A Volatile, Illiquid Paradise

By | October 2, 2015

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Summary Two characteristics of today’s market – volatility and illiquidity – are in focus for many investors. What many small investors fail to realize is that straightforward Graham-style investing isn’t the only way to profit from volatility. This market is paradise for the small, self-directed value investor with a willingness to take on insurance liabilities. There is a lot of confusion about volatility . Some people think that volatility is the square root of the variance in a price series. They would be correct, except when they’re not. Others think that volatility is whatever the CBOE’s VIX metric says. This is also true, but limiting. Similarly, still others would argue that volatility is whatever the derivatives market implies that volatility is. Most will agree, however, that volatility is bad . We say “most,” but Seeking Alpha really isn’t “most” people. Any investor with even a cursory understanding of Graham-style investing knows the metaphor of Mr. Market, the moody, irrational purveyor of market prices. If we are patient with him, we can take advantage of his irrationality, which is what we ought to do as investors. In this understanding, volatility is simply noise , and it certainly isn’t a bad thing. As value-driven investors, we encourage this latter mentality, but we wonder if “volatility-as-noise” cuts the conversation too short. We see more opportunity here than the traditional Graham paradigm suggests. Taking advantage of more When we take advantage of what we estimate to be mispriced securities, we are directly using the volatility of the market to our advantage. The idea is that our counterparties (sellers or buyers) are simply lacking in time, cash, or information (or perhaps they are limited by fiduciary obligations), and when we trade shares, their loss is our gain. What if we take this one step further? If we are comfortable taking advantage of others’ value miscalculations by buying or selling a stock at a certain price, why would we not also be comfortable taking advantage of our counterparties’ miscalculations (or irrational obsession) with volatility itself? Return to the popular impressions of volatility. Each has profound limitations. When we take the square root of a variance , we are more often than not simply using a security’s end-of-day closing prices. This ignores daily ranges, which can be quite significant. When we refer only to the VIX , we correlate volatility almost exclusively with indices’ downside and thereby mistake “volatility” for “fear” (thank the financial media for this). When we rely on the implied volatility of derivatives, we assume a standard deviation of returns in a stock, largely ignoring the possibility of gapping and skewed returns. Assessing risk with any one of these volatility measures is a fool’s errand — and there are plenty of fools in the market. The illiquidity trap When we view volatility as baseless noise rather than risk , a whole world of opportunity presents itself. I.e., if we think that Mr. Market’s irrationality presents us with opportunity, then others’ “risk” can be our reward. If you were afraid of volatility (here meaning simply variation in a price series), as many portfolio managers are (think pensions), you would be eager to hedge against it. This has always been the case, though as we gaze into the maw of a potential bear market, survival instinct makes portfolio insurance more appealing than ever. As a corollary, selling insurance (puts) in periods of (VIX-style) volatility can be quite profitable. August 24th demonstrated, however, that this is not “normal” volatility. In the last few years, the Wild West of HFT penny-spread market-making turned the average transaction size into a tiny fraction of what it used to be, and largely pushed other market-makers out of the game. When the exchanges then gradually disincentivized even HFT market-making (thank you Michael Lewis ), no one was left to provide liquidity — especially in times of uncertainty (see 2010 Flash Crash ). What this means for the aforementioned portfolio managers is that the exchanges are not friendly places to do business in volume. For large orders, crossing networks and dark pools are preferred. The problem with these venues is that your counterparty is typically as well-informed as you are (i.e., they won’t be buyers when things are hairy). With nobody to sell to, paying a premium for a put option (and guaranteeing yourself a customer at a pre-determined price) becomes even more appealing. Selling insurance Value investors have beliefs about the intrinsic value of companies . Whether by virtue of cash-flow growth, “real options,” management savvy, or relative undervaluation, we can determine a range of prices at which we would be happy to own any publicly traded stock. Sometimes those ranges are small and confident; sometimes they are wide and uncertain; sometimes they converge at $0.00. Regardless, we have a basis for investment and a preferred entry point. The upshot to this assumption is that by selling insurance to portfolio managers in the form of put options, we can have our cake and eat it too. By selling a put at a strike price within our target range, we can not only provide ourselves the opportunity to buy into a stock at a favorable price, but also collect premium for our trouble (regardless). Furthermore, since brokers tend to be generous in their risk calculations for put-sellers (thank the Black-Scholes-Merton equation for conventional risk-assessment), we can get our fingers into all sorts of opportunities at relatively low cost, spread risk across multiple sectors, and collect premium while we wait. To most speculators, “risk of assignment” in the case of a decline in price would be detrimental. To a value investor, “risk of assignment” at a favorable price doesn’t sound much like risk at all. This is the strength of being a value-oriented investor. Ignoring a high-volatility, high-premium market environment is a missed opportunity. To some readers, this will already seem mind-numbingly obvious. Indeed, some contributors on Seeking Alpha are already practitioners of this philosophy (though they are not usually the most visible). Others, however, may not have seen an opportunity for this approach in the frothier, low-implied-volatility markets of the past few years, and may have discarded the idea out of hand. Now – in a high-volatility, high-uncertainty, and low-liquidity market – is the time to reconsider. Scalper1 News

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