One of the major hallmarks of the Bull Run after the financial crisis was the lack of volatility. The implications of this lack of volatility has been dire. In the past few quarters, the trading revenues from big investment banks has fallen while others have been forced out.
As shown in the chart below, the Chicago Board’s volatility index peaked in 2008 when it soared to slightly below 100. After the peak, the index started declining. Last year, it spent all its time at the all-time low level.
Surprisingly, it was at these prices when global risks were rising. For example, the VIX had very little movements even when North Korea tested its missiles. It remained at historically low levels even when Trump was threatening fire and fury to North Korea. It also remained low at a time when hurricanes and fires engulfed a significant part of the United States.
All these were signs of complacency among investors. By being complacent, they believed that markets would always move up. They bought the dips whenever they happened.
For traders, the lack of volatility was a bit difficult because it was near possible to make trading decisions. How do you do comprehensive technical analysis when financial assets are only moving up?
The lack of volatility also attracted many traders to the risky world of cryptocurrencies. Most people who rushed to buy bitcoins and other cryptocurrencies knew nothing about them. All this pushed cryptocurrencies to almost a trillion dollar valuation before they started to crash in January.
To measure the volatility or fear in the financial markets, traders use the CBOE Volatility index, also known as VIX.
This index was started in 1993 by CBOE. At the time, the index was created to measure the expectations of the 30-day volatility implied by at-the-money S&P 100 index option prices. Later, the CBOE teamed with Goldman Sachs to update the VIX model. The updated VIX is based on the S&P 500. It estimates the expected volatility by averaging the weighted prices of the S&P 500 puts and calls over different strike prices.
Often, a rise in volatility leads to low stocks price as investors put their funds from the stocks.
For a while, an anonymous trader (or group of traders) started to bet that the era of low volatility was almost over. The trader(s) is commonly known in the financial markets as 50 Cent.
In March last year, CNBC reported the trader had continued to lose money by betting that volatility would peak up. At that time, he had lost more than $75 million. At the end of last year, the trader had lost more than $197 million.
50 Cent was not alone in this. Recently, another trader, known as VIX Elephant started accumulating VIX options. In December, he bought more than 2 million VIX contracts. He lost between $20 and $30 million that month.
Starting Friday, the volatility the elephant and 50-cent have bet on for years has returned. In the past five days, the VIX index has gained by more than 100%. The VIX has gained as investors have become increasingly worried about inflation, which could accelerate the rate of interest hikes. For traders, the return of volatility is welcome because it increases the swings of financial assets and thus increasing the potential for returns. Of course where there is volatility there is risk, something a fact that some trading on volatility may overlook.