Time to prepare for volatile volatility?

With the S&P 500 rallying and the VIX Index on the verge of breaking technical support, which way is volatility like to go? Bill Luby at VIX and More says that the VIX could be regarded as either high or low, depending on the time frame.


How fat are the near-term tails?
There are indications that we could be in for a fat-tailed event. Tyler Durden at Zero Hedge speculates that the behavior of quant fund returns indicate that we could be in for another blow-up:

"Anyone who is doing anything sensible right now is either losing money or is out of the market entirely." These are the words of a quant trader, who is seeing something scary in the capital markets. Scary enough to merit a warning that we could be on the verge of another October 87, August 2007, or January 2008...

He pointed out that the runup was accomplished on low-volume, which may not be sustainable [empahsis mine]:

[T]he Volume Weighted Average Price of the SPY index indicates that the bulk of the upswing has been done through low volume buying on the margin and from overnight gaps in afterhours market trading. The VWAP of the SPY through yesterday indicated that the real price of the S&P 500 would be roughly 60 points lower, or about 782, if the low volume marginal transactions had been netted out.

Durden believes that the fast quant fund money is withdrawing to the sidelines. As many of these funds are liquidity providers, this suggests that the market could be setting up for a period of high volatility should any market participant try to come in to buy or sell in size. (Read his whole post here and follow-ups here and here.)

This is very intriguing analysis. If Durden is right, then is it time to buy volatility?

Stat Arb + Economic Stress = Trouble?

As part of a continuing series on surviving as a quant , I would like to focus on how investors need to know the economic rationale behind a quant strategy.

The statistical arbitrage hedge fund strategy, or “stat arb”, is a case in point. Classic stat arb can be simplified as buying oversold stocks and shorting overbought stocks, along with some risk control layered on top of the stock selection process.

The economic rationale behind this type of strategy is that the stat arb practitioner is being paid to provide liquidity to the market. In normal times, this approach can be quite profitable but it can backfire badly during periods of economic stress. If you use a short-term investment strategy of buying oversold stocks and shorting overbought stocks during a recession, you will ride the big losers (e.g. Adelphia, Enron, etc.) all the down to the bottom.

The accompanying chart shows the investment results of an overbought/oversold model. It ranks US large cap stocks on a short-term overbought/oversold measure and buys the bottom 20% most oversold and shorts the top 20% most overbought stocks. I do not pretend for the moment that this is an actual stat arb strategy as it has no risk control. However, it does serve as a proxy for the performance for these types of strategies as I have discussed elsewhere. This model had a drawdown of over 20% in 2001, as many stat arb strategies did at the time, and has been having some difficulty currently.

The signs of economic stress in are everywhere, particularly in the US. Investors should be wary of too much exposure to stat arb strategies under these economic conditions.