2005 Volatility

Markets in review

Michael Wexler, Fund Manager, Maple Leaf Capital
Originally published in the August 2005 issue

Speculators and hedge funds continue to flounder in stagnating markets, with results for the first half of 2005 broadly +1.5%, barely unglued from the zero level by a surge in equities in June that floated all ships with beta. Investors have complained little, likely with bigger problems to worry about given some of the sizeable hedge fund implosions this year in Europe. But this respite from criticism is temporary, and participants must look hard at the causes of this pause in performance. In fact, they have not only themselves to blame, but also the market itself – a lack of inspiring opportunities from financial Mother Nature. Opportunities to position or trade successfully in the volatility space, or any other for that matter, have been rather few. The markets have simply been dull.

There have been three major events in financial markets this year, widely discussed and monitored.

First the US dollar has rallied

While everyone loved to hate the US dollar in 2003 and 2004, the greenback has surprised and strengthened so far in 2005, albeit at a modest pace – up 7.5% against the Yen, 11% against the Euro, and 7% for the dollar trade-weighted index in six months. This has worked well for some macro funds, and most trend followers have joined the fray and finally started to profit at some point along the way. However, the modest pace of the rally without much whipsaw action (five of six months dollar positive, max 3.9%, min -1.3%) meant few vol trading opportunities and, as is typical in FX derivatives, few gross imbalances between realized and implied volatility.

Second, the bond 'conundrum' coined by Greenspan

Is it pension flows, global savings, Asian buying, long term deflation, lack of corporate investment?

Everyone has their opinion now, although few of the explanations are truly satisfying. As far as trading opportunities, there was surprisingly little market movement linked to this whole subject. A few blips as Fed governors made comments, and as the big investment houses threw in the towel on their long-term bearish bond views, but generally just a lot of scuffling around as everyone looked for a trend to emerge; reversion to 4.20% US 10yr has held magnetic.

Third, the blow-out in credit spreads in April

Catalysed by the long awaited GM/Ford news, this has certainly been the talk of the hedge fund world as many famous sizeable funds were handed their heads. Amazingly, there was very little follow-through to other asset classes. While there unfortunately isn't yet a developed market in credit volatility (this will come in 2006), of the major areas for trading volatility FX, commodities, and FI were entirely unaffected, and equities had a blip, a modest blip. The VIX index popped from 12 to 17 in mid April as the S&P lost 3.7% in three days, but gave it up in late May as people realized it wasn't an LTCM type contagion event with systemic implications and the 'hedge fund bubble' wasn't popping. In hindsight, it was a very isolated event, unique to credit and correlation, and well absorbed by financial markets as a whole.

With vol markets and markets in general relatively dull, it seems wise to be contrarian and carry a long vol bias. While there are no immediate catalysts pending to shake up world financial markets, the level of implied volatility is priced for very boring times ahead. There is no more risk premium for economic risks, political risks, terrorism, disease or any of the uncertainty associated with human existence. At some point, China may take action to slow its growth, the Fed hikes will begin to bite, the US consumer will retreat, and housing bubbles will deflate. Alternatively, unpredictable shocks can always occur to break the equilibrium. It is too hard to call the timing, hence one must be patient in carrying positions that will profit when instability increases.

At current levels of implied volatility in many assets, long vol positions will break even assuming a continuation of the current steady times. Hence the risk/reward is extremely attractive to own volatility. There are very few cheap things in the world, but this is one. Limited downside, great upside. One must bear in mind there will be 'noise' associated with holding such a position. Good days, bad days; good months, bad months. April/June are examples of that – nothing changed in the world, just the normal ebb and flow of the motion of asset prices.

Of particular interest is the prospect for increased volatility surrounding China, and the follow on effect to surrounding countries, commodity prices, and commodity driven currencies and countries. The rate of investment growth in China is unsustainable, the government is coming under increasing pressure to take appropriate action, and its ability to engineer a 'soft landing' should seriously be questioned. This may be a major driver of volatility in the next 6-12 months.

Again looking backwards, the best volatility trade so far this year would have certainly been short volatility in just about everything as it moved from multi-year lows to multi-multi-year lows. However, as an overall approach this has been and remains unappealing. Judiciously selected, sized and structured appropriately, short vol positions have had merit; yet the potential for a significant drawdown from a broad short vol portfolio is uncomfortable, an accident waiting to happen. With a long vol bias one maintains positive fat tails and attractive stress scenarios, not to mention business longevity, all priced extremely attractively.

Some descriptions of this year's volatility in all four asset classes and the long term volatility context follow.


To begin, everyone's favourite – equities. This is the most watched asset class from a volatility perspective due to the widely followed VIX index of implied volatility on the S&P500. S&P realized volatility so far this year has averaged just over 10, including an interesting spike in late April discussed earlier. In the context of the quiet period of the last two years (post-Enron, September 112001, US economic 'double-dip') this is even lower than normal.

In the context of the longer-term picture of equity volatility, this remains a protracted period of muted activity similar to the mid 1990's. The VIX index of implied volatility expectations hovering around finally reflects this whereas in 2004 it clung to 15 as traders believed the 1997-2002 volatile years would return.

Things across the pond haven't been any more exciting, with the FTSE averaging below 8 vol this year and again hovering at multi-year lows. On the continent the picture is much the same. In fact, 2005 has been dramatically (30%) less volatile than 2004. Japan is no better, with the Nikkei moving a paltry 12 vol this year, comparable to year lows and well below its long term average.

It is also worth looking at vol trading opportunities – the volatility of implied volatility. Both the VIX and VDAX (DAX implied volatility) have been 'normal' this year as far as standard deviation of implied volatility. This in fact means very low movement, as the base number itself is half or one third of what it was in past years. For example, if the volatility of the VIX number itself was 70 three years ago, when the index was at 33, this means the index typically moved 1.5 units per day up or down. Now, with the volatility of the VIX still at 70 but the index itself at 11, this means the index moves only 0.5 per day, hence opportunities are fewer for trading, unless one triples position size – which a VAR model would suggest is appropriate but a seasoned risk manager knows is not. It is also the case that slippage and transaction costs as a percentage of the target profit increase substantially.

Fixed income

In fixed income, while 2004 was far more interesting than equities, 2005 is proving equally stagnant. There is much talk about the bond 'conundrum', but not much action. Realized vol has bounced off the lows, but averaging sub 5, and it is no 2004 or 2003 or 2002.

At the front end of the interest rate curves, volatility on 1-year Eurodollar futures has averaged just over 22, a horrendous multi-year lull as the Fed has delivered the promised 'measured' pace of tightening.

In Europe the Euribor futures have a had a slightly better time holding up at the lows with the rising uncertainty about European growth prospects and the constant flip-flop comments by ECB officials. Nothing has stopped the constant grind lower in the price of 'gamma', or short term options on fixed income instruments.


Currency markets as mentioned earlier have had some excitement. The excitement in the Euro related to the negative constitutional votes has kept vol equal to the past couple years and the Yen has had a bit less joy.


Where has there been some roaring action? Commodities? Unfortunately liquidity to trade volatility as an asset class is quite poor with the exception of oil and gold. The latter has actually not participated in the increased volatility, but the former has been a big contributor, along with base metals and agricultural products. Oil vol has stayed elevated, failing to find a comfortable price to consolidate, while gold vol has slumped in sympathy with currencies as the metal has stagnated at $425.

In summary, fewer market opportunities arose so far in 2005 compared to 2004 and prior years. Of the major asset classes for vol trading, only commodities have been exciting, and even then only oil, not gold. The highlights of 2005, such as the strong dollar, credit spread shakeout, and puzzling bond market strength, have done little to create volatility trading opportunities. This is a time to patiently carry a long volatility bias, and generate some alpha from relative value trading.

Michael Wexler is a fund manager with Maple Leaf Capital. The firm's Macro Volatility strategy, started in January 1, 2004, has posted a return of 21% since inception with a Sharpe ratio 1.4, and marked their expansion into volatility trading in multiple asset classes and without a dedicated directional bias. www.mapleleafcapital.com