DDIntel - Volatility, Yield, and Global Macro

You might think stocks go up or down, and that’s the end of the matter. Bears and bulls battle it out to determine market direction. But there’s another bear bull battle that is arguably more important for determining stock prices, and that’s volatility.

Volatility is simply a measure of how fast stock prices are changing in a given time period. In mathematical terms, the change in price is the “first derivative”, and the rate of change in the change of price (i.e. volatility) is the “second derivative”. In physics terms, the price change is the velocity, and volatility is the acceleration.

Just as traders make directional bets on stocks, some traders make directional bets on implied or expected volatility. On average, most of the time, implied volatility is greater than actual volatility, meaning what the market expects volatility to be is greater than what it ends up actually being.

Why is this the case? In general, since investors are risk averse, they buy “protection” against major market moves. Like life insurance, most of the time, the insurance companies (in this case, options sellers) collect revenue to offer this protection.

However, there are of course periods of time when volatility spikes, and consequently, those long volatility can reap massive rewards. A financial hurricane of sorts. How does one short or go long volatility? Well, the VIX is not a tradable instrument, and the VXX has a significant downward bias, making it unsuitable for anything but a short term play. 

Therefore, typically, investors who expect actual volatility to be larger than implied volatility are options buyers, while investors who expect implied volatility to be larger than actual volatility are options sellers. There are many different strategies and approaches to trading volatility, such as buying or selling straddles, buying or selling tail end options, and so forth, but these are beyond the scope of this DDIntel.

Instead, we would like to bring attention to the interplay between volatility and yield. Yield can mean many things; most broadly, yield means return, but usually, when investors refer to yield they are talking about interest rates or bond yields. 

Interest rates are likely the most important macroeconomic determinant of economic activity and asset prices. From interest rates flow inflation, bond yields, government and private financing activities, and more. 

Typically, volatility spikes when markets decline, and bonds usually go up when stocks go down. Therefore, volatility is typically positively correlated with bond prices. But this wouldn’t be DDIntel if we didn’t point out that this relationship can break down, as happened in 2020. If recession expectations shift or Federal Reserve policy changes, then all assets can rise or fall in tandem. Cash can be king. Or trash.

This week’s graphic contains a comparison of the VIX with the US 10 year Treasury in the background, and in the foreground, there are a pair of hands manipulating a ball of energy, which is meant to symbolize volatility. The hands represent the market’s attempt to manipulate volatility, an imperfect and not always successful operation. The outer energy bubbles represent tail options that can be highly risky, but also highly rewarding. 

Volatility and Yield. Two of the most important and misunderstood asset price determinants. An elegant yet delicate interplay. This week’s DDIntel covers 8 top recent articles generated by the DDI community. Read on to learn about indicators for value investors, inflation in Germany, why most forecasters fail, and how to use Google Sheets to make a pricing api for financial analysis. 

Whether you’re dabbling in options strategies or want Warren Buffet to teach you how to read an annual report, this week’s DDIntel has got you covered. Be sure to subscribe, forward this to others who might like it, and check out our previous issues. You may also want to learn about how to work with DDI here.

Venture capitalist Amit Garg shares his insights into healthtech startups and business models. Not only does he include a helpful appendix of acronyms, but he breaks down the healthcare tech space into its first principles. You either get the customer to pay, get someone else to pay, or sell data. Welcome to US healthcare capitalism.

Did you even know you could use Google Sheets to get US stock prices? Well, not only can you do that, but software engineer Minhaz Vadakekara shows how to get commodity prices such as gold or silver as well. For those of you looking for a productive introduction to macros, not the economic one, but the modern way of enhancing spreadsheet functionality, check out this in depth coding tutorial.

In the latest sign that inflation is an international problem, Germany posted their highest inflation numbers in 70 years. The ECB no longer believes that inflation is transitory. As such, expectations for a 50 basis point hike have increased.

Here, author Arslan Mirza explores whether or not China needs to continue holding onto its $3 trillion in US foreign exchange reserves. From a strategic perspective, China must consider its geopolitical alliance with Russia, as well as its competitive/cooperative dynamic with the US. Mirza argues that it is important for China to strengthen its industrial independence, and the “de-dollarization” may just be the right approach.

Warren Buffet and Jeremy Grantham are two of the most successful investors of all time. Their secret? Value investing, or looking for high quality companies that are considered “undervalued” by the market. How do they determine if a company is high quality and undervalued? Well, they look at things like those 8 indicators outlined by Chief Architect at IBM, Thomas Reinecke.

Speaking of Warren Buffet, Jason Huynh outlines how to read annual reports using lessons learned from Buffet. From providing a checklist of metrics to explaining how to read the CEO and Chairman’s letter, Jason articulates in simple terms how to understand one of the most important financial measuring rods: a company’s annual report.

Private sector economist John Krompas explains why even the best economic forecasts fail. It comes down to concepts known as endogeneity and reflexivity. Essentially, the forecaster, especially the more successful, must anticipate the market reaction to the forecast itself! Read on to learn more about economic forecasting.

Trying to learn more about options trading? Check out Mike Toney-Hoffman’s strategy of selling put options on the SPY. Consider it a turbo charged long portfolio. You might think this strategy would break during bear markets, so read on to check out what technical indicators he uses to ensure tolerable risk management.