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Kurt Cobb

Kurt Cobb

Kurt Cobb is a freelance writer and communications consultant who writes frequently about energy and environment. His work has also appeared in The Christian Science…

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Buying Volatility: Good Or Bad Idea?

Buying Volatility: Good Or Bad Idea?

Wall Street’s buying of options--options on stocks, on commodities, on currencies, on almost anything--has been seen as a sucker's bet (unless you are doing it to hedge an existing investment).

For the uninitiated, options are the right to buy or to sell something--practically anything really--at a set price over an agreed period of time. I can call my broker and buy the right to purchase Yahoo at $35 a share between now and April 15 next year for $2.32 a share. I can also buy the right to sell Yahoo at $25 a share for $1 a share. I might do this if I owned the stock and wanted to protect my investment in case of a decline. With Yahoo trading at about $32 a share, neither option would make me any money right now. But either one could make me money, and possibly lots of it, if there were to be a major move in Yahoo either up or down between now and April 15. In essence, I would be buying volatility.

Yahoo dropping to $2 a share or zooming upward to $200 in the period before the options described above expire would surely destroy a significant chunk of the wealth of those who sold options to others that allow them to sell at $25 in the former case or to buy at $35 in the latter case. Related: Can China’s SPR Rescue Oil Markets?

But, it turns out that most stock and commodity options expire worthless. And so, those selling the options walk away with the premium paid by the buyer and then reinvest that money or spend it elsewhere. These option sellers (or "option writers" as they are often called) make a very handsome living during times of low volatility such as we have seen since the stock market bottomed in 2009.

But the true description of their situation comes from the world's most famous student of risk, Nassim Nicholas Taleb. He describes option sellers as people who are picking up nickels and dimes in front of a steamroller--and don't know it. They are selling options--sometimes for mere pennies--when they are risking dollars if they are wrong. Such events, they reason, are so rare that these events won't happen to them.

But they fail to understand that hidden risks in the world-at-large which affect the prices of financial instruments (and many other things in our lives as well) cannot be quantified or anticipated in a systematic manner. Taleb calls such hidden risks "black swans," defined as rare, unforeseen, but highly impactful events. When a black swan creates huge volatility in the financial markets, some option sellers can be wiped out. And, it turns out that such rare events are far less rare than standard financial models predict.

It stands to reason then, that in a world of increasing instability such as the one that is now emerging--increasing geopolitical turmoil around the world (especially in the Middle East), increasing climate-related turmoil (for instance, last week's 1,000-year rain in South Carolina), and increasingly jumpy stock and commodity prices (especially oil)--that option sellers would be running for the hills. Related: VW’s Dieselgate Scandal Could Cost Up To $87 Billion In Total

But old habits die hard. Some options such as those on the S&P 500 Index are more expensive now than they were in July before all the volatility. But as yet, option sellers haven't faced the kind of wipeout many faced in the fall of 2008. The ever-present steamroller has picked up speed, but the option sellers don't yet seem to feel even the heat from the steamroller's massive wheel.

In a sense, anyone who has not played the risky game of stock and bond investing in recent decades is considered foolish. For the steady march of both markets from generational lows in 1982 to generational highs today has made anyone who simply bought and held seem like a genius.

Lucky, however, is not the same as smart or well-trained. We can be reasonably assured that someone playing Rachmaninoff on the concert stage didn't simply get there by chance. My dentist whom I visited only last week didn't extract my painful tooth by luck. That kind of work takes training--at least it does if you don't want the patient to feel the drill cutting up the tooth or the roots coming out as parts of the tooth are removed! But investment mavens and gurus who are listened to by millions may be nothing more than lucky to have caught the greatest bull market in history. Let's see how they do on the way down.

Options are really insurance, insurance against bad outcomes. People have car insurance, home insurance and even life insurance. But almost no one takes out investment insurance. The whole idea seems absurd when financial markets are "known" to go only in one direction, up. It is the legacy of an age of perpetual growth that we hear that the market always comes back.

Except when it doesn't. Japan's last great bull market peaked on the final trading day of 1989 when the Nikkei Index reached 38,957. The index touched its post-boom low in March 2009 just above 7,000. Today, 25 years after the peak the Nikkei stands at 18,438. That's what a stock market did in a country in which economic growth essentially stopped for 25 years.

Are we headed for an era of low or no growth? Does a "great stagnation" or a "secular stagnation" lie ahead of us? Related: Is The Oil And Gas Fire Sale About To Start?

Even if not, history is replete with long bear markets--a really famous one that lasted from 1929 to 1942 and a not-so-famous one that lasted from 1966 to 1982. The New York Stock Exchange closed at the beginning of the First World War on July 30, 1914 and didn't open again until December 12. A few years later bonds issued by one of the great powers involved in that conflict, Russia, became worthless as Lenin and his revolutionary government repudiated all debt taken on by the czars.

Of course, nothing like that could happen today. We believe that we have figured out how to have only prosperous years without any side effects from the mountains of debt we've built up worldwide and the massive financial imbalances between rich and poor and between nations. We've learned to ignore disturbances like the ones currently going on in Syria and Iraq, in the South China Sea, and in Ukraine. Days of reckoning are for other people, not for us. We live in the financial land of perpetual sun where nighttime has been engineered away.

And yet, I can see the first shadows of a long forgotten economic, financial and geopolitical night starting to creep into our daily lives and into the mood of the times. I can see more volatile days ahead.



Full disclosure: I own no investments related to Yahoo, the S&P 500 Index, the Nikkei Index or crude oil. I do own other investments that would benefit from high volatility in the stock and commodities markets.

By Kurt Cobb

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