Friday, May 23, 2014


Yeah, a storm is threatening
My very life today
If I don't get some shelter
Lord, I'm gonna fade away
--Rolling Stones

As volatility continues to drip lower, Toddo notes that lack of price movement entices market participants to ratchet up leverage in order to magnify returns. Leverage can be increased by using margin to increase position size. It can also be done by 'selling vol' via derivatives.

Such actions build 'compression' into markets. Compression is like potential energy. Highly compressed markets have great potential for unleashing stored energy. As potential energy turns kinetic, large price movements occur.

The longer low volatility periods persist, the more market participants are tempted to mistakenly extrapolate current conditions far into the future. As they become increasingly convinced that the environment has changed for the long haul, investors take on increasingly more risk via levered positions.

When prices begin to percolate for whatever reason (e.g., exogenous event, reversal of herd direction, etc), these levered positions turn against investors. As they scramble to reduce risk by shedding leverage, prices move even more, creating a reinforcing effect that catapaults volatility higher.

The process continues until market forces rebalance and the system 'decompresses.' Decompression is manifest in the volatility storm that Toddo suggests is brewing.

position in SPX

1 comment:

dgeorge12358 said...

Vertical and horizontal lines are the expression of two opposing forces; they exist everywhere and dominate everything; their reciprocal action constitutes 'life'. I recognized that the equilibrium of any particular aspect of nature rests on the equivalence of its opposites.
~Piet Mondrian