Volatility pricing … is the rock really so steady
The expression ‘steady as a rock’ is associated with stability, steadfastness and reliability. The kinds of characteristics that fund managers like to co-opt into their firm names.
The Heisenberg uncertainty principle offers another perspective as it implies that even the most tangible of everyday objects, a rock for example, that you can clearly see, hold in your hands and study in detail has, at a subatomic level, a blurriness about it that makes it impossible to measure precisely. This vagueness seems jarringly at odds with our common perception of a rock as something we can be certain about.
In financial markets uncertainty is always present; it’s just the degree of it that varies. A widely followed market commentator observed this month that central banks have to “…navigate an unusually fluid economic, financial, institutional and political landscape”. In less eloquent terms … uncertainty is high.
What is jarringly at odds with this observation is that volatility implied by pricing in various option markets has dropped to record lows. For example, the CBOE Volatility Index (VIX), which measures future volatility expectations implied in the pricing of S&P equity index options, and a similar measure for US treasury volatility (MOVE) both hit record lows this month.
Much has been written to explain this abnormally low market pricing of volatility. The more widely cited possibilities include the global economic growth rebound, the rise of passive investing and extreme monetary policy forcing yield seekers to boost returns by selling options.
But perhaps it’s just that low volatility begets low volatility. This sort of self-reinforcing feedback loop results in option sellers, emboldened by the recent history of low volatility, being enticed into selling more options, which in turn reduces volatility further and generates profits for their short volatility strategies, in turn triggering yet more option selling. This dynamic typically works and works and works … until it doesn’t.
To understand this, behavioural finance studies of ‘recency bias’ are useful. They find that investors tend to overemphasise the importance of the most recent information at the expense of using broader data sets that would yield more balanced analysis. The evidence strongly suggests that decisions skewed by recency bias usually don’t turn out well.
And indeed, current levels of option prices seem more anchored to the recent history of benign market conditions than the potential for future uncertainty that they are supposed to reflect.
For investors with expertise in option markets, this represents a pricing inefficiency that can be exploited, not just to generate returns but also for defensive portfolio construction. Volatility strategies can be a very effective tool for fixed income managers who prioritise capital preservation.