Measuring the Volatility of Volatility

Jared Dillian |

I recently watched the movie Interstellar in the theater. I liked it so much, I watched it again… and again. Three times in 10 days. Next, I’ll get the DVD and see it dozens of more times. It’s my new all-time favorite movie.

I’m something of an astrophysics geek. I think in another life I might have been one of these nerds working for the SETI project like Ellie Arroway in Contact. For my fifth-grade science project, I constructed a planetarium show. When my schoolmates were playing Contra on Nintendo, I was reading about quasars.

Interstellar fascinates me because I don’t understand how someone gets $150 million of financing to make a movie that no one who doesn’t understand Einstein’s theory of relativity can fully appreciate. Christopher Nolan is a stud. There is no other explanation.

I had to smile each time I left the theater, listening to the people walking out. “I didn’t understand any of that!” they would say. I think knowledge of the cosmos is pretty low in my corner of South Carolina.

I won’t spoil it for you, but let’s say there’s a lot of physics knowledge required for that movie. Incidentally, there’s a lot of physics knowledge required for trading too.

The derivatives guys understand this. Most conventional option pricing models are based on something called “geometric Brownian motion,” which was originally used to describe the movement of a particle suspended in a liquid or a gas.

Emanuel Derman, author of My Life as a Quant and contributor to the Black-Derman-Toy model that pioneered the pricing of bond options, started out as a darn good physicist. Then he was hired by Goldman Sachs. Lots of quants (quantitative analysts) are former physicists. Finance and physics really are that similar.

I have my own theories about financial physics.

  1. Stocks and bonds are matter. They are things. They are particles. They literally are physical objects—in the old days, certificates. Nowadays, they have a CUSIP. You can clip the coupons. In bearer form, they were worth money. Nowadays, nobody really gets to hold a bond in his hand, but it’s still tangible as far as I’m concerned. The foregoing also applies to currencies. And commodities… well, they are as tangible as you can get.
     
  2. Credit and volatility are not matter. They are forces very similar to gravity. Think about it: credit is the willingness or ability to repay. It’s a feeling, a sensation, a psychological construct. But it is not a thing. It has neither a certificate nor a CUSIP. But credit is directly related to volatility—otherwise the credit guys wouldn’t hedge with VIX call spreads all the time.

The one thing we know about gravity is that it is not constant in the universe. There can be large disturbances, like a black hole, where time can actually slow down—exactly like the gravitational time dilation described in Interstellar. When volatility increases (and credit widens), options decay more slowly. Volatility (“vol”) and time work in opposite directions.

Vvol Is Sky-High Right Now

We are currently experiencing—I’m grinning as I write this—disturbances in the force. Credit and volatility have never acted this way before, and I can quantify it exactly.

Never before has the VIX gone from 11 to 20 in just four days. A few weeks ago, I wrote about the outsize influence volatility ETFs were having on the vol complex, and that remains true. I think this can partially be explained by people panicking out of XIV, the VelocityShares Daily Inverse VIX Short-Term ETN.

But it’s actually bigger than that. Volatility is itself volatile. You can measure the volatility of volatility; traders call it “vvol.” And the only times vvol has been this high since the advent of VIX options were in 2007, 2008, and 2011—all times of serious crisis.

But we aren’t in a crisis now, are we?

Well, we might be, if you think vvol has any predictive power, as I do. Certainly nothing of the magnitude of ‘07,  ‘08, or  ‘11. But when you’re having 700-point intraday round trips in the Dow and vvol is at crisis levels, I think it’s time to start asking the hard questions.

“… Where No Man Has Gone Before”

The bigger picture is: Russia is experiencing a full-blown currency crisis, whether anyone is calling it that or not; emerging markets are in meltdown mode (as predicted by some of my colleagues here at Mauldin Economics); and the price of the single most important commodity in the world has just been cut in half in the span of a month or two.

These are not normal times. And the bull market in stocks is very, very advanced.

Even though I write for a living, I’m a former trader, so I still spend my days staring at the screens. I haven’t seen anything like this before. New territory here—and not in a good way.

But I’m a student of volatility and credit, and I paid attention in early 2009 when no put option was too expensive and no bond was safe. It feels as if something like that might be in our future.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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