Trading volatility as an asset class has a long-standing tradition in finance, most widely applied in the alternative fund space. Those who don’t trade still spend an awful lot of time watching it, as it is the primary fear/greed signal for global portfolios. And when its signals misfire, you can be certain that the sands that underpin the global financial system are shifting.
That is precisely what we are seeing at the moment. The price of volatility should be thought of as representing the cost of hedging. Because the future becomes more uncertain the further out you go, the cost of hedging further out into the future should rise.
This is the fundamental relationship we see embedded in the VIX futures curve. This fundamental characteristic has led to very steep volatility curves and, where there is a slope, there is a carry trader.
Investors would routinely sell VIX futures and pick up the carry as they rolled down the curve towards maturity. This has always been a magnificent carry trade: investors sell tail risk and receive a handsome premium for their troubles.
The long wait for Armageddon
But for the lonely bears of a defensive persuasion, buying volatility as a long-term strategy is simply untenable. A long vol position, as it matures, will roll down the curve, losing value and bleeding profits and losses.
You may sleep well at night, knowing that the next day’s financial Armageddon that you carefully forecast will bring rich rewards; if it doesn’t happen on time, the woodshed awaits.
So, this upward-sloping curve (or contango) represents a fundamental axiom of finance. Hedgers have to pay an insurance premium; carry traders collect the premium. It was ever thus. Well, until now.
While ‘more sellers than buyers’ may be a pithy retort to explain why a price fell, it does illustrate that markets do not always price how they should. Traders care not for financial axioms and flow will always dominate over reason.
As such, nonsensical structural distortions can often materialise from time to time: yet these usually occur during times of stress and are quickly priced out when calm returns. However, in the volatility markets, distortions are not only appearing but persisting.
For several years now, long-end rates volatility is cheaper in price than short-end volatility. It’s as if the market is saying that it has more certainty where base rates will be in 30 years than in three years’ time.
This is, of course, nonsense from a fundamental perspective. ‘More sellers than buyers’ has cheapened long-end volatility to such an extent that we find ourselves in a situation where you get paid to hedge your long-rates exposure. Why do you get paid?
Well, a long vol position in US rates, as it matures, will roll up the curve and appreciate in price. If the fabled bond vigilantes ever hold the fiscal incontinence of the US administration to account by dumping long-end bonds, the hedge that you’ve been paid to take out should make a tidy sum.
To give a sense of how much the slope of the vol surface matters when hedging any exposure, consider two simple long volatility strategies. One buys long-term S&P volatility; one buys long-term US rates volatility. Both strategies made a tidy return in the Covid debacle but in the following years the long equity vol position slowly bled out its return.
The US rates vol, however, while it never quite had the punch of equity volaltility in the crisis, proceeded to gently trickle upwards. There is no clever macro narrative behind these differing profiles: it is simply down to the different slopes of the curves.
Strange turn of events
When the phenomenon in the US rate appeared in 2016, there was much debate as to how long the structural distortion would last. The Fed, however, has quite enjoyed suppressing long-end rates volatility as it has alleviated much of the rate rise pain for the US mortgage/housing market.
Now the story has taken quite a surreal turn, as volatility curves have begun popping up in equity land – in particular, in the curves of those companies run by our favourite tech oligarchs. But this time, rather than a balance sheet bloated central bank weighing down the volatility curve, enter stage the new protagonist – the zero-day option market.
The zero-day options market takes the award for the largest market that barely anyone has heard about. The vast majority of all options traded on the US indices now have a term of less than 12 hours.
Over the last year, the flow for the Magnificent Seven has been an unrelenting call buying frenzy and this push for ever-shorter dated call options has sent short-dated option pricing (i.e. short-term volatility) higher. And at the more ‘sensible’ end of the speculator spectrum, we also see the explosive rise of the single-stock income maximiser exchange-traded funds (ETFs).
These investors buy the chosen Magnificent Seven stock of their choice and sell three-to-nine-month call options against their position to generate a significant yield while giving up some of the upside in the stock.
As these ETFs have grown truly gargantuan, there is now a steady tidal flow of call selling (equivalent to volatility selling) at the back of the curve.
Getting paid to wait
And just like the US rates volatility curve, we now see a backwardated surface across most Magnificent Seven stocks that has nothing to do with the investment outlook (short- or long-term), but everything to do with distorted flow dynamics. Too many people are buying short-dated volatility and too many people are selling long-dated volatility.
For a defensive fund, looking for ways to drift higher in a raging bull market, whilst maintaining a strong negative beta to the stock market, these backwardated volatility surfaces are manna from heaven. Irrespective of one’s views on the now-standard practice of vendor financing and round-tripping of revenues for the tech sector, the painful reality for any long-only investor is that one must own the US tech sector.
Timing an underweight position, or for the brave of heart, a short position, has ended the careers of many fundamental investors. There are no bears left standing. Yet now it is possible to buy a long volatility position in your favourite tech behemoth and get paid for the privilege of your contrarian view.
No need to time the market, no bleed, no lingering corrosive self-doubt. Just sit back, put on your slippers, buy tech vol and enjoy the bubble.
Toby Hayes is portfolio manager of the Trium Alternative Growth fund. The views expressed above should not be taken as investment advice.