Derivatives of Derivatives - The American Spectator | USA News and Politics
Derivatives of Derivatives

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…

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