“Success breeds complacency. Complacency breeds failure. Only the paranoid survive," says Andy Grove. Maybe we’re paranoid and maybe we’re like Grove, longtime chairman of Intel, who believes that having fear of what can go wrong today is paramount to staying solvent. In the business of risk management, knowing the math always trumps ignorance of it in terms of preparation and seeking opportunities. As we have indicated in several previous articles, ignoring the math breeds complacency; avoiding the math breeds failure, perhaps catastrophic failure.
Study these two charts: (Daily charts as of July 11, 2014)
Now let’s say that you are given the opportunity to trade or invest in either of these two securities; which would you choose and what would be your position?
Most investors, professional and non-professional, would avoid the security on the top as if it were the plague. Simultaneously, the crowd (both professional and non-professional) can’t get enough of the security on the bottom and would plead for dips that they can pile more of their hard earned money into, especially if given the blessings of a Wall Street analyst.
So what are these two securities? You may think the stock on the top is near insolvency while the stock on the bottom has a product the world is clamoring to possess. In both instances you would be wrong. Both of these securities are the same issue, just expressed as the inverse of the other. The chart on the top is the CBOE Volatility Index (VIX); it’s a measure of fear and as you can see, there is none. The chart on the bottom is the inverse VIX or the XIV; it goes up when fear goes down or when complacency remains expectant. It’s chasing yield without fear of being caught; it’s reaching for returns in a snake-pit.
Now let’s apply some math to shine a spotlight on stock market complacency and the inherent problems with reaching for yield. The average implied volatility for the Standard & Poor’s 500 over the past 20 years has been about 20%. This simply means that the S&P 500 is usually expected to stay within a +/- 20% band one year out 68% of the time (one standard deviation). Let’s examine the following just three years ago on May 31, 2011:
The SPX (cash S&P 500 symbol) closed at 1310.33. The implied volatility of the June at-the-money 1310 puts, expiring on June 15, 2011, was 20.57. Using some volatility math (the implied volatility divided by the square root of time left to expiration) we find that one standard deviation implies an expected change of 4.05%; a two standard deviation change, which has a 95% probability of occurrence, would simply be 8.1%. Therefore, selling the SPX June 1205 put (8.1% below the close of 1310) for $2.60 would give the seller a 95% probability of success. Selling 100 put options for $26,000 would require approximately $2,500,000 of margin in a standard margined account, thus allowing the short premium seller approximately a 1% return for 14 days or an annualized rate of a little more than 25%; the target return for many short premium programs.
Fast forward to today, July 11, 2014. The SPX closed at 1967.57. The implied volatility of the July ATM 1965 puts expiring on July 25, 2014 (options expiring 14 days out as the above example) is 9.65%. To receive the same targeted return (25% annualized) on $2,500,000, the put seller would have to sell puts only 3.3% out-of-the-money or the July 25th 1900 puts … a difference of nearly 5% closer to the money than the same return profile for a put seller just a scant three years ago! Alternatively said, for the same targeted return of 25% per annum with the same risk profile of just three years ago (approximately 8% OTM), the put seller today would need to increase size by a factor of 4 to achieve the same nominal dollar return.
The above example is not hypothetical; this is happening today with nearly reckless abandonment. There is no fear. Risk parameters are being largely violated. As you can see from the above real world example, there is massive tail risk once again. It was just six years ago that Nouriel Roubini warned of the “black swan” event on the horizon due to the gross miscalculation of the quants Value at Risk (VAR) Holy Grail risk models. Complacency, and the chasing of yield without fear, is producing another black swan with a beaver’s fat tail.
Actually by definition it wouldn’t be a “Black Swan” as we are, as many others have recently, sounding the warning bell. What is unknown is the trigger. It could be anything and in our current world there are plenty of candidates: Russia/Ukraine crisis, Iraq situation, Iranian nuclear proliferation, Syria and ISIS, the reemergence of Eurozone banking crisis etc. There are a myriad of hotspots that can set off a crisis and the underlying risk is what we described above. It is not the crisis itself—one will come—but the underlying risk in the system when it arrives. We continue to think that Janet Yellen, and her gang of money printers, will be deer in the headlights when the crisis hits.
By the end of July 2011, the SPX dropped nearly 20% in a stunning four-week drop! This came after the completion of QE2 and before the announcement of operation twist and QE3.