How to call it right and get it wrong.

Smart people call it right and win. Dumb people call it wrong and lose. It takes a special kind of idiot to call it right and still lose. On February 5, 2018, I was that special idiot.

On that eventful day, the VIX index surged 118%. The near-months futures went deep into backwardation, causing billions of dollars of damages to short volatility traders. The index closed around 37, something unthinkable just a couple of weeks earlier when it hovered around 9 for much of January, and averaged about 11 for all of 2017. It was so unthinkable, that it literally blew up Credit Suisse’s XIV Exchange-Traded-Notes after the closing bell, as margin calls on the futures contracts steamrolled the equities in the ETN.

The VIX index, created by the Chicago Board of Options Exchange in the 1990’s, is often called the “fear gauge” of Wall Street. To understand what the index signifies, we need a little bit of background information.

Most people know about the stock market, bond market, real estate market, and nowadays most people even know about the cryptocurrency market. Yet, underlying all of these markets is an identical intrinsic property, volatility.

What is volatility? It’s an easy concept to understand, but it is difficult to put into words. When applied to financial markets, some have described it to be a measurement of the “speed of the market” (Natenberg), and others have described it to be a statistical “measure by which a security is expected to fluctuate in a given period” (McMillan.)

In the most concise way I can explain without too much distortion, volatility is the likelihood and the size of deviations from the average. It is a measure of uncertainty. I have written in the essay on bitcoin that the volatility is what makes bitcoin unfit to be a currency. The underlying idea was that bitcoin prices can undergo sizable changes very quickly, and therefore you could not use it as money for anything.

The key question is how do we measure this vague “measure of randomness?” Volatility can be measured two ways, backward looking and forward looking. Realized Volatility is a measurement of volatility in the past, and is fairly easy to calculate. It is simply the standard deviation of the changes away from the average prices over a certain period of time. Future Volatility is more difficult to conceptualize. Future volatility is forward-looking, and contains all the inherent uncertainties of the unknowable future. Thus we can never actually calculate it with much certainty, and all future volatilities are estimates. Soon option traders started calling their estimates for future volatility the Implied Volatility (IV). So while IV may have the same units as realized volatility, it is not derived the same way. Realized volatility is a concrete calculation from past data, implied volatility is simply an educated guess of what the future volatility is.

Most traders estimate implied volatility by calculating the realized volatility of a certain period in the past as a baseline (usually with a n-day moving average,) and apply a rough mental adjustment. An example would be if the S&P500 Index has a realized volatility of ~12% over the last year, and a certain piece of bad news suddenly breaks out. The actual effect of the news is not known until retrospect, but we would expect prices to move more than it did during the relatively calm previous 12 months. So a mental adjustment is applied to the 12% realized volatility, and the implied volatility would be perhaps 25~30%.

The actual construction of and the mathematics behind the VIX index are complicated (has to do with 2 near-months futures and variance swaps) and irrelevant to this essay, but goal of the VIX is to estimate the future volatility of the S&P 500 over the next 30 day. In other words, the VIX index is the implied volatility for the S&P 500 for the next 30 days. The reason it is called the “fear index” is because it is often the crashes and not the gains that lead the biggest and fastest price changes in the market, i.e. the biggest increase in market volatility. It is always quicker to roll down the hill than it is to climb up, and the market is no different. (This is something we will revisit soon in extensive verbiage.)

Back in late 2016, I began paying attention to the VIX index. I was personally going through a dark period at the time, and I began looking at the world with an even more cynical eye that I had in the past. When the Brexit tally was completed and signaled Britain’s intent to exit from the EU on June 24, 2016, the VIX shot up rapidly to a peak of about 25, before rapidly decompressing back to about 15 after the next trading day closed. A few months later as the US election wound down, when Trump beat out Clinton, the VIX again shot up before rapidly decompressing.

Mean-Reversion, or the tendency for volatility to return to a historically average value is not at all unusual. In fact, it is almost tautological that volatility must mean-revert. If volatility is a deviation from the average, then there must exist an average state. If something deviates from the normal and doesn’t mean revert, then the original average can no longer be considered the average and will have to change accordingly. But then the deviation will also change, as it will be measured from the new mean, causing it to mean revert.

Brexit and Trump’s election were important events, and the jitteriness the world felt about the two situations was reflected on the VIX index. Yet in a very important sense, those were the outliers. We might not have known the outcome of Brexit, or the 2016 Election, but we knew that there were going to be a decision. Either Britain was going to leave the EU or it was going to stay. Either Clinton was going to become president, or Trump was (Or perhaps Gary Johnson, but regardless, somebody had to win the election on that date.) This type of uncertainty has definitive certainty to it.

Yet we don’t have to look much further back to the previous peak in the VIX, which occurred in January and February 2016, where the VIX began the year at 15 and reach 30+ twice. What was the reason for that? I have no clue. What about the “Flash Crash” of August 24, 2015, where the VIX shot up to 50+ from an absolutely unknown cause? There were no warnings. What about the August 2011 turmoil due to Spain and Italy’s sovereign debt? Who really saw that coming? What about 2008? The real estate bubble leading to a global financial crisis that nearly blew up the whole world’s economy? The disaster to which Federal Reserve Chairman Alan Greenspan infamously quipped that nobody could’ve seen coming? It is not true that nobody saw it coming. Some people did see it coming. Michael Lewis’s book The Big Short and subsequent movie adaptation did a fairly good job showing that. But the point remains that most people didn’t and they probably shouldn’t be expected to see any of those events coming.

In fact, by examining some of the past ups and downs of the market, I soon realized that most of the volatility spikes, and by association market drawdowns occur at times when almost nobody expect them to, and the uncertainties from events like Brexit and Trump are nothing like the uncertainties of these other market reactions. To quote Rumsfeld, Brexit and Trump were known unknowns: you know something was going to happen, you only didn’t know what. But the most severe market crashes and volatility spikes are unknown unknowns: most people don’t even have a clue that something big is about to go down before it happens. Those events are Black Swans.

With that realization, I took a closer look at the VIX chart, and overlaid the S&P500 with it. It became clear that if we ignore the Brexit and Trump votes, since the last real VIX spike in Early 2016, the VIX index has become increasingly suppressed, and the S&P 500 has steadily climbed higher. One striking feature of that graph is how linearly the S&P 500 has been in the last 2 years, and especially 2017. Because the VIX is the volatility of the S&P 500, the less fluctuating (more linear) S&P becomes, the lower the VIX gets, and we can see a very steady downward trend in the VIX below. After the Trump election the VIX closed higher than >16 just once, which I found very odd.

Philosophically, I have a theory that is crucial for my understanding of the world. First, I believe that good things and bad things can occur randomly. However, for anything deemed good to be more than ephemeral, there must exist at least one solid fundamentals reason for such goodness to continue to exist. But not only that, more importantly is that these fundamental reasons must not decay or lose their effectiveness. On the other hand, this existence of a fundamental force is not necessary for bad things to extend indefinitely, because that is the natural condition.

I firmly believe fundamental human condition is tragic. The tragic nature is the results of the fragility of orderliness in this universe. What we define as good is typically the nonrandom result of a deliberate overcoming of intrinsic chaos. This intrinsic chaos is entropy and is the default direction to which everything in the universe aims towards. It is improbable that nonrandom results (orderliness) will continue indefinitely without deliberate reasons or energy. Therefore, what we view as good always requires deliberate efforts to maintain, to not only suppress the natural tendency to decay into chaos, but to persevere towards higher order and more progress. Again, more importantly, these deliberate efforts must also themselves not lose effectiveness as time progresses. This second-order requirement of a resiliency of the first-order orderliness is often missed and ignored. This is actually just a rephrasing of the law of diminishing marginal return in economics, where the fundamental source of return always loses its marginal worth as the total return expands. Which means, in the universe, not only do orderliness decay towards chaos, but also the energy maintaining orderliness are in of themselves subjects to decay.

Therefore although a few bullish sessions can exist solely by chance, an extended bull market must have a fundamental reason for such prosperity to last, and such fundamental reason must in of itself be sound and robust. Otherwise it is highly likely that the seemingly prosperous times will turn out to be a dangerous illusion. This same criterion is not necessary of a bear market, because a secular bear market where things fall apart is chaotic, the default state of the world. A myopic view of history and aggrandizement of human progress have led us to believe that this past 60 years of exceptional prosperity and relative peace is the default condition for human life, and that couldn’t possibly be farther from the truth. *

*As an aside, I believe that the vitriolic differences between Steven Pinker and Nassim Taleb rest on this point. Pinker believes he sees a fundamental reason that has caused global violence to decrease in our recent past (see The Better Angels of Our Nature.) He does not realize the second-order requirement that this fundamental reason of less violence must not decay. Taleb does not deny that recent history has shown reasonable arguments for peace to exist. However, Taleb views these reasons to be very fragile and can thus cease to exist at anytime, due to a build up of fat-tail risks that can cause irrevocable damage in a globalized scale such as the risks of nuclear war, ecocide from climate-change, or biocide from GMO, etc. In other words, Taleb sees no meta-reason for the reasons for world peace to exist. Thus he has sternly warned in his own caustic prose that these self-congratulatory pats on the back by Steven Pinker and many others is naïve and ignorant.

To understand the current behavior of the market, I thought I first had to find out what the natural state of the market is, beside utter chaos. There is a good reason to expect the market to maintain some order above chaos, because it is human nature for everyone to constantly strive for a better life. And because human nature is resilient and robust, and the population will continue to replace each other, I see it to be fairly reasonable that should the market continue, it would continue to behave in the same way it has always been behaving.

From history, one can see that market volatility is a type of Mandelbrotian wild randomness that is completely unpredictable. Examples of crashes abound, from the 2011 Flash Crash to the 1987 Black Monday and the grand daddy of them all, the 1929 market plunge that started the Great Depression. In his book Misbehavior of the Market, Benoit Mandelbrot creates a convincing exposé via fractal mathematics proving that market risk is fat-tailed, and there is very little one can learn about the tail events of the market from an average and standard deviation (which is volatility).

In the book, Mandelbrot notes two quasi-biblical forces that can explain but not predict market behavior. First there is the Joseph Effect, in which Mandelbrot cites from the Bible where Joseph notices that good harvests tend to last for seven years, and bad harvests tend to last for seven years. Joseph’s recommendation to the Pharaoh is to save up in times of abundance to prepare for times of famine. Mandelbrot notices in the markets that just as Joseph did in harvests, that the good times tend to clump together, and the bad times clumped together. In other words, there is a trend-following tendency in the markets. Mandelbrot called this effect Joseph Effect.

But beyond the clement and mild Joseph Effect is also the erratic and jarring Noah Effect. The Noah Effect is the titanic shifts between the seven years of abundance to the seven years of famine. These shifts are unpredictable and usually catastrophic. Within the market ecology, these are the times when a seemingly bulletproof trend sudden buckles and reverses. This is when entire hedge funds capitulate and large investment banks collapse. This is when liquidity in the markets freezes and prices plunge towards absolute zero. This is when every investor and trader who thought they were smart enough to slip out the fire exit before the cops showed up, comes to the desolate realization that everyone else had the same idea and the fire door is now jammed. Ultimately these are the times when ruinous losses are sustained and incredible windfalls are made. Akin to the biblical deluge of God’s wrath, these market crashes are sudden, catastrophic, and offers warning only to the very few that paid attention prior. The jarring effect here is that when the Noah Effect occurs, it does not matter for how long the trend has been occurring, or how robust the trend seem to be. The deluge of Noah buries everything under its torrential waves.

Another important idea from Mandelbrot is that when the Noah Effect occurs, the averages of the past tells us very little about how far into the deep end this crash will go. In other words, the standard deviation of the S&P 500 (volatility) offer little in predicting the depth of these extraordinary plunges and the average volatility bears almost no relation to the volatility during crises. Options traders have known and studied this concept of “volatility of volatility” or “vol of vol” for quite a while, which mathematically is the 4^th moment of a probability distribution (kurtosis.) Kurtosis allows us to conceptually come to term with extremely unlikely events that shouldn’t happen yet have happened and will keep happening. To keep it in biblical terms, kurtosis is the idea that there is nothing in past floods that could have helped predict a flood of biblical proportion.

Thus, if Mandelbrot is correct in his assessment of the market, then it is a structural inevitability that markets combine periods of trends formations with periods of sudden reversals and crashes. And when these crashes and associated volatility spikes happen, we have very little ability in predicting the size of the movements and the damages it will cause.

So I thought in late 2017 that fundamentally we had a situation of immense danger. The extended period of linear growth in the S&P500, with a VIX that is suppressed down from its average by almost 40% (from 17 to 11), is in of itself dangerous given its tendency to return to the average, which would cause the VIX to spike almost 55% (from 11 to 17). Forget the kurtosis and the chance of a biblical flood. I thought a simple rainstorm after this drought would bring this whole thing to the ground.

Given the natural state of the market to be cyclical and abrupt, there are the two questions I wanted to answer: Were there fundamental reasons for the suppression of volatility in 2017? And if so, how stable was this reason and how likely is it to continue to have effect?

To answer the volatility question, I thought about where volatility came from. The answer is market volatility comes from market risk. However, in opposition to what some academics have to so say, volatility per se is not risk. Risk is an unquantifiable aspect of the uncertainty in the future and volatility is the attempt at quantifying that risk. But since you are measuring something intrinsically un-measurable, there are naturally limitations associated with the measurement, thus as long as volatility is used to substitute for risk, there will be shortcomings in the risk models. Part of kurtosis comes from the inability of these risk models to accurately measure tail risks, and even with adjustments such models is still and will always be incomplete and inadequate.

It is often said that the financial market is like a casino, and that just like casinos, the House always wins. To me, that is half true. The house may always win, but the markets are not exactly like a casino. The reason is that while casino risks come from extrinsic bets on the games, market risks are intrinsic to its own operations. In a very underrated book What I Learned Losing A Million Dollars, author Jim Paul explained that market risks comes from the inherent operations of the market, while casino risks is simply created and tagged onto the game itself. If you had ever played a game of poker without betting real money, then you understand that the risk of casino games is not intrinsic to the game, but is only created when you bet money on the outcomes. Meanwhile, no business operation has ever existed without taking on risk. When the grocery store prices a head of iceberg lettuce for 50 cents, the grocer is taking risks on that customers will show up and buy the lettuce, he is taking risk that he will sell enough lettuce at sufficient profit to keep the store open, and he is taking many other risks in addition to that. These types of risks are unquantifiable and can only be estimated with volatility.

The difference between the casino and Wall Street then, is that casino will never put themselves on the wrong side of the odds, because the odds of games are easily calculable. We cannot say the same about the business and market risks that Wall Street has to manage. Sometimes they make errors, and sometimes those errors are huge. The error of this low volatility condition is that Wall Street is pricing and equating risk with volatility, and if risk isn’t actually decreasing with this decreasing volatility, then they must be underpricing the risk. We might have ourselves a situation where we are playing at favorable odds.

So question becomes were risks truly lower given the decreased volatility? Chris Cole is the Managing Partner at the hedge fund Artemis Capital Management, and he has written incredible papers on the divergence between volatility and risk. In one of his more recent essays, he argued that there is a host of both explicit and implicit trades that essentially is betting on stability in the market, in trader lingo, such trades are called short volatility trades. He especially pointed out that there are extensive unrecognized risks in strategies such as risk parity, risk premia, and the leveraged share-buybacks. The gist of the paper was a hypothesis that the trades shorting volatility (bets on stability) has been both the driving force to this low volatility condition, as well as the result of it. In other words, large trades betting on lower volatility had actually led to lower volatility, and the lower volatility then led to more trades betting on even lower volatility because of the first short volatility trades making a profit, then the cycle continues. He found a metaphor to this market in the ouroboros, an Egyptian symbol of a snake eating its own tails. However, in the midst of this self-cannibalization of the market, Cole sternly warned in his paper “risk cannot be destroyed, it can only be shifted and redistributed.”

Cole’s paper got me thinking about whether there are any changes in the intrinsic risks of the market? Federal Reserve’s Quantitative Easing program had supposedly ended, and talks of rate hikes abound, and that is risky for the bond market. A few tech stocks (FANG) have been the bullish force driving much of the growth of the S&P500, and concentration is always risky for the equity market. The big banks that crashed the world economy in 2008 got even bigger. Real estate prices in many parts of America have gotten back or even exceeded peak prices before the crash of 08, and Canada and Australia’s real estates markets are showing obvious signs of distress. China has started to show signs of slow growth. There is also brewing geopolitical risks overseas. While at home, there is obvious sociopolitical tension between the populist and progressive, the liberal and conservative, and even generational tension between the Baby Boomers and the Millennials. All of these things are risky. Let’s not discount the fact that the government actually shut in January of 2018 and national debt was approaching 20 trillion at the end of January, which is more than $60,000 of debt per citizen. And these are only the known risks. How many additional tons of dynamite is out there that I don’t see is scary to think about. So I think it is safe to say that risk have not been reduced.

Therefore, regardless if there are fundamental reasons for the decrease of volatility, there are no reasons robust enough to reduce market risk. And volatility is used to price risk, and since risks cannot be destroyed, this divergence between risk (the same) and volatility (decreasing) must eventually re-converge, and volatility must inevitably spike.

It was under ideas like this that I found the suppressed volatility very concerning from a fundamental level, because I could not see a reason for volatility to be this low, given that the risk is anything but decreasing. Next I looked at it from a psychological aspect. Not only was the S&P500 rising and VIX dropping, but people are also really starting to believe in this false narrative and much like the ouroboros, it is feeding back upon itself.

I have found that the main reason people invest in ongoing bubbles is not because they necessarily believe that the prices will never come down. It is my experience living through the real estate bubble in the mid 2000’s that many cautious people finally jump in to invest in bubbles right at the top because their fear of not being able to afford a house in the future finally exceeded their fear on buying a house that loses value. The similarity was not lost on me when a friend told me last year in regards to his IRA that he couldn’t afford to not be fully invested at this point in his career. He was barely 30 years old. It is as Livy once brilliantly stated and Danny Kahneman later rediscovered in Prospect Theory, that “men feel the bad more than the good.” For retail investors, it is rarely greed that dispels the natural fear of losses. It takes a fear to exorcise a fear. In this case, it is the fear of missing out (FOMO) that makes average people make terrible financial decisions, often at the worst times. The amount of investor money pouring into Credit Suisse’s XIV ETN that explicitly bets on ever lowering VIX and the reports of a former Target manager turning his life savings into 8 figures by a short volatility strategy solidified my sense of investor euphoria, and hinted to me that the end is probably be near.

So with my analysis complete, I decided to bet against the continuance of the low volatility condition back in late 2017. So I began a simple strategy of long volatility. I will not bore you with the actual options I traded, but in layman’s terms, I would place bets that volatility is to increase and slowly waited on a potential windfall payday.

On February 5^th, 2018, the fateful day I waited faithfully for finally happened. As mentioned earlier, the VIX surged 118%, closed at 37, and rocketed another 30% more the next day, ultimately to a high of ~48 before retreating back. The S&P500 also experienced one of its worst days in a few years, drawing down nearly 5%. Was this the big one?

In Dino Buzzati’s poignant novel, The Tartar Steppe, the protagonist Giovanni Drogo is a soldier sent to a small barren outpost, with a mission to prepare for a possible invasion from the northern steppe. The novel is a beautiful composition detailing the immense pain and agony that people suffer when they hand over everything in their present for an uncertain but possibly glorious future. In the novel, Drogo patiently trains and waits for the enemy to rise over the northern horizon year after year, while his friends, family, and everyone he cared about in his old life moves on or disappears. Eventually he has nothing left in his life but the illusory enemies in the northern steppe and the excruciating hope for a glorious battle. Yet when the invasion finally occurs decades later, Drogo has become an old man, cruelly incapacitated by age and disease. Drogo is discharged from the post, and the book painfully closes with him taking his final lonely breath in an inn by the side of the road while the battle happened. He had missed it.

On February 5^th, 2018, my enemy finally appeared upon the northern horizon of the tartar steppe. But just like Drogo, I had missed it.

I didn’t put on the trade that would’ve landed a windfall. And what a windfall that would have been. Retrospectively, had I put on the trades I had on in the previous month, It would’ve profited north of 4,000% of my original investment. I had done all the research necessary, I had made the contrarian call and I was proven right. I saw the Black Swan event from a mile away but I was ultimately not able to capitalize.

Why did that happen?

To me, it was a lack of discipline that had me sitting from the sidelines during one of the most exciting moments of my short trading career so far. Although I had little doubt that this barrel of dynamite that I sniffed out was eventually going to blow up, what I didn’t know was what the trigger was going to be, and when the trigger was going to be pulled. These long volatility trades I put up had negative carries, which meant that I would be paying premiums for options that lose value and expire as time pass. Thus if this low volatility were to continue despite all reason, the lost options premiums may potentially exceed the eventual gain. I remember constantly thinking about Keynes’s quote, “the market can remain irrational longer than you can remain solvent.” So I will admit that it was an extremely painful trade. The almost daily downward ticks in the brokerage account is almost like Chinese water torture, constantly reminding me with each maddening water drop, of the sustained losses and forced me to needlessly doubt my trade incessantly. Ultimately inability to face this pain led to me miss out on the battle of the Northern Steppe.

But now I know that the pain of losing a manageable amount of money in premiums is nothing compared to the pain of watching the barrels of dynamites exploding exactly as you predict, yet having no profits to show for it. I should not have been worried about the timing of the trade at all. If making the exact right trade at the exact right time is the goal, then it is an impossible goal that nobody will consistently reach. What I can hope for as a trader is only that I make roughly the right trades at roughly the right times. My mistake this time was that I looked for certainty in an uncertain world. Perhaps the market would’ve remained irrational and the low volatility condition would’ve continued, but there is no information in the world before Feb 5^th that could’ve eliminated this bit of uncertainty. Given the research that I’ve done showing good odds for a volatility spike, and given that the cost to play in terms of option premiums were at historical lows, it was a major misstep that I did not take advantage of such condition.

But without a disciplined system, I was not able to keep up a consistent trading habit. It allowed my emotions to take control of my trading, which is never a good idea. Some months, I would see the VIX climb a couple of point during one day, and I would sell my position at a small profit and re-enter the trade when the volatility dropped back. Other months, every option I held would expire worthless as the VIX never increased, and I’d be out the entire investment I put into those options. I mistakenly never created systematic entry points and exit points. Not having a system gave me the freedom to enter and exit at whatever point I chose convenient, translation: I entered and exited on my whims, without any thoughts, based solely on emotion.

Jesse Livermore once said “ It never was my thinking that made the big money for me. It always was my sitting.” He was referring to being patient in the market, and not allowing the noise of the market to pulse through the signals. I was not able to have patience and sit on my strategy until payday. Fortunately, I am learning this lesson early without suffering a big loss besides a few months of cheap options premiums. This lesson is paid in full by opportunity cost. It is a lesson that I will take to heart as I continue to explore this market.