Peak Volatility – How Hot Can It Get?
(11 min read)
Is there a concept to approach ‘Peak Volatility’? And if not, why not? No, I am not mixing my words up over recent, let’s politely call it erratic, market behaviour. To get an idea of what kind of truck could hit you might just help you to survive. Selling volatility to pocket the carry has been a very lucrative trade for many players for many years until it wasn’t (isn’t) anymore. In subdued, ‘normal’ markets, annual returns between 30% and 50% are by no means uncommon and can be achieved by shorting the front month futures, rolling them into the next expiration when the time comes – and all that while sipping tea until the time arrives for ritual self-disembowelment. Were it not for the occasional (but inevitable) unpleasant surprises, this strategy could keep a hungry hedge fund manager fed quite nicely. So, the question I have been encountering, unsurprisingly, over recent days goes like this: how high can volatility go?
As so often, physics provides an analogy. It’s a well-known question: what is the maximum temperature a system can approach? Almost all students who have stumbled through a Physics 101 textbook can answer the question’s opposite, what is the lowest temperature any system can approach? It’s 0° Kelvin or -273.15° Celsius – affectionately known as ‘absolute zero’. Ridiculously simplified, this is the state where nearly all motion ceases to exist. Without motion there is no friction, and without friction, no heat.
Applying this analogy to security markets, the ‘absolute zero’ of a marketplace would be zero volatility. Theoretically, that would happen either because everybody agreed on the price of a security and trading only happened upon this universally agreed price without any deviation to the upside or downside. Or, more likely, it would be if enlightened central bankers all over the world stepped up and closed markets and stopped trading to avert pending doom. Of course, you could argue that in this case volatility is not really zero but merely in a state of suspended animation, waiting to resume its reign of terror once markets open up again. But for the sake of this argument, let’s say we have defined the lower boundary of volatility with relative ease.
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