You’ve mentioned before of market players being “caught short volatility”. I know this has to do with options. Can you explain this a bit further. I don’t recall it in the course but maybe I missed it?
I’m thinking it has to do with market players selling options expecting volatility to remain subdued and for prices to stay in a range….but if volatility increases and the market breaks out…that forces them to have to cover….thus, accelerating the move?
Is there anywhere to get this info. of whther the market is short or long volatility?
Throughout all my trading and knowledge and studies of the market over the years, I learned that you can conceptually break down trading into roughly two things – either your trading or trade is long volatility, or it is short volatility. You can have on a long vol trade or a short vol trade.
Long Volatility = long vol
Short Volatility = short vol
Now obviously let me explain this a bit further because it can be really confusing.
Lets say you place a directional trade in any market – whether you buy or short a stock, currency, futures contract, etc. You are betting on a directional move. The bigger the move, the bigger your profits. Thus, what you are really betting on is volatility. The more volatility in your favor, the more money you make. Thus you are in a sort of way “long volatility.” You are betting on a big move.
As David Ryan in the Market Wizards book said:
If you really think the stock is going to make a big move – and that should be the only reason you are buying the stock to begin with…
Ryan is talking about the MDMM and GM moves. Of course there are also the smaller inefficiencies such as the ODVE, and intraday volatility moves, stops tripped, option barriers, etc that you can take advantage of as well. You don’t always have to be going for the MDMM or GM moves. You can add in some tactical trading for the smaller moves if that is what your heart and philosophy desire.
That is why, if someone is engaging in directional trading, the big profit months are made when there is big volatility (lots of ODVE, MDMM and GM moves). Which also means that the lowest profit months can also occur during times when volatility is the smallest (lack of ODVE, MDMM, GM moves). Which can also mean that the losing months were either due to being on the wrong side of the volatility moves by misinterpreting the information, or placing trades in a low vol environment expecting a big move, but getting chopped up and whipsawed and suffering losses.
You aren’t usually going to see a hedge fund blow up when there isn’t volatility. You only see the huge Profit and Loss swings when there is big volatility. For example, John Paulson lost around $1 billion dollars on paper over the past week or so during the collapse in Gold with the MDMM to the bearish side.
So when you are engaging in directional trading, the name of the game is to find the volatility. It is all about what the past / current moment situation and volatility is, versus what the future / near future volatility is going to be. Because if you can find a situation where the current moment vol is low, but the near future is going to be higher, sometimes much higher, in the form of the ODVE, MDMM, and GM moves, then you can make a lot of money because you can get in with a smaller stop loss for a big reward risk ratio trade.
So directional trading is one way to structure a long volatility type trade.
You can also do so in the options market – both vanilla options and the exotic market.
If someone believes a stock is in a tight range, but will explode with volatility in the near future, then they can buy the underlying stock (directional trade), or they can buy a call option. They can be “long calls.” Which is a bet on volatility. So they are long on volatility.
Same thing if you expect a market to drop or collapse. You can be long puts, which is a bet on volatility to the bearish side. So they are long volatility.
For example when Paul Tudor Jones shorted the Nikkei in 1990, he could of structured the trade by being short the Nikkei futures contract, or he could of bought put options on the Nikkei index. Or a mixture of both. He definitely bought put options on the index for sure because he said so in this interview:
In some cases people can be long both puts and calls in the same market. That is what is called a long straddle type of option. In that case they are paying a big premium up front for both long puts and long calls, so they need a really big move in one direction to compensate for buying so much option premium to bet on long volatility in both directions.
There are all sorts of ways to structure trades via the options market. I am not familiar with all of them. A good options book will list the dozens and hundreds of ways you can do it.
Then there is the exotic option market.
When someone purchases a One Touch option, or Double One Touch option, that is a form of betting on volatility. They require the market to be volatile to hit their barrier price or else they will lose out on the option premium.
Now we can go onto the “short volatility” type trades.
As you know, every time someone places a trade, there has to be a counterparty to it. So every time someone places a directional trade, there is someone on the other side. Every time someone buys a vanilla or exotic option, there is someone on the other side. Which means that any time someone is going long volatility, there is someone on the other side that is short volatility as well.
So if you were to purchase a long put option, someone is selling it to you. So you are long volatility betting on a big drop, but the person that sold it to you is short volatility, expecting the market to not drop too much.
If a hedge fund goes to buy a One Touch Option, and a bank sells it to them, then the hedge fund is long vol, while the bank is short vol.
Why do people engage in selling volatility? Because usually when you short volatility, you get to pocket an upfront premium. And if the market is not volatile, the option can expire worthless, and you get to pocket the premium. As the option sellers will typically cite the statistics that show that most of the time the market is not volatile and not trending. And if you ever get an option firm trying to sell to you, they can tell you that 95% of options expire worthless or something, so you should be an option seller rather than a buyer.
The advantage of option selling is that the time decay works in your favor. And you get an upfront premium, which some people use the cash to invest it elsewhere.
For example, Buffet went short volatility in a way when he sold a bunch of index put options to the tune of billions of dollars to some other firm that wanted protection from a collapse in the stock market. This firm wanted to buy really long dated index put options and they found Buffett willing to sell it to them. So they paid Buffett a lot of money – either hundreds of millions or billions of dollars, in exchange Buffett took on the liability that if the stock market collapses by a certain date past a certain price, he will have to pay out a lot of money. So Buffett took those billions of dollars in option premium he got and invested them as he saw fit to generate a return. Obviously, he has a liability on this books, and that liability goes up and down depending on the stock market. When stocks collapsed in 2008, that liability grew tremendously and he had to record the paper losses on that index put option contract he wrote. When the stock market rises his liability decreases, because the stock index gets further away from the index put strike price.
The disadvantage with selling options, is that you have a capped profit potential, and you have unlimited liability. The most you can make is the option premium you collect. And if you sold a call option to someone, and you are unhedged, and the market keeps on rising and rising, your losses can keep on growing and growing.
The advantage with buying options is that your profit potential is unlimited. And your risk is limited to what you paid for the option. If you buy $500,000 in call options on a stock, and the stock drops 50% overnight lets say, then your maximum loss is still capped at $500,000. On the other hand, if you bought $2 million worth of a underlying stock, then you have open ended liability. The stock could move against you 5%, 10%, 50%, etc, depending on how wrong you are in the market. Your risk is not capped, even if you think you have a stop loss in place, because the market can gap against you.
The disadvantage with buying options is that they are only for a limited time. You need to get the timing right as well.
Other people can have a different variation of what “long volatility” and “short volatility” can mean. Some people consider going “long volatility” as meaning that you are betting on risk aversion, which in some cases it is true. If you expect the stock market to collapse, and you buy put options, then you are in a way going long volatility, expecting a crisis to happen to cause volatility to the downside. Then some other people consider a “short volatility” trade as a bet on risk appetite continuing, etc.
So in the case of the forex market, sometimes there can be an imbalance in option positions, where there is a lot of players that have sold a lot of options. There can be a long of players that are short volatility, and for one reason or another, they can leave the position un hedged, either partially or in full. If the market breaks out of the extended trading range, then their liability will start to grow and they may be required to execute orders to reduce their liability. And they complete their hedge by placing orders to go with the breakout. This can result in sent/psych shifts when the breakouts happen as not only is the news/sent/fund/macro pushing the market, but also the option players caught on the wrong side of the move have to reduce their liabilities as well.
These types of trades when the currency market is caught short volatility usually do not happen that often. They typically require a very extended trading range of many months to occur. A consolidation of a few days or weeks may not be enough.
Various examples of this short volatility phenomenon occurred in the USD/JPY in late 2012 and early 2013 when it finally started to break out above 82.00 and 84.00 and 86.00 with the help of the news/sent/fund/macro players. It also occurred partially in EUR/CHF during January 2013.
It also occurred in USD/JPY in 1995, when it broke out to the downside. Soros was caught on the wrong side of it and lost a few hundred million dollars, although he still managed to end the year up nearly 40%. Soros has a paragraph or two about this in his book Soros on Soros: Staying Ahead of the Curve.
One of the reasons Long Term Capital Management blew up in 1998 was because they were using excessive leverage, where they had $5 billion of equity capital trying to manage $100+ billion in positions, but also because a lot of their trading was based around shorting volatility. They were betting on risk appetite (and thus betting against risk aversion) continuing. They were also short a lot of equity volatility. They were expecting equities to rise very slowly. They were not expecting a big collapse. When equities collapsed During July – Sept 1998 and risk aversion rose, they lost virtually all their money because they were short vol and their liability was open ended.
As to how to find this information on whether the market is stuck short volatility, I have not found any special indicator or graph that displays this. I consider it kind of like searching for the magic holy grail indicator where it magically tells you where the stop losses are and where the big bids and offers are. It may or may not exist, but I stopped looking for such a magic indicator and just developed my principles and daily habits.
I just perform my daily habits, and do a daily recap of the charts. If I see a big consolidation over many weeks or months, then perhaps there is an imbalance of option positions building up. But I would stress that, in my opinion, it is more important to get the macro right. For the difference between USD/JPY big rise and the EUR/CHF smaller rise, even though they were both caught short vol, was because the macro forces were stronger in USD/JPY. So I would say getting the macro right is more important. Sometimes IFR will have some comments on whether the market is stuck short vol, and those can potentially be interesting.
As a general rule, the times when the market is going to be caught short vol and cause a sustained breakout, either a MDMM or GM move will occur mostly in the liquid currency pairs. It won’t really happen in some of the exotic currency pairs. For example if USD/JPY and AUD/NZD have both been in a trading range for one year, then I would say USD/JPY has a much higher chance of being caught short vol than AUD/NZD, because AUD/NZD isn’t as liquid and not that many people really follow it.
But then again, I don’t want to look at the markets purely from a technical analysis perspective of consolidations, etc bla bla bla. I want to think in terms of the principles in the mastery course – the ODVE, MDMM, GM, battle of scenarios, news/sent/fund/macro, the market can form a big move any time and any place, depending on the news/sent/fund/macro order flow, etc. That is what I want my primary philosophy to be based on.
Why? Because back in my chart pattern and price pattern days I was caught in numerous trades where the charts were beautiful and the market consolidated for such a long time, and the tech indicators were wonderful and the breakout happened, but the trade fizzled out and I got chopped up and lost money. After it happens a few dozens or hundreds of times, I started thinking, maybe there is something else going on that is causing my trades to win and lose? I couldn’t get it out of my head. Why did some trades work out marvelously, while others fizzled out?
Maybe the charts and the time spent in consolidation didn’t matter? Maybe I had a wrong list of reasons? Maybe these charts and price patterns and tech indicators really aren’t causing the market to move?
That is how I gradually found order flow and developed my news/sent/fund/macro players based trading philosophy. It is far superior in my opinion.
So next time you read a trading book or any article or any piece of trading information, ask yourself, is this person or company, long vol or short vol? What scenario are they betting on? Are they betting on risk aversion or risk appetite? It can be a very enlightening question to ask and find and answers to. Many revelations and epiphanies will occur.
For example, most of the people who have money in 401k’s they are all short vol for the most part, and betting on risk appetite. If volatility increases to the downside in the equity market, and risk aversion occurs, they will lose a lot of money. Warren Buffett bases a lot of his investing philosophy on being short volatility and betting on risk appetite. When he owns all the companies he does and all the stocks he does, and he sold all the index puts contracts, these are all short volatility positions betting on risk appetite continuing and betting against risk aversion.
That is one of the tricks to understanding the books such as Inside the House of Money and The Invisible Hands. Think in terms of the principles in the mastery course – the information flow, ODVE, MDMM, GM, battle of scenarios, news/sent/fund/macro, long volatility vs short volatility, risk appetite vs risk aversion, Calm world versus Crisis world, etc.
Small Update #1:
Thanks for the awesome response, Grk! I really appreciate it. That clears up my understanding…but I did have a couple other questions related to what you wrote…
1) Could long or short vol. be broken down even simpler into long volatility is expecting a big directional move (more conducive to breakout trading) and short vol. is for those expecting ranges to hold, so they would be selling rallies and buying dips within a broader range)? So if someone is expecting a large 500 pip directional move (based on whatever scenario they’re betting on)…that could be considered long vol. While those that expect, say, a 300 pip range to continue so they’ll sell the top end of the range and buy the bottom end of the range, then they would be considered short vol.?
2) you mentioned that those in 401ks are banking on risk appetite and that this was short volatility. But couldn’t risk appetite also be LONG vol. if it leads to strong moves upwards in, say, the stock market?
1. Yes, one way is to break it down into someone is expecting a big move, say placing a trade expecting a MDMM or GM to happen, while someone else is not expecting a big move, and they are trying to pick up the small intraday retracements and ODVE, while taking on the risk that the freight train might move against them. So Yes, you could say the person expecting the ranges it hold is short vol. While the person expecting a breakout to happen is long vol. That is one way to look at it.
2. Yes, those betting on risk appetite can be thought of as being long volatility, in the sense that they are expecting a big move to happen, just to the bullish side, the risk appetite side. Although, not everyone who is long the stock market is expecting a big move to happen to the upside. They may be expecting a gradual move higher, a choppy grind higher.
So there are different definitions to being long vol, vs short vol. I try to be flexible and give you guys all the definitions I know that are relevant.
So the first way is someone who is expecting a big directional move, vs someone who is only expecting a small move (but taking on risk that a big move may happen against him).
The other way is in the options market where someone is long volatility in the form of buying puts and calls, while someone else is short vol in the form of selling (writing) puts and calls.
Then the last way is when someone is betting on risk appetite and expecting the market to grind higher slower, say the S&P, they are considered being short vol, while someone who expects a crisis to happen and has all these risk aversion trades, is considered to be long volatility. Why? Because usually the equity markets fall much faster than they rise. Everything gets destroyed a lot faster than it gets built up. Which is why there have been many more 5%, 10%, 20% moves to the bearish side in the S&P in one day in the past. When was the last time you saw stocks up 5%, 10%, or 20% in a single day? It doesn’t happen that often. Hence the reason that a risk aversion trade can be considered being long vol, because risk aversion trades can have big volatility associated with them, if you are correct.
So there are around 3 different ways of looking at it. You can keep the 3 different ways in the back of your mind and use them as you see fit.
There is an example in the Market Wizards book of the power of being long vol if you get it right.
Tony Saliba talked about how he had one trade where from my calculations, he spent around $60,000 – $100,000 on buying the October $180 calls in Teledyne. The stock gapped up to $200. The options that he bought for $1.25, were worth at least $20, if not much more. He made millions of dollars as the reward to risk on the trade was anywhere from 20R to 40R. His 60k – 100k in option premium turned into millions of dollars as he bet correctly on being long vol, got the direction right, got the news/sent/fund/macro correct, and got the timing correct as the move occurred before his options expired in October.