Long while ago, Oct 2011 to be exact, I wrote a blog on high volatility. It was the days when the global Vix as well as our domestic variant were all punching very high numbers (20-30%). Times were different, one may say, but are they, really? This is something that I had written back then, “…massive global cash infusions have scared market participants on both ends of the spectrum. They’re scared to miss out on the next big move up, so they jump in boldly when prices start moving up. But they’re also scared that the market could plunge, so money is extracted quickly at the first signs of downward price pressure. This leads to the rapid up and down movements that have characterized the markets over the past four years in the overseas markets and lately this has been happening in our markets also.” If you substitute ‘global’ cash infusion with ‘local and global’ cash infusion, then the rest of the lines would read the same in 2017! Reminds me of the phrase, the more things change, the more they remain the same.
We have moved now from a high volatility regime to a low volatility one, with global as well as local Vix tending towards 10% or lower. It is not as though the problems in the world have disappeared or even receded. Each day, week and month brings forth its own new challenges. Still, why is the volatility reading so low? For starters, one has to understand that realised volatility itself is moving lower. Next is the huge flow of money into equities. We are seeing solid bull markets in progress in many markets particularly the US and India. A strong rising market drives volatility down.
But the more important reason I feel is the substantial rise in Option trading, enabled now by Algos and higher computing power available with traders. Option selling is rampant even from small traders. Prop desks across the country are mainly engaged in this activity. This has been high yielding activity for a long time and even though the yields have dropped (a function of too many people entering that business), it continues to be enough to hold thru any fat tail event that occurs every now and then. In a world of falling interest rates, ease of execution, ample capital and no fat tails, this “yield enhancement” from option selling has become almost a religion. Across all asset classes, the “carry” trade is simply another form of volatility selling, and the carry trade in all back-tests looks like a persistent, structural phenomenon.
The intermediaries in the options trade are mostly the prop desks. But as the size grows, the sellers like to farm out their risk and they find other buyers (mostly FIIs and bigger players holding portfolio longs) or they sell other options, further creating pressure on prices. Or they create hedge strategies using futures and complex variants of these are now possible using Algos. This is connecting different instruments producing a big correlation that impacts the market every now and then. It probably explains the sharp bouts of rise and falls that we are now experiencing, ones where no ostensible reason for the sharp move is even available. Dynamics of mean reversion have begun to appear more and more often now in the markets and this is pushing down volatility even further. For trends, now larger shocks are necessary, it appears.
The introduction of weekly options on Bank Nifty has further exacerbated this downward move in volatility. Since option selling has now more or less become the established way of trading options for many, the shorter expiry time drives smaller trends- either towards quietness, as long option holders fold their positions; or sharp, shortlived trends- as any news based spike leads to short covering creating an upward draft that brings in the trend followers and we have an exaggerated move. This lasts briefly because all participants are thinking and playing the short term. One now hears that weekly options may also be introduced in the Nifty and that will further exacerbate this trend of short spiky moves. Forecasting which of these will happen with any degree of certainty has become impossible, since we just don’t know the balance of positions with complete accuracy and how the various market participants will behave. But we do know that the balance has shifted as the number and amounts of volatility selling activity has increased over the last many months. It has been one of the only games in town that has resulted in persistent performance and hence attracted other investors from the sidelines. With falling prices however, for the same unit of option selling income, sellers have to sell larger and larger notionals, thus exposing themselves to market fluctuations.
In a sense, you could say that the instrument that was created to deal with and perhaps reduce volatility, is now verily creating the volatility!! As a technical analyst and one reading possible market directions, one has to take note of the changes created in the environment by all this options and volatility based activity. Moves are becoming sharper but shorter. So those engaged in short term trading need to provide for the quick changes and lean towards mean reversion strategies. For those tracking the longer term, it would mean providing for additional noise within the bigger trend. This influences stop placements, need for multiple exits and re-entries etc. In other words, the old world has changed and we better realise that if we have to produce better results.