Trader’s Narrative

The Chinese say, May you live in interesting times. This year the market started out the year with a few truly interesting backdrops. Among them a colossal trading loss that shook Société Générale to its core.

Did you know that Jerome Kerviel’s was the largest trading loss in history?

At least so far!

To provide some context about loss, here are the top 10 trading losses ever. At least, it can provide you with some perspective about yours

Notice how all, except for one, were a result of trading in derivatives? The only equity loss big enough to make it on the board was $0.8 (by Friedhelm Breuers from WestLB, Germany) which ties for the last position.

Lesson? Trading derivatives is like juggling running chainsaws which also happen to be on fire. Unless you know what you’re doing, it will get messy.

Sure, these losses look unreal but each and every one of them started out as a small loss. The only reason why they are up on the board is they were allowed to balloon into grotesque proportions. So it is with the losses of us mere mortals. If we allow our convictions to overrule our discipline, we’re headed towards the same fate.

If anything, such gigantic losses should, for once and for all, put a damper on conspiracy theories of market manipulation. After all, if someone can’t bully a market with a few billion, then the market is indeed bigger than anyone and everyone.

Source: Wikipedia

What lessons do you draw from this?

From a historically low reading of 10 earlier in the year, volatility as measured by the CBOE’s VIX has all but tripled. On Friday it closed lower but intraday it reached a high of 29.84.

That’s high both on a nominal basis and relative basis (see graph below). In the preceding two corrections, volatility only reached 20 something. And relative to its 50 day moving average, volatility is now about as stretched as then.

This is par for the course when we are operating with a correction thesis. Volatility spikes, the market gets spooked, smart money moves in (hopefully you) and the market resumes its merry way upwards.

But a funny thing happened that is giving me concern about this recent volatility spike. Funny as in weird. Not ha-ha.

VIX Futures
A little over 3 years ago, the CFE started trading in VIX futures. This allowed people to go long/short “pure volatility” for the first time. So we now have a futures market in volatility itself. And we can analyse this market like any other futures market.

Although we have limited history, what we see in market corrections is a move by the commercials to reduce their long positions in volatility and a concomitant move by the retail crowd (small speculators) to increase their long positions. A good example is last summer’s market action in June.

Smart Money vs. Dumb Money
So it is a bit disconcerting to now find the smart money commercial players in this market actually going more and more net long, even as the VIX has increased. And to kick things up another notch, the dumb money, small speculators are now extremely net short.

Perhaps the commercials are hedging some of their gargantuan net long index futures positions? or perhaps some other wrinkle is in the works? One solace we can cling to is that the only other time when the commercials and small speculators were this long/short in the VIX market was in July 2006. Which worked out just fine as the market continued to recover and roar higher.

Whatever it is, I’d still prefer to see the commitment of traders in the volatility futures market acting according to its past script.

Hat tip to Jason Goepfert at SentimenTrader.com