I would have been a ripe candidate for the Milgram experiment.
You know the one: “Kill that man”. No way. “Hello, I’m Doctor Smith. Kill that man”. Yes, Doctor. Straight away, Doctor.
Tell me something under the guise of authority and I’m inclined to trust your credential-glazed opinion. Or at least this used to be true. I’ve been a financial journalist for some time now and have grown cynical.
Paradoxically, the more time I spend in the company of experts, the more I come to question the wisdom of their opinions and predictions.
Yes. This is an article about the VIX.
While it would be foolish to doubt an expert’s grasp of the facts – the derivatives space, in particular, is an intimidatingly wonkish and academically muscular industry – they don’t get every call right.
Indeed, there’s a whole branch of thinking devoted to this notion. Philosophers, and more commonly lawyers, refer to it as ‘argumentum ad verecundiam’ or the appeal to authority. It’s a type of inductive fallacy.
It’s probably the wrongful assumption responsible for more lost investor money than any other.
It certainly cost me in my 2007 flirtation with Apple.
‘But I’m not bitter’
In late October 2007, I wanted to make a personal investment in Apple stock.
I sensed a glowing future for the men from Palo Alto. In the course of researching the company, abusing my access as a journalist, I spoke with a number of industry insiders – among them an information architect for Morgan Stanley.
He informed me that because of the restricted nature of application development, talented developers would flee to the rival Google Android platform. I heard similar remonstrations of Steve Jobs’ firm, from those that ought to know, on the grounds of poor build quality, poor business user penetration and stock overvaluation.
The encounters turned me from an Apple evangelist to Apple cynic.
Instead of buying into the stock, on 14 December 2007 I wrote a piece – that can still be found online – calling the top in the share price.
In years since Apple has risen nearly a third in value.
Then, there was something the ordinary man could grasp that escaped the experts.
And maybe history is repeating itself.
When I ask the expert’s opinion of the VIX, the verdict is damning. I’ve previously detailed in these pages the professor – Eckhard Platen – who believes the VIX, and other volatility products, may incite the next financial crash.
Carol Alexander of the ICMA Centre and the legendary Peter Carr have also criticised its method.
Postdoctoral qualification and critical acclaim to one side, I think they’re wrong.
Or rather, I urge the derivatives community to look outside of its models and convention and embrace the possibility of this thing.
The most exciting concept since BRIC
Last month on CNBC, I watched something quite incredible. Bob Pisani and Courtney Reagan, CNBC anchors, were discussing derivatives theory with a scruffy academic during market hours.
The academic in question was Robert Whaley, the creator of the VIX. Professor Whaley was lecturing on the virtues of his index, without interruption or deviation, for ten minutes. During market hours.
As I watched the feed, do you know what it reminded me of?
Nothing.
I’ve never seen ten minutes of discussion on derivative theory on network television.
As someone that worked on CNBC Europe’s news desk for many years I can tell you what that was. CNBC was educating its mass audience on the ways of the VIX. If I were to compare it to anything I would compare it to Goldman Sachs’ BRIC concept.
We are hearing it more and more often. The initial critics and their valid criticisms are no longer steering the conversation. VIX has entered the mainstream lexicon. Next stop, critical mass.
Wise to this, investment banks are countering with their own volatility indices. Deutsche Bank has launched its Equity Long Volatility Investment Strategy (ELVIS), Merrill has its Option Volatility Estimate index (MOVE) and Credit Suisse’s effort – the Fear Barometer (CSFB).
You know what they say about imitation.
And if they aren’t launching competitor indices they are tricking the VIX to create potent tail hedges.
Barclays has benefitted handsomely from its first mover advantage in being the first of a dozen providers to produce a short term VIX futures exchange traded note, VXX. This note sees volumes of $1bn on a typical day.
Societe Generale has introduced an ETN that will dynamically roll from short dated to medium dated futures to minimise the bleed or negative cost of carry that short term holders suffer.
And on the prop side, traders are gaming the VIX even more creatively to maximise the convexity of a rise in volatility. As I wrote in the Financial Times: “It’s a bearish trade with massive firepower: If short S&P is a leaky water pistol then long short dated VIX futures is two sticks of dynamite. Short 1×2 is those two sticks of dynamite going off in a dynamite factory. ”
This is a trend that has a powerful momentum. And there might just be a way of trading in the VIX’s burgeoning popularity without investing in any of these products.
This ain’t Tesla
CBOE created a market for listed options in 1973 and went on to become the world’s largest options exchange, both on contract volume and notional value.
Expressing a view on the VIX through its proprietor CBOE might make sense. Especially as when the final lock up expires on this share, we’ll know what the market really thinks about it.
Share lock up agreements stop insiders from selling their shares at the vulnerable time after a company first lists. CBOE arranged its lock ups in two tranches – the first expired on 14 December and the last expires next month on the 14 June.
Investors fear lock up expirations because they are the time when there is, on average, a 40% increase in trading volume. The share price reaction is nearly always negative. And those firms financed by venture capital tend to experience the worst sell offs.
This was the case with Tesla Motors, the electric car manufacturer that fell as much as 15% when its lock up expired.
Investors that may be wary of CBOE, which trades at a premium to its sector peers, will be relieved if the post lock up slump is not too severe.
Is a takeover imminent?
Goldman Sachs certainly thinks so.
Certainly, M&A has been in the air ever since CBOE went public. This is a reflection of the highly competitive nature of the exchange business. M&A and exchanges are like cheese and wine. As the exchange model involves high, though largely fixed costs, synergies can be quite significant. Neither Nymex nor CBOT got past year two of independence before CME snapped them up.
CBOE is one of the few independent exchanges left and at $3.6bn, is still relatively small.
A business in the fast growing US option space and the heavily discounted, yet exciting futures space would also be good business for NYSE’s and Nasdaq’s existing options franchises.
Though JP Morgan suggests CME, again, would be the most apt acquirer:
Signs from the options market
How fitting that the asset class that CBOE brought to prominence would represent the best way to profit from any post lock up buyout.
In December Goldman Sachs wrote a handy report on how to spot shares that appear to have priced in their M&A candidacy already and how to trade those that don’t.
With a study of M&A activity over the past couple of years Goldman has arrived at three unsurprising observations.
1. Stocks that are bought out tend to rise c.30%.
2. Short dated options tend to spike in implied volatility.
3. Long dated options tend to slump in 12 month implied volatility.
As such they recommend a long position on three month calls and a short position on 12 month straddles*.
*As you might guess from the first observation, the call in the straddle is 30% out of the money. Options liquidity is sketchy in OTM twelve month options so be careful of the spreads.
To return to the question in the title, what makes the CBOE special is the VIX. The product is the only liquid listed volatility product. It is developing a narrative that chimes with ordinary investors and creative types are finding more ways to make it assume its intended role as a tail hedge.
The commonplace rumour over CBOE’s M&A candidacy is not currently priced in.
Whether that’s because investors are waiting for the lock up expiration or if the market doesn’t share my expectation that VIX could become the next BRIC is unclear.
Take this non-expert’s opinion: I get the VIX and that counts for a lot amid a permanent backdrop of economic uncertainty. If you don’t believe me take a look at the price of gold – fear sells.
Theo Casey is an FOW columnist and financial journalist. He can be reached on Twitter @theocasey.