The cost of a crowded volatility trade | FT Alphaville

The cost of a crowded volatility trade

FT Alphaville just had a very interesting conversation with Ari Bergmann, managing principal at Penso Advisors, with respect to what’s been happening in the world of volatility hedging this year.

And specifically how things have changed since July.

Two points stand out:

1) There’s not been much of a risk/reward in equity-related volatility hedging strategies at any point this year (or post-2008 for that matter).

2) The volatility hedges that made a lot of sense pre-July 2011 were mainly in interest rate, CDS and money market instruments. All of these, however, have since lost their allure due to a major re-pricing of risk in the market this summer.

With respect to the first point, Bergmann is essentially saying that any “black swan” hedging strategy focused on equity options or Vix futures would have proved hugely expensive and thus unsuccessful:

Unless you got the timing right and the levels right it would have been far too expensive. The risk/reward hasn’t made sense. Once the risk is priced in you’re not getting anything for it. It becomes like a trade. You are sure to lose money unless you get your timing right.

The point here is that the “giveup” in terms of the pricing of the insurance proves more expensive than the potential insurance you receive in return.

Currently, says Bergmann, December put options are priced in such a way that you would need a move of 17.4 per cent or more to the downside to break-even on the trade. That’s hardly worth anyone’s while, he argues.

The Vix curve, meanwhile, is a good example of just how crowded and expensive the Vix trade itself has become. For most of the year, the steep contango was reflecting the fact that insurance sellers could command unreasonably high risk premiums in return for the insurance they were offering:

We would never have advocated Vix futures because of contango, the risk rewards.. made no sense in our view

Thus, the ultimate Vix trade for most of the year will have been selling selling volatility insurance for an impressively high premium. The proverbial picking up pennies ahead of a steamroller trade.

That said, Bergmann says there’s no doubt that the spike in realised volatility this summer will have stopped many of these sorts of players out. Where they’re headed to now, is anyone’s guess.

Bergmann is tight-lipped about his current advice to clients. But he says there are opportunities out there if you tie hedging needs with macro views.

To be efficient hedging has to be an alpha strategy. If you look at cost of insurance, there will be a negative expected value. If you buy hedging which is smart so that the trades in themselves are alpha trades then you have expected value.

As to the current re-pricing of risk, Bergmann says it’s clear the market has moved into a new paradigm.

The market is finally aware of the risks out there. That the party is over… that the 2008 crisis is not over yet, that there are many risks on the horizon that people are already aware of. As well as a lot of risks people are not thinking about it yet. And all this with a need to invest. There is nothing really safe.

The world is such that we have created a system that requires you to take risk. The concept of risk free is an oxymoron. People are finally realising it.

In this world you cannot get away from risk, you will just have to be able to manage risk. Risk on and risk off… now we realise there is no such thing risk on or risk off, there is only a trade-off of risks.

Ultimately, says Bergmann, the biggest misconception in the market is not about where the risk lies, but in what is considered safe.

He uses hurricane Irene as an anaology:

You saw the hurricane that went over the US. The risk of low-lying areas was  extremely high, and everyone was required to evacuate. But the question they asked was where to evacuate? Where else is safe? The evacuation was based on an assumption that somewhere else was safer. But people always have this assumption, it’s a misplaced security blanket. In the end, the low lying areas didn’t get hurt and where people went to safety got terrible damage.

The whole environment, when you look at everything, there is no such thing as safety only relative safety.

The moral of the story: if you don’t have to work for your volatility hedge  but depend on it coming conveniently packaged as a Vix future) you can’t expect the risk/reward to be anything but sub-standard.

Related links:
Correlation remains at highs reached in the crisis
– FT
A Vix curve ball
– FT Alphaville
The calm before the (volatility) storm
– FT Alphaville
More thoughts on what’s behind low volatility – FT Alphaville