The Truth about Volatility

The Truth about Volatility


O brave new world!

This is a bet that the S&P 500, currently at 3,200, will reach 4,000—by the end of the year. A 25% move in six months. As you can see, the probability of that happening is not zero.

The downside put options are also expensive—the probability that the S&P 500 falls to 2,000 by the end of the year is not zero.

It might be tempting to sell the 4,000 strike call options, and the 2,000 strike put options, which is known as “selling a strangle.” You’re betting that the market will finish somewhere in between.

That is not one of my favorite trades.

As everyone knows, stocks have gone up a lot recently. And volatility has come down, but not all the way down to historical levels. It is still quite high.

Just look at the CBOE Volatility Index (VIX):

The volatility market is smart. It knows that things haven’t completely returned to normal after the peak of coronavirus deaths. It knows that things haven’t completely returned to normal in the aftermath of the civil unrest. It knows that there is an election coming up, and there are a number of ways it could turn out, all of them bad.

Over the course of my career, I have morphed from a mean reversion trader to a trend follower.

Everything trends—including disorder.


Source: Alex Norris

Regimes in Volatility

Twenty years ago, former quantitative analyst (and physicist) Emanuel Derman wrote a seminal paper called “Regimes of Volatility” while working at Goldman Sachs. I read it when I was 26 years old, though I didn’t understand all of it then.

There are regimes in volatility—sometimes it is persistently low, and sometimes it is persistently high. It is low more often than it is high.

My take is that we recently passed from a low volatility regime to a high volatility regime—without really knowing it. What I mean is that disorder trends.

We are experiencing financial and social disorder. The two are related.

Sure, stocks have gone up, but that’s not the point—the point is the volatility. And as you know, there’s all kinds of weird stuff happening in the stock market, with day traders bidding up bankrupt companies like Hertz (HTZ) and SPAC electric truck makers.

Like what you're reading?

Get this free newsletter in your inbox every Thursday! Read our privacy policy here.

Things are a bit crazy right now. Would you bet on:

  1. Less Crazy
  2. More Crazy

The answer is b. Things will definitely get more crazy.

I spoke to my mom the other day on the phone, who told me that the protests following the death of George Floyd were bigger than what she experienced during the Vietnam War. And those protests are pretty well-known.

People think of the late ‘60s as a time of great social turmoil. This was also right around the time that stock markets peaked:

You Don’t Want to “Sell Options”

You don’t want to sell any options.

A lot of people don’t realize there are a lot of ways to sell options that don’t involve actually using options.

  • When you buy a corporate or municipal bond, you are selling options.
  • When you buy an index fund, you are selling options.
  • When you buy a stock that is conducting a share buyback, you are selling options.

I talk a lot about how you should build a portfolio that gains from disorder.

One thing I recommend doing is stress-testing your portfolio. What will it look like with stocks down 30%? What will it look like with stocks up 30%?

But stress-testing doesn’t even cover it. Stress-testing wouldn’t have predicted price movements in the early weeks of COVID-19, when the credit markets crashed and seized up, and the airlines nearly went to zero. Stress-testing wouldn’t have predicted what happened after that, either.

The point is that you want to own optionality, rather than be short it.

In finance circles, this is the conventional wisdom. People pay money for hedges all the time. But hedges are expensive, and people sometimes fall in love with their hedges.

2020

There are countless memes on Facebook and Twitter about how 2020 is the worst year ever. People were even talking about “murder hornets” for a little while.

But I look at it differently—it’s not the worst year ever. 2020 is the most volatile year ever, and people are uncomfortable with volatility. I happen to thrive in volatility. It’s been a pretty great year.

There are two types of people in finance: people who understand options and people who don’t. The people who don’t are missing out on 90% of the story.

Options were the first thing I learned about in finance, and it shaped my entire view of risk and reward. People who don’t understand options see the world in a very linear way. Options traders understand nonlinearity. They try to gain exposure to it, rather than being exposed to it.

If you can’t handle a second iteration of what happened in March, cash is probably a good place to be.

Like what you're reading?

Get this free newsletter in your inbox every Thursday! Read our privacy policy here.


Jared Dillian

Tags

Suggested Reading...

Pre-order
Jared Dillian's
NO WORRIES

 

FIRE Is Impractical
and Objectively
Wrong



Discussion

We welcome your comments. Please comply with our Community Rules.

0 comments

Apostolp@aol.com
June 30, 2020, 1:28 p.m.

Hi Jared! It would be great if you put together an Options Masterclass!

jack goldman
June 11, 2020, 9 p.m.

The truth about gold and silver? Debt notes are a false system of weights and measures used to grossly distort the US economy from August 15th, 1971 to 2020. We are living a lie, measuring prices in false and illegal debt notes. The real weights and measures system is gold and silver. Gold and silver reveal stocks and wages have fallen 50% from 1966 to 2020 in the REAL world, down from 28 ounces of gold to 14 ounces of gold. We are living a lie using debt notes. We go mad in crowds and come to our senses one at a time. How do we go bankrupt? Slowly at first, then very fast. It is sad what the failed baby boom is doing to their children. May God forgive the baby boomers of their sins.

terencew@digitalcreations.net
June 11, 2020, 5:48 p.m.

The article was good mostly because it confirms my belief in options..it can get nerdy and it is not the prime focus of most little guys like me. I have been successful in getting 5 figure returns trading options, yah blind squirrel maybe, but it is powerful and exciting work.
The election..both sides bad..sorry about your depression..it passes.

lawyerew@verizon.net
June 11, 2020, 2:38 p.m.

I don’t understand your “selling options”
When buying bonds or index funds section in the article. Could you please explain and/or recommended a book? Thanks.

Jeffrey Calkins
June 11, 2020, 1:49 p.m.

Selling options has it’s place.  If you are an active investor, BUY the 2000/4000 strangle you mentioned at the top and sell front month ATM options to take advantage of high volatility. With your longs that deep ITM the risk is minimal and you are guaranteed to collect on one short leg every month.  Roll, rinse and repeat, and consider it one long trade.  If you are a passive investor with a long time horizon, selling OTM puts on down days with high vol is a good way to leg into a position, particularly if you are using 1 lots.

The 10th Man - Jared Dillian

Recent Articles

Archive


Interviews with leading experts digging deep on the most urgent stories you need to know about. Get Global Macro Update Interviews with leading experts digging deep on the most urgent stories you need to know about. Get Global Macro Update

The 10th Man

Fundamental investing and technical analysis are vulnerable to human behaviour—but human behaviour itself is utterly predictable and governments' actions even more so.

Read Latest Edition Now

What you always wanted to know about investing, but that you didn’t know to ask

Get Jared Dillian's The 10th Man

Free in your inbox every Thursday

By opting in you are also consenting to receive Mauldin Economics' marketing emails. You can opt-out from these at any time. Privacy Policy

×
The 10th Man

Wait! Don't leave without...

Jared Dillian's The 10th Man

Instinct and financial experience combined by a former Wall Street trader and served in one of the industry's most original, entertaining, contrarian voices. Get this free newsletter in your inbox every Thursday!

By opting in you are also consenting to receive Mauldin Economics' marketing emails. You can opt-out from these at any time. Privacy Policy