Authored by Christopher Cole via Artemis Capital Management,

A full version of the article is available on the Artemis website.

Volatility and the Alchemy of Risk

The Ouroboros, a Greek word meaning 'tail devourer', is the ancient symbol of a snake consuming its own body in perfect symmetry. The imagery of the Ouroboros evokes the infinite nature of creation from destruction. The sign appears across cultures and is an important icon in the esoteric tradition of Alchemy. Egyptian mystics first derived the symbol from a realphenomenon in nature. In extreme heat a snake,unable to self-regulateitsbody temperature,will experience an out-of-control spike in its metabolism. In a state of mania, the snake is unable to differentiate its own tail from its prey,and will attack itself, self-cannibalizing until it perishes. In nature and markets, when randomness self-organizes into too perfect symmetry, order becomes the source of chaos.

The Ouroboros is a metaphor for the financial alchemy driving the modern Bear Market in Fear. Volatility across asset classes is at multi-generational lows. A dangerous feedback loop now exists between ultra-low interest rates, debt expansion, asset volatility, and financial engineering that allocates risk based on that volatility. In this self-reflexive loop volatility can reinforce itself both lower and higher. In a market where stocks and bonds are both overvalued, financial alchemy is the only way to feed our global hunger for yield, until it kills the very system it is nourishing.

The Global Short Volatility trade now represents an estimated $2+ trillion in financial engineering strategies that simultaneously exert influence over, and are influenced by, stock market volatility. We broadly define the short volatility trade as any financial strategy that relies on the assumption of market stability to generate returns, while using volatility itself as an input for risk taking. Many popular institutional investment strategies, even if they are not explicitly shorting derivatives, generate excess returns from the same implicit risk factors as a portfolio of short optionality, and contain hidden fragility.

Volatility is now an input for risk taking and the source of excess returns in the absence of value. Lower volatility is feeding into even lower volatility, in a self-perpetuating cycle, pushing variance to the zero bound. To the uninitiated this appears to be a magical formula to transmute ether into gold… volatility into riches… however financial alchemy is deceptive. Like a snake blind to the fact it is devouring its own body, the same factors that appear stabilizing can reverse into chaos. The danger is that the multi-trillion-dollar short volatility trade, in all its forms, will contribute to a violent feedback loop of higher volatility resulting in a hyper-crash. At that point the snake will die and there is no theoretical limit to how high volatility could go.

Thirty years ago to the day we experienced that moment. On October 19th, 1987 markets around the world crashed at record speed, including a -20% loss in the S&P 500 Index, and a spike to over 150% in volatility. Many forget that Black Monday occurred during a booming stock market, economic expansion, and rising interest rates. In retrospect, we blame portfolio insurance for creating a feedback loop that amplified losses. In this paper we will argue that rising inflation was the spark that ignited 1987 fire, while computer trading served as explosive nitroglycerin that amplified a normal fire into a cataclysmic conflagration. The multi-trillion-dollar short volatility trade, broadly defined in all its forms, can play a similar role today if inflation forces central banks to raise rates into any financial stress. Black Monday was the first modern crash driven by machine feedback loops, and it will not be the last.

A reflexivity demon is now stalking modern markets in the shadows of a false peace… and could emerge violently given a rise in interest rates. Non-linearity and feedback loops are difficult for the human mind to conceptualize and price. The markets are not correctly assessing the probability that volatility reaches new all-time lows in the short term (VIX<9), and new all-time highs in the long-term (VIX>80). Risk alone does not define consequences. A person can engage in highly risky behavior and survive, and alternatively a low risk activity can result in horrible outcomes. Those who defend and profit from the short volatility trade in its various forms ignore this fact. Do not mistake outcomes for control… remember, There is no such thing as control… there are only probabilities.

The Great Snake of Risk

A short volatility risk derives small incremental gains on the assumption of stability in exchange for a substantial loss in the event of change. When volatility itself serves as a proxy to size this risk, stability reinforces itself until it becomes a source of instability. The investment ecosystem has effectively self-organized into one giant short volatility trade, a snake