Final Post on VIX Until Next Crisis + Other Disquieting TopicsSPCFD:SPX CBOE:VIX
I know, I know, I'm presenting yet another obvious finding suggesting problems with volatility in today's market. This will be my last post on the subject and then I leave the rest to the higher powers that be. No more volatility-speak until the next currency/credit crisis, I promise.
In the paragraphs below, I am going to do my darndest to swiftly dismiss all rationale for the apparent discrepancy displayed above, from both a functional standpoint and an ethical standpoint. I am not complaining or ranting; my only goal is to present my observations, provide my sincere analyses, and pose difficult questions that probably do not have such simple answers.
First, let's address the chart above - how can anyone justify that this week's price "volatility" is at similar levels as those measured in MARCH? The only thing that I can say with certainty is that it absolutely "should" not be - because there is no justifiable reason for it. There are, however, a few or more unjustifiable reasons for it, but let's prove out the lack of justifiability first; both quantitatively and qualitatively.
1) Actual Quantitative Definition: Volatility = sqrt(price variance)
So the S&P ranged tightly this week within ~150 points of the open. Does this price action suggest more price variance than pre-Covid S&P? Maybe, but not much though. Does this price action suggest more price variance than the circuit breaker weeks in March? No, it absolutely, unequivocally, in no way, shape or form could it possibly be compared with those weeks, mathematically or otherwise. But, especially not mathematically. Not going to belabor this or argue about whether math/logic is a sound basis for argument since I'm assuming it is.
2) Qualitative Arguments: I would venture to say that it's even harder to believe that market-wide "fear" is even close to that of the start of this entire selloff. We ranged within ~150 points this past week. We had multiple circuit breakers during the same week in March. So then maybe people are fearful of an economic depression? I'm going to go with no on this as well given that corporate profits seem to be ever-increasing. Perhaps it is because they no longer have a huge line item that requires to pay their employees relatively high amounts to do what the computer can do for 1/1-fraction of the price. It's a sad truth, but it seems to be a truth that was bound to emerge sooner or later.
You can still argue either of the above, I guess, but I'm going to move on to the next part of the story: the revised mathematical logic used to calculate implied volatility across indices and (perhaps) even individual stocks.
Goldman Sach's Revised Approach to Volatility Futures: See link for the white paper and for reference calculation. I'll save you the time. GS revised the way VIX futures are calculated based on the difference between the weighted average strike of the most out-of-the-money calls - most OTM puts. This difference IS the problem. While I do find this approach to be a clever way of determining market sentiment and predicting "implied volatility", it is totally inappropriate for aggregate markets. At best, it might be a reasonable experiment to test on low float stock options on an individual basis. I'm a firm believer that volatility is never implied and should not even be attempted to be quantified by a system, much less implement it blindly.
But other than my opinion, why is this objectively bad? Because by the GS redefined volatility calculation, volatility is now mostly a function of out-of-the-money options on SPY . So... now the problem reveals itself. Clearly the millions of unemployed Americans are taking absurd positions in all sorts of stocks and futures, which is artificially keeping volatility higher than it should be and is the reason why current levels of volatility are not reflective of actual, mathematically-derived price variance.
Now that I've called out one culprit, let's name some more names, shall we? The ultimate responsibility rests on the shoulders of the self-regulatory body called the CBOE. GS merely came up with a clever solution, acting in a consulting capacity. While their logic may be causing big problems, the CBOE's gross negligence is nothing short of shameful. Not accusing them of corruption, but at the very least, they are THE institution to get pissed at here. But, gross negligence isn't as bad as taking advantage of gross negligence. Enter your friendly broker-dealer that get's randomly assigned to be the D. Market Maker by the CBOE.
To know whether MMs are taking advantage of this situation, you needn't look farther than the prices on OTM contracts for popular individual stocks; they are in some cases laughable and other cases totally impossible to reach. These "impossible to reach" contract premiums are where I draw an ethical line because, while I am not buying them, there are millions of Americans who are. The millions of unemployed, including recent college grads with no career prospects, have just entered a world of quarantine and were given 1,200 dollars (minimum) to do "whatever" with during their time in solitude. Meanwhile, a neat little brokerage firm called Robinhood makes it as easy to obtain a margin/options account as it is to obtain a mortgage from Rocket Mortgage (a close second in terms of disturbing financial topics). In any case, the masses of bored, quarantined people are now almost certainly going to give the 1,200 dollars back to the government via Robinhood because they 1) Don't understand how options work 2) Are almost exclusively buying lotto puts and calls and 3) Are apparently only purchasing fewer than 5 contracts at a time (way OTM), which means that they absolutely have no basis for purchasing them other than to pass the time.
Back to the prior paragraph, Market Makers who set contract premiums are making a fortune taking advantage of those that need hope the most. As a weekly swing trader who's been at it for some time, I am quite sure that if my very reasonably close OTM options are expiring at breakeven week in, week out, over the past month, then there is absolutely no chance that the farther OTM contracts are getting there.
How can I be so sure that demand for such ludicrous contracts exists and that MANY people are losing actual money this way? How can I say these things without considering an alternative explanation? That's right, you guessed it.
Because friggin VX futures are still trading above thirty-friggin-five and by the very mathematical definition described above, must necessarily make the aforementioned assumptions true. Put it to you this way: if it doesn't, then there are far bigger structural problems coming our way.
Thus, we have the cycle of volatility and exploitation that I've seen transpire over the past 4 months. Many different players are involved and have every incentive to keep quiet. Even though I'm a pig, I find this to be as disgusting as it gets. While I am not certain of these things, there is quite a bit of mathematical, inexorable evidence, which I have touched upon in this piece already and plenty more that I have well documented empirically. Also, it's hard to argue when there was such obvious Oil manipulation a few weeks back (Oil futures prices should never go below zero). Moreover, I must assume that general market manipulation is at all-time highs across the board. Nobody is really watching right now because of this virus and other social issues, which means it's an ideal time for exploitation. In order to even start to fix this (ethically and functionally), the following needs to happen at a minimum:
1) Thorough Audit of CBOE and Subsequent Public Trial
2) Get rid of all volatility derivatives and perhaps even the VIX itself. Don't really understand why it exists in the first place
3) A total restructuring of how market makers are able to price options going forward. They cannot simply say "implied volatility, so there" anymore
4) Regulate Robinhood the same way all typical brokerages are regulated
5) Change the definition of "typical" for the way most brokerages are "typically" regulated.
To finish whatever this post is, off, I will leave you all with this: I wonder what happens when implied volatility becomes more fact than obscure estimation? Will all prices become completely predetermined by some group of entities? If so, what does that imply about causation, and could such an abstract concept integrate tangibly?
Don't know, but I hope some of the world's brightest market participants, do.
