The Volatility Spring
Seldom have there been as many ‘known unknowns’ as we have today. To wit, the US dropping bombs on Syria and what this may mean for stability in the Middle East and therefore oil prices, Brexit causing uncertainty for both the UK and Europe, and the French elections looking to potentially lead to a Frexit and further European uncertainty. All this against the backdrop of many other risks to political, economic, and market stability caused by recent leadership changes. Given these risks, why are the FX markets so eerily quiet, and why are FX volatilities so low?
One would think that with all of these events either happening or on the horizon, market participants would be buying options for protection, and thereby pushing up the price of these options, which is reflected in higher implied volatilities. However, we’re seeing quite the opposite.
As the charts below show, implied volatilities have fallen in all major pairs over the past 4 months, even as these events and risks have unfolded.
I think most people would find this situation surprising. As a former options trader, I’ve seen this many times in the past 20 years, and I still find it surprising. However, there is an explanation to why this occurs, and what usually follows these periods of high uncertainty and low volatility. Let me try to explain it without getting too technical.
The Volatility Spring
When markets start to trade sideways, as we’ve seen in most currency pairs over the past 4 months, traders and portfolio managers who would normally make money by following trends (a trading style which makes up the majority of the investing market), struggle to make returns. Seeing that markets are not trending, they are drawn into selling options in order to collect premium, or looked at in another way, they take a bet that markets will continue to within recent ranges. Let’s look at an example.
A trader decided back at the beginning of February that EURUSD would continue to be directionless, and therefore she would struggle to make money by doing what she had been doing, which is to be short EURUSD. Instead she sells a EURUSD Straddle. A straddle is sold by selling both a EUR call and a EUR put with the same strike and expiration date. The table below shows the details of the straddle.
If, at expiry, EURUSD is outside of this 1.0295 / 1.1415 range, the trader will have lost a greater amount from the spot move, than the premium she collected from selling the option. Anywhere inside of this range and she makes money as she gets to keep at least some, if not all, of the premium.
This is attractive proposition given the recent ranges EURUSD traded in preceding the selling of the straddle, and it has thus far, as of today, been working out well (dotted lines), and attracts more punters into doing the same thing.
So part of the depression in implied vols has been from selling these options in the first instance. Now, let’s look at this trade from the perspective of the bank who bought the straddle from our trader. Banks do not tend to ‘roll the dice’, hoping that at expiry EURUSD will be outside of the range and they will recoup the premium they paid, and make some profits. Instead the trader at the bank will try to make the premium back incrementally by adjusting his spot position daily. As spot moves higher, the bank trader becomes long EURUSD and he sells. As spot moves lower he becomes short EURUSD and he buys. This is referred to as being ‘long gamma’.
Effectively the long gamma trader makes money as spot goes up, and makes money as spot goes down. Sounds too good to be true? Well the caveat is that every day the option that he bought becomes less valuable, so he suffers from what’s called ‘time decay’. Therefore, the gain from the movement in spot has to be sufficient to overcome the loss from the time decay.
As noted above, to capture the value of the positive gamma, the trader sells EURUSD as spot moves up, and buys EURUSD as spot moves down. If there are enough long gamma traders out there due to the portfolio managers of the world selling volatility, eventually the ranges become smaller and smaller due to so many traders buying low and selling high. As ranges become tighter, the long gamma traders cannot make up their daily time decay and they throw in the towel and start selling options to reduce this time decay. This further depresses implied volatility. It is like compressing a spring.
Eventually implied volatility is so low, with a large portion of the market participants now net sellers of vol, that when there is a shock to the system, and there ALWAYS is, everyone finds themselves with the same bad position.
Losses pile up as EURUSD jumps outside of its range, people start to panic and try to cover their positions, and the magnitude of the spot move is exacerbated by everyone being in the same boat.
In our example, let’s imagine that EURUSD moves higher, and breaks above the 1.1415 breakeven level. Our PM needs to buy EURUSD to cover her position as the EURUSD call she sold is now well in the money and she’s losing more money with every pip above 1.1415 that it trades. All of the other sellers of volatility are in the same position and trying to cover their short positions, thereby pushing the spot rate ever higher. Volatilies jump as those who have sold a lot of options are trying to buy them back, and we see the ‘volatility spring’ uncoil in an explosive fashion.
We saw this exact scenario play out back in 2009, when vols pushed significantly lower in the summer, luring people into selling options, only to jump quickly once the Volatility Spring had been compressed far enough, and a shock hit the market.
So, what’s the moral of the Volatility Spring? When uncertainty is high, and volatilities have been significantly compressed, take advantage of cheap options, and purchase protection. There is no way of predicting in which way the market will explode when the spring uncoils, but it’s a virtual guarantee that the market will experience a big move.
In the case cited above, from the September 30th low in implied vols, EURUSD sold off 8.4% over the following 6 months.
Author: John Glover