WESTPAC: The Lack Of Volatility Could Be Signalling A Market Top

The S&P, Dow and the DAX all hit new all-time highs last week.

While fighting the Fed and its balance sheet has been a loser’s bet since 2009, there are strong signals in the options market that a top is at hand, according to the latest Westpac research from the FX Options team.

Besides having attracted the non de plume of “financial weapons of mass destruction” some years back, options are an integral part of the fabric of financial markets. Without them many corporations, investors and governments could not conduct their business and hedge their exposures as efficiently.

An option is a derivative, it is the right, but not the obligation, to undertake a transaction at some point in the future.

Take for example an earth works company who needs to buy a Caterpillar D9 Bulldozer but thinks the Aussie dollar might rise (making each Aussie dollar worth more US cents and so cheapening the price of the tractor in Aussie dollars) but equally want to protect themselves from a fall.

That company can buy an option to sell Aussie and buy US dollars on the day of delivery of the D9. For this right to buy Aussie at a fixed price in the future the company pays a premium to the bank (think of it a bit like insurance) and if the Aussie falls they can transact at the agreed strike price and so haven’t lost out and the D9 doesn’t cost any more than budgeted for.

On the other hand, if the Aussie rises making the D9 cheaper, then the company doesn’t exercise the option and simply transacts in the spot market. Their cost is the spot price plus the premium already paid but the D9 was cheaper because the purchase was hedged using options.

What is important here is that for a small fee up front the bank, in this case, offers to transact a much larger face value of Aussie Dollars to pay for the D9 Bulldozer. The company has covered its risk but the bank, as the seller of the option, has taken on more risk.

So how does the bank work out how much to charge you for this risk? There’s a myriad of inputs but one important combination is probability and volatility.

Probability is easy. It’s just the chance of something happening. Like three heads or three tails in a row in the probability tree above. The maths is fairly simple.

Volatility on the other hand is a traded product in itself and is a good estimate of where market participants think the price is going.

You can call volatility a fear gauge in many ways because it tends to spike when people and traders are worried and then drift lower when traders are less concerned.

Hyman Minsky suggested with his Financial Instability Hypothesis that volatility moves from periods of stability to instability. It is the stability that breeds the pre-conditions for the instability to occur. Think the market reaction to the Fed intention to Taper earlier this year.

Which is all a long winded way of saying that Westpac reckons that the set up for a big break out in volatility — and with it a drop in prices — is on the horizon.

In a client publication this morning Westpac said, “while market volatilities are capturing underlying price action, they do not appear to be reflecting the gap that is growing between over extended equity markets and global economic growth.”

An end to QE and slowing global growth are the big risks.

Bulls, you have been warned.

And the irony is that the best way to hedge your exposure might just be buying options.

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