Best of TTU – The Impact of Volatility Trading

Kathryn Kaminski and I had the opportunity to sit down with Nigol Koulajian, the founder of Quest Partners, in which he shared his wealth of experience including life lessons and even his take on the modern scientific trading systems that are used today. One of topics which I particularly liked, and would like to share with you here, was his view on the VIX and Volatility trading within the managed futures industry and also outside of the industry. If you would like to listen to the full episode then you can do so by clicking here.

Nigol… “Certain investments that don’t have great risk-adjusted returns can temporarily turn into amazing bubbles because the return stream has certain characteristics which give time for other investors to come in. So it becomes very self-reinforcing like a positive feedback loop. There are ways, in certain industries, where you can reinforce that intentionally. If you’re an activist investor, you put on a position and then you say, “Here, I got my position,” and other people come in, you can do great. Effectively, it’s like a pump and dump of penny stocks in the eighties. Crypto currencies are a little bit similar. Traders receive text messages saying, “Buy this!” and “only this much for each account”.

"...it’s like a pump and dump of penny stocks in the eighties"

So, effectively these things are being a little bit manipulated. In the same way, regulators, if they don’t control these things, it can be very, very harmful for investors in the long-term. In the case of the VIX, starting from the Fed put, starting in 2009, which was when the market was not going to go down fifty percent anymore. It’s only going to go down twenty. Then you had equity hedge funds which said, “Since it’s going to go down only twenty then I’m going to buy at minus fifteen.” Then, because the minus fifteen is there, you have short-term swing traders who bought at minus ten. Then you had short-term CTAs who bought it at minus five, and then you had artificial intelligence or machine learning techniques who said buy it at minus three.
So, it’s become very self-reinforcing where effectively people are now justifying that the economy is doing great and that’s why the vol. is low. There’s an aspect of the reality that is that markets lead the economy and not the other way around.
I would say, today, what’s going on in the equity world, and the VIX, in particular, has become a very self-reinforcing bubble which is suppressing the vol. in the market. So when an implied vol. in the market comes down; when people sell options in the market until those options expire, effectively you have mean reversion trading. If the market goes down, the options sellers are buyers of that market that is going down, and the option sellers are sellers of the market when it goes up. So they suppress the vol. of the market.

Typically, that lasts until the options expire. So, look at the open interest in a market. What drove the implied vol. compression? With options of this maturity, that’s typically when you’re going to see the mean reversion of the market. Then it typically breaks out. So the VIX is quite a serious thing because a lot of, I’m going to say, very sophisticated investors are putting large amounts of money at play in it. Based on volatility and normalized risk techniques they think they’re taking very little risk. “
Niels: “ On that note, Nigol, you mentioned the word manipulation, there’s the VIX, you talked about big trades, and so on and so forth. But, I think there was an article in Bloomberg recently that mentions that on December 20th of last year, 2017, the “VIX elephant” put on a very large position - something like two hundred and sixty thousand lots. The article went on to talk about how relatively easy it is to manipulate the settlement, which has a huge impact if you’re trading options and you’re waiting for expiring, etc, etc.