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The Central Bank Of Volatility

I have always found it puzzling that most of the discussion surrounding the LTCM story has focused on the “math stuff”. To many observers, the fund failed because its funky models went awry, because the extravagant quantitative techniques used by the geeky principals ceased to work in the face of unprecedented market turmoil. This line of thought fits the commonly-held stereotype of LTCM as a theory-driven laboratory where ultra-sophisticated mathematical alchemy was devised by PhD-holding rocket scientists who pocketed untold sums of money because of their superior brainpower.

Now, I don´t doubt for a second that LTCM was full of very intelligent people who had, by the way, proven their worth as traders for many years prior to the creation of the fund. I don´t pretend to play down the techniques employed in devising the trading strategies. But I have always been a bit suspect about the overriding role of the quant stuff when it comes to LTCM. I mean, DE Shaw they weren´t.

Again, exaggerating the quanty (non-human) aspect behind LTCM´s decision-making processes serves the purpose of satisfying those comfortable in the belief that hedge funds and other derivatives users are driving the world into chaos through the mischievous use of esoteric equations and computer programs. To learn that perhaps some of the strategies were less-than-complex, in fact quite simple, would be akin to heresy to such deeply-entrenched conventional wisdom.

Take the “short long-dated equity volatility” strategy, which was a late starter but ended up causing untold mayhem. Call me naive, but as hard as I try I can´t see anything out-of-this-world about nakedly selling options into the market. I am possibly missing something, but what LTCM basically decided to do (apparently in a quest to diversify away from its traditionally dominant fixed-income trades) was to sell equity index options to the structured products players that needed to buy long-dated volatility as a way to hedge their positions. Nakedly selling options is a simple strategy, isn´t it?. In fact, some people may see it as an easy way to generate income without having to think too much.

But while LTCM´s equity volatility trades may not deserve to belong under the “funkily complex” category, they deserve our attention for one crucial reason (besides the fact that it cost the fund hundreds of millions in losses), something that is as relevant today as it was back then: the tricks that implied volatility can play on you.

Apparently, LTCM believed that shorting (implied) volatility at 22% was a bargain because historical (realized) volatility had been around 15%. The thinking seems to have been that 22% was way too high compared to the usual 15%, and thus anyone selling at 22% had to make money eventually. The problem, of course, is that this analysis was akin to comparing apples with oranges. Implied volatility and realized volatility are simply not the same thing. The latter is true real market turbulence. The former is whatever number traders are consensually inputting under the pricing model´s volatility parameter. Part of that number may reflect the market´s expectation of future real turbulence, but it likely also contains other stuff. As we know, traders use the volatility input to manipulate the model so as to obtain the price that they want; in doing so, they may produce an implied volatility number that is useful for their pricing intentions, but that has very little to do with what they think real volatility is going to be like. Implied volatility is thus, by defition, a very distorted picture of expected volatility. An approximation at best.

LTCM looks as if they overlooked this basic fact. They seem to have believed that they were betting on real volatility (or at least real volatility estimates by traders) being below 22%, when in fact they were gambling that the number that traders would input as volatility in the model would be below 22%. Two widely different things of course. It is one thing to gamble on real market turbulence or the expectation of it (parameters that could be reasonably calculated to a certain degree), and another thing to gamble on traders´opinions about a whole bunch of stuff (real volatility but also liquidity concerns, crash-o-phobia, demand-supply disequilibriums, and in general anything that would affect their gut feelings).

Eventually, long-dated implied equity volatility did rise to staggering levels (30%, then 40%), thus killing LTCM, and for weird (ie, very difficult to forecast) reasons. After the Asian and Russian crisis, the number of players in the structured products market went down dramatically and “volatility supply” simply dried down. As supply goes down, up goes its price. Anyone who wanted to purchase long-dated volatility had to pay dearly. As LTCM began to hurt badly, counterparts apparently marked up the implied volatility against the fund as a way to protect their interests. Demand-supply travails and traders´ survival instincts are what truly drove implied volatility to crazy levels well above 22%, not a sustained belief that true market turbulence was going to be that high.

In the options markets oranges are oranges and apples are apples.