Volatility for Sale
The VIX has recently been recording record lows, and even if it went up to 12.57 on Friday, 10th November 2017, due to jitters caused by the news of a probable delay in a cut in the corporate tax rate, it is still very low historically. The VIX has been taken to indicate the fear of investors regarding trading, and it can also be a measure of complacency.
It is important to keep in mind that the VIX is the basis for the determination of the prices of puts and calls in the derivative market. Low volatility means lower prices for derivatives while higher volatility results in higher prices for contracts. The derivative market is huge. Currency and credit derivatives in the US in 2017 amount to $557 trillion. The US national debt is now over 20 trillion, and that is 105% of GDP. The Forex market is about 5 trillion daily and is considered the largest global market but is small in comparison with the stakes at risk with derivatives. The market capitalization of the NYSE was 21.3 trillion in June 2017. These figures make it clear that the derivatives market is far larger.
As long as volatility remains more or less constant, traders can make money selling options since the strike price will rarely be reached, and the option will expire worthless, thus ensuring a neat net profit on the sale. When, however, volatility suddenly shoots up and lots of options are exercised because the strike price has been reached, the seller risks losing a lot of money since options are usually covered only on margin. It is thus to the advantage of traders selling options that “buying the dip” is incorporated in the algorithms that now account for about 60% of the trading done on the market. If stock prices do go down but are immediately brought back up by preprogrammed buy orders, then the risk of losses in trading is lessened.
The possibility of a “flash crash” is, however, not entirely eliminated, and it is to be expected that when a correction of more than 3% occurs or worse, a crash comes, then it will come very quickly as computers work in nanoseconds. The damage will have been done before anyone can react, and that means that in a worst case scenario the market will be automatically closed in the event of a drastic fall in prices for any single session. The shock could obviously influence trading in subsequent sessions.
Be that as it may, the number of market observers who expect a correction has been increasing while others claim that the market still has room to move upwards. The question is how high the market can go before the bulls begin to falter. Traders and investors will have to watch volatility closely to avoid being caught off guard.
Walter Snyder
info@swissfinancialconsulting.ch
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