
The reason these translate into higher VIX values is that the
market usually becomes more volatile on the way down and less on
the way up. That’s not a hard-and-fast rule, but it’s more common
than not.
I’m still short this stuff, hoping that Greece, even if it
doesn’t get absolutely settled in the short term (and it won’t)
will come to be seen as a more isolated problem and not likely to
spill over into Italy or Spain.
The market seems to be betting that way at this point with
Italian government 10-year bond yields having
plummeted more than 20 percent, from above 7% to below 5.5% over
the last month, including a solid bond
auction on Tuesday. Spanish government 10-year bonds at about
5.3% yield are also well off their high yields over 6.5% reached in
late November.
All this as Greek bond yields remain
just below their all-time highs, with the 10-year closing Tuesday
around 33 percent yield. The rate on the 2-year note is an
astonishing 184% as of late Tuesday.
[For those who want a little bond math: The reason for these
very high rates is that the Greek government will never redeem
these bonds for their full face value. The market understands this
and is pricing these notes and bonds as if they’ll eventually be
worth not more than 30 percent of face value, and perhaps
substantially less. There is in fact a real chance that they will
become worthless, though that is not the most likely scenario. So,
for example, imagine there is a government two-year note that was
issued with a 5% coupon with a $100 value. If you buy this bond,
you get interest of $5 per year, and at the end of the bond’s life,
the government then gives you that year’s $5 plus the $100 face
value. If, however, the market comes to realize that the government
will only pay back $30 rather than $100 at maturity, then the bond
will trade for something closer to $30…a little more as investors
believe the annual interest payments and $30 principal payment at
maturity are safe, and less as they question the likelihood of
those payments. If that note is trading at $25, then the apparent
interest rate on it is roughly (100/25) x 5%, or 20%. This is
what’s happening to Greek debt, as the market remains worried that
neither the $30 principal nor the $5 interest payment are safe. The
plunging prices making it appear that investors are getting
enormous interest rates whereas they’re just hoping to get out of
these things without losing too much more money.]
In other words, the market seems to be thinking that the
Italians and Spanish may have things well enough under control that
a Greek default (which seems likely even if they get a temporary
shot of capital from the European Central Bank or the EU) will not
turn into the first domino in a longer chain of sovereign debt
failures across Europe.
An investor interviewed on CNBC on Tuesday noted that Greece’s
population was about the size of Los Angeles’ population, and that
Greece’s budget was about the size of Philadelphia’s budget. His
point was that this need not become an issue of “contagion”.
I think that prediction by the market is better than 50/50 to be
correct, but the uncertainty sure does make for difficult trading
for someone selling VIX-related products. Perhaps I should be
buying stock in companies that make blood pressure medication
instead…
