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Volatility Paradox


Fil and John discuss some eye popping volatility levels in the bond market


Editor's Note: This is an online conversation between Professors Fil Zucchi and John Succo.

Fil: This is from Tony Crescenzi @ Miller Tabak - is there some "obscure options markets reason" that makes the 4 volatility not look completely absurd?

"For the 10-year note, implied volatility for the March and April options is trading at just 4%, which appears to be the lowest level since 1998, during the Asian Financial Crisis. Low volatility levels often precede sharp sell-offs, as was the case in the latter part of 1998, as it tends to reflect complacency, but it is somewhat rational to believe that Treasury yields won't move much in the very near term, as there seems to be little in the pipeline that could disrupt the view that the fed funds rate is headed to 5.0, no higher, no lower."

John: His perception is the market view, hence low volatility and low option prices. Sellers just think it won't move much. He is also right that low option prices signal complacency and often precede large moves. He just needs to put the two together: large moves often occur when option prices are low because no one expects a large move. When no one expects a large move they sell options. This creates large amounts of short gamma, so when a move does occur it is exacerbated by all those who re-hedge because they didn't expect it! This is why I am a contrarian by nature. I am with the crowd 15% of the time, not with it 70% and against it 15% of the time trends happen as the crowd is getting in and bigger reversals happen when the crowd all at once tries to get out moves have very little to do with fundamentals (actual expectations) and much to do with psychology: the crowd getting larger and then suddenly smaller.

Fil: Yes, I've finally gotten to the point where I can juggle the gamma/delta process in my head generating only marginal smoke - but 4% vol. It's almost like saying that there won't be a move at all in the next cpl of months - it does raise the specter of the pre-heart attack perfect sinus rhythm mentioned by Scotto

This is why I talk about compression, everyone increases size because moves are so small, then they get caught when the move occurs. Low vol is a function of egregious liquidity in system; as that liquidity is drawn out we could see vol pick up in all asset classes but it is objective of the fed to keep it low as it indicates risk is low. They are trying to get everyone to think risk is low. We are operating under the thesis that eventually this will fail and vol will pick up in all asset classes, but the important point is that with vol this low, and option prices this low in all asset classes, we could get a huge move. Just because of that because everyone is set up to "enjoy" continued low vol and many hedge funds are selling vol just to make a little money including bond options big.

Fil: Right - but taken to the extreme - and I guess we are almost there - we could have a situation where buyers would actually get paid to take options - like the negative Swiss interest rates in past times. Based on what you see - Are you suggesting that these sellers are aware of the risk taking and are simply ignoring it? Not aware of the risks, period (kinda hard to believe); or aware of the risk but counting on a backstop?

John: Options will never go negative price. impossible. They are about as cheap as they can go. Sellers ignore risk under so much pressure to make return human herding mentality at work.

Fil: Bizarre

John: How markets work; flows come in slowly and exit quickly; they keep coming as a result of pressure to perform; they exit to control risk; no one thinks about risk until it's too late.

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