How Did Volatility Get So Low?

As I try to escape from the Indian monsoon floods and make my way back to
Chicago, I am inspired to write about volatility since I have seen quite a bit
of it in the last few days.

Well, it’s a different world, Bubba, and you’d better get used to it (for a
while). The rapid advance of electronic trading has created an environment where
risk can be instantaneously hedged away 24 hours a day (not yet “24/7”, but I’m
sure that’s on way). This is accomplished through complex global volatility
books where highly correlated instruments are used to hedge one another.

For example, suppose you buy a straddle on a semiconductor stock on the CBOE. In
today’s digital world that trade is probably being hedged two nanoseconds later
by the purchase of volatility in a correlated stock that is theoretically a
better value. Or maybe it is a highly correlated semiconductor stock in Taiwan
that evening (or maybe they bought cheap volatility the previous evening and
hedged that risk by selling it to you today!)

The integration of global volatility books with electronic trading platforms
allows volatility spikes to be dispersed throughout the world, and the fact that
they are “on” 24 hours a day makes it difficult for the huge gaps, spikes, and
panics of yesteryear to occur. In addition, electronic trading has dramatically
lowered costs, and commission rates continue to plunge. This has caused an
explosion of liquidity as everyone and their mother can now log in and flail
away. (I can get to my servers with a latency of 55ms from this coffee bar; I
could trade competitively right now if it were a weekday).

How Does It Unravel?

You knew I’d get to this part, didn’t you? How will this all fall apart? I have
a couple of scenarios. The first one is easy: The electronic exchanges are as
vulnerable as any other business to hackers. A coordinated attack on several
exchanges simultaneously could cripple the ability of the entities that run
these types of books to execute their hedges. If it persisted it could cause
severe mayhem (I have visions of them emptying out the bars on Lincoln Ave. in
Chicago and begging all the ex floor-traders to go back to the pits).

The second one is guaranteed, it’s just a matter of when: The correlations
dissolve. The relationships relied upon for cross-hedging turn ugly, and the
groups that have used them as hedging vehicles discover that they actually have
on two very different (and probably at that point, very painful) bets. When this
happens it will be ugly with a capital “U”.

In The Meantime…