Some days you lose a million… other days you find six figures.
In financial markets, the connotation of the word “volatility” changes depending on where you’re hanging out. If you’re at a midtown Manhattan happy hour on a Thursday firing back a third scotch on the rocks – volatility sounds like a great thing. But if you’re drinking beer with a doctor, an accountant, and an insurance agent at a backyard barbeque in the suburbs – well, it doesn’t feel so great.
Typically, traders love volatility and investors hate it…
For traders, volatility creates far more opportunities to “scalp” a quick trade. Stocks move intraday, and they can get in and out, making money.
But for investors, it makes it much more painful to hold on to smart investments. It can sometimes even force positions to get closed out prematurely. That usually results in generating a loss or no gain, even if the idea ultimately proved correct.
Regardless of your opinion on volatility, the one thing we can say for sure is that it’s back.
The CBOE Volatility Index (VIX) is the most common tool to monitor volatility. The index reflects option traders’ collective expectations for the S&P 500 Index volatility in the coming 30-day period by using both calls and puts to calculate it. The VIX is also sometimes synonymous with “market risk,” and called the “fear gauge.”
There have been a lot of factors behind the recent increase in volatility. Mostly, the newfound fear in markets is due to concern over higher interest rates. We also have a Fed chairman in place who doesn’t care if the Dow is down 1,000 points in a day. So within the Fed, there’s a new tolerance for volatility… that’s putting an end to a recent thriving trade of “selling volatility.”
Traders selling volatility helped keep VIX levels at historic lows because they kept selling it, month after month. But now, it feels like the Fed is finally taking off the training wheels.
After nine years of stimulus, it’s warning that central bank balance sheets are going to be lighter and interest rates are going to be higher. The Fed is pulling away the security blanket. And the easy trade of selling volatility is over.
The recent interest-rate hikes were broadly expected and the markets took it in stride. But there’s a concern over how many more there’ll be this year. And now with whispers of trade wars, technical analysis weakening, economic data so good it doesn’t leave room for the upside, extremely high valuations, and almost too-bullish market sentiment, volatility is on the rise.
Traders love volatility and investors hate it.
This doesn’t mean the bull market is over. It just means we’re in a different kind of market. Something more like:
The bull market isn’t over – is it? No. It can’t be. But maybe it is. Perhaps I should sell some stock. Oh, my God, the market is going to zero. Stop. That’s crazy talk – this is a buying opportunity. Right? I should buy a little and see how the market reacts. Crap – I missed the rally, but now it’s too late. What should I do? I don’t know if the bull market is over.
That’s what a volatile market feels like.
And much like there are two sides to every trade, there are also two sides to volatility.
The Downside of Volatility
Right before the market closed on December 11, 2008, I pulled up my book of positions on the computer screen. The one I was watching closest was my most recent trade.
I’d shorted 5,000 SPDR S&P 500 Fund (SPY) puts late in the day at $1. The market had taken it on the chin yet again, this time because of worries that the $14 billion auto rescue bill wouldn’t pass in the Senate due to Republican opposition. SPY was down almost 3%.
I shorted the out-of-the-money puts because I thought the market was oversold. And the options were super-expensive due to the volatility. The time premium in them was essentially nil because the options expired the next day. All I had to do was wait 24 hours to collect $500,000 of premium. I was set to make easy money unless the market blew up on Friday.
Remember that volatility isn’t good or bad. It just is.
I had a scheduled day off the next day, so I decided to meet my friend Steven after work. We met up at the movie theater at Kips Bay. After buying a small popcorn, Sour Patch Kids, and a medium cherry ICEE, we found our seats near the back of the theater. As the previews played before Slumdog Millionaire, I checked my phone one last time to make sure nothing crazy had happened. That’s when I saw the headline: “Bernie Madoff Arrested in $50 Billion Ponzi Scheme.”
That can’t be good, I thought, especially after the year we’ve had so far. The market felt like it couldn’t take any more bad news. But surely it was an isolated event without major market implications. So I put my phone away and watched the movie.
That night when I got home, I tried to see if the news was affecting markets overseas, but it wasn’t clear. My best course of action would be to let my short puts ride.
The next morning, I called my assistant to check in. She started whispering to me on the phone. It was hard to understand what she was saying, but when she repeated herself, I heard it loud and clear… “The risk manager covered (bought) all of your puts on the open,” I screamed NO, but it was too late. The market had initially opened lower on the fear of the Madoff news, and my puts had gone from $1 to $3. At the time they were basically at the money, so the $3 they were priced at was all volatility. And I’d just clocked a $1 million loss.
SPY closed that Friday up 0.7% because investors cheered the Treasury Department’s suggestion that it might step in and bail out the troubled automakers. The White House said it would consider using some of the money set aside to help banks and Wall Street to bail out the auto industry. And the SPY puts I had sold closed at $0 – meaning I would have made $500,000 if they weren’t repurchased on the open.
The Upside of Volatility
In spring 2012, I visited my old office at Morgan Stanley. I was doing some reminiscing research for my book, The Buy Side. I was connecting with former colleagues about the old times – playing the “remember when” game. I walked over to my old group of brokers and sat down next to my friend Michelle. We’d worked together, and she was still there. We were chatting about the time I hid under her desk and made her think a mouse was biting her feet when Todd, a broker, walked up to us.
“Hey Turney,” he said. “I was hoping you could sign this change of address form.”
I had no idea what he was talking about.
Todd was my broker when I worked at Morgan Stanley, and I left my account there for several years after I left the firm in 1999. But in 2007, I pulled my account because I wanted to consolidate my money in one place. After explaining to him that it wasn’t necessary for me to sign the form because I didn’t have an account there, he persisted. So I walked over to his desk to take a look at what he was talking about. He pulled up my account on his computer.
Apparently, I only pulled some of my money… for whatever reason, I had decided to leave shares of the VanEck Vectors Biotech Fund (BBH) and SPY in my account. Forgetting about brokerage accounts tends to happen when you’re struggling with addiction issues.
But Todd showed me that the value of the account was more than $120,000. It was like I’d just found six figures on the ground.
Then Todd pulled up a chart showing me the value of my account over the years. During the financial collapse, it had gotten as low as $40,000.
It’s impossible to know what I would have done if I knew about the account during the volatile market meltdown, but I can safely say I wouldn’t have pulled $120,000 from it today. So by unknowingly ignoring that volatility, I maximized my profits.
The Market Has Changed
So what should you do in this newly volatile market?
Remember that volatility isn’t good or bad. It just is.
Your style of trading and skill set will determine if you like volatility or not. But the ability to recognize a shift or an inflection point in a changing market is the key to success. And being able to adjust to that change is truly a talent.
I’ve seen far too many people blow themselves up by trying to change their stripes completely. That usually never works. The market has changed – have you?
Turney Duff is a former trader at one of the biggest hedge funds in the world, the Galleon Group, where its founder and several Galleon employees were found guilty of insider trading. Turney rose through the ranks and then fell prey to the trappings of Wall Street: money, sex, drugs, alcohol, and power. Turney chronicles his spectacular rise and fall in his bestselling book, The Buy Side: A Wall Street Trader’s Tale of Spectacular Excess.