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.
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