Professional Documents
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By JM
January 5, 2010
Volatility is a good hedge against all kinds of disasters: socialism, Obama, other geopolitical and
macroeconomic events, government tax revenue shortfalls—pretty much anything that influences price
uncertainty. But it is only good for this when acquired at a good price. Buy it cheap, and it is beautiful
insurance. Buy it dear, and the negative carry is a leaky artery. So the issue really reduces to finding a
good price for volatility. A good place to answer that is history.
Volatility is influenced by extrinsic events, as well in intrinsic events. Intrinsic factors are equivalent to
turbulence in fluid dynamics, events that generate from the movements within volatility itself:
expectations in changes in volatility, as traders take long and short positions in the asset; level and time‐
dependent effects, like technical trading off resistance and support.
Fun Facts about Vol
1. Asset returns have a heavy tail, in general 2 < kurtosis < 5. The variance of returns is stable
and finite, though non‐normal. The precise distribution has been difficult to determine.
2. There is an asymmetry in gains and losses. There are large drawdowns in residual securities
but not equally large upward movements. Usually.
3. Returns display a high degree of variability: there are irregular bursts in volatility.
4. Volatility displays a positive autocorrelation over several days, meaning that high‐volatility
events are likely to cluster in time.
5. In general, volatility is negatively correlated to the return on the asset it measures.
A Good Price for VIX
VIX a type of volatility measure traded on CBOT. Without detail, it simply measures the variance of S&P
500 price changes pretty close to real‐time.
The long term average for VIX is around 20 (19.53%). We’re there. But the real sweet spot for long VIX
is around 10%, noted in the shot below. Investors buying volatility in the sweet spot (shown in red
circle) insured their portfolios. The best insurance around in fact: cheap with big payoff. But they had
to wait for it.
Based on the fun facts, volatility in general goes lower as the return on assets increase. There is no way
plunge protection can re‐engineer this phenomena. The more stocks get gin‐and‐juiced, the cheaper
insurance gets on the downside. Given that there are massive interests at work in propping up loser
stocks, the long term‐average is probably not as low as the price of VIX will go… meaning that stocks
have some more leg to go up and that decline insurance will get cheaper.
Looking at it inversely, VIX only hitting its long‐term historical average indicates that stocks have more
room to go, and they will drop some way below the average before the crack higher.