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Why The Next 30 Days Are Crucial for Markets – and Your Money

2 | By Shah Gilani

As sure as your summer tan is going to leave you pale, the coming market volatility will turn you white with fear if you’re not prepared.

Sure enough, volatility’s been reasonably subdued this summer… but summer’s over.

When most investors think about volatility they think about the VIX, the Chicago Board Options Exchange (CBOE) Volatility Index. Often referred to as the fear index, the VIX represents one measure of the market’s expectations of market volatility over the next 30 days.

And the next 30 days are absolutely crucial to the markets.

Here’s why everything’s about to get volatile.

What We Talk About When We Talk About Volatility

I was one of the traders on the Floor of the CBOE who came up with the VIX. We didn’t call it the VIX. We had no idea it would turn into the VIX.

It was 1983 and options on the OEX had begun trading. The OEX, which was originally named the CBOE 100, is a capitalization-weighted index of the 100 most actively traded stocks (based on options volume back when the index was created) at the CBOE, and was later re-named the S&P 100 when Standard & Poor’s took over management of the index. I was a market-maker in the OEX pit on the opening day of trading.

Back then we used Monchik-Weber computers, programmed with the Black-Scholes options pricing model, to determine fair-value of the options we traded. The problem was the model’s values weren’t usually close to what the actual prices of options were in the real world.

Figuring out whether calls and puts we were trading were priced commensurate with the risk in buying or selling them was critical. There had to be a reason why prices in the real world were different from the elegant Black-Scholes model’s valuations.

We figured it out.

In the free market, where true price discovery happens, investors price options based on their expectations, usually based on fear and greed. By extracting the actual  volatility measure out of the price of an option, which in the Black-Scholes model would be mathematically based on a measure of actual historical volatility, we could determine the “implied volatility” that investors created by pricing in their fear and greed.

Using front month calls and puts on the OEX, we started with five strike prices above and below where the underlying OEX was trading, stripped out the implied volatility in each option and created an index of implied volatility.

In essence, that’s what the real world thinks (in terms of how they price options) volatility is going to be in the near term.

Our work caught on, got refined, was applied to the S&P 500 Index options, and ended up as the VIX.

Psychology Moves Money, Money Moves Markets

What the VIX tells us is where psychology is and what investors are feeling – most importantly whether they’re feeling greedy or fearful.

My motto is that money moves markets, but psychology moves money. So, when the VIX is low it means investors are comfortable and aren’t paying wild prices for options. When the VIX rises it’s because investors smell fear and start paying up for puts as protection, to lock in profits, hedge, and speculate that a downdraft is coming.

The fact that the VIX has been so low is partly telling us that investors are complacent, and that they expect a “controlled” environment to yield gains as opposed to spikes and drops.

That’s all artificially induced by central banks.

And that’s a BIG problem.

Complacency is only part of the psychology. The other part is apprehension. Investors are not active. They’re not aggressive buyers up here, so they don’t need to bid up calls or bid up puts to protect big positions they’re putting on, because they’re not putting big positions on. That’s part of the reason the VIX is so subdued.

But that same complacency and apprehension can turn to fear in a New York second.

And that turn is coming up in September.

Central banks are meeting throughout September, and any unusual moves – by that I mean unexpected moves – could trip up markets instantly.

Investors, partly because they’re being fooled by a low VIX, have lost sight of the increased cross-asset correlation that has so many investors in so many of the same positions.

A selloff anywhere, in any asset class, can easily trigger margin calls and selling across asset classes, which could theoretically cause a global rout in very short order.

The Markets Are in for a Crazy Fall

The two biggest positions investors have on are in bonds and currencies, and they are directly related.

In case you don’t understand why investors are bending over backwards to buy negative-yielding bonds in Japan and Europe, it’s about the currency piece of the trade and front-running central banks.

For example, the Japanese yen has been rising because investors are buying yen and parking their yen holdings in Japanese bonds. Japan’s central bank has been buying all kinds of Japanese bonds, taking yields into negative territory. Investors know they’re going to keep buying (at least they pray they’re going to keep buying), because when the BOJ buys bonds it raises their prices so investors who aren’t getting paid any interest are at least getting capital appreciation.

And as more investors move into those types of trades, front-running the BOJ, they have to buy more yen, bidding up the yen. And like magic, investors make money on the currencies they bought to buy the bonds they’re holding.

It’s about currencies and bonds, that’s a monumental correlative relationship. If one falters the other will follow.

How thick are those positions? They’re leveraged well into the trillions of dollars.

With U.S. elections coming up, political craziness in Brazil, the Middle East, Europe, China, North Korea, and all over, something somewhere could give way, hitting currencies and triggering massive volatility and panic selling of bonds.

Stocks won’t be immune – they’ll fall like dominos.

We’re getting ready in my newsletter services for a crazy fall – yes, I mean autumn… and potentially falling markets, across multiple asset classes.

Volatility measures, first and foremost the VIX, will be the canary in the coal mine.

Good luck hanging onto that tan.

Sincerely,

Shah

2 Responses to Why The Next 30 Days Are Crucial for Markets – and Your Money

  1. Edouard D'Orange says:

    I don’t think that markets are going to get volatile. The central banks will rather quickly act to do what they deem necessary to calm dropping markets. Big banks, which are protected, will demand action to save the industry. The Federal Reserve has enumerated the tools that it has at its disposal. Even you, Mr. Gilani, predicted that Chair Yellen would name them before she did in her recent speech. Why won’t she use them should she decide it’s the time. Investors will still invest, even at a modest pace in this scenario. Japan has been doing this boogie (or kabuki theater) for decades. What makes you think that this time is different?

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