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Artemis - The Great Vega Short – Volatility, Tail Risk, And Sleeping Elephants

Artemis - The Great Vega Short – Volatility, Tail Risk, And Sleeping Elephants

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Published by: u24razv on Apr 12, 2011
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The Great Vega Short -volatility, tail risk, and sleeping elephants
Note: The following article is an excerpt from the Fourth Quarter 2010 Letter to Investors from Artemis Capital Management LLC published on January 4, 2011.
Artemis Capital Management, LLC |
The Great Vega Short - volatility, tail risk, and sleeping elephants Page
(310) 496-4526 
 520 Broadway, Suite 350 Santa Monica, CA 90401(310) 496-4526 phone(310) 496-4527 faxwww.artemiscm.comc.cole@artemiscm.com
The Great Vega Short - volatility, tail risk, and sleeping elephants
The seeds of risk grow best in the sweet rain of euphoria.
In the eyes of this volatility trader the current paradigm of monetary and fiscal stimulus may best be understood as the greatest leveraged volatility short in economic history. Thecurrent stimulus program is analogous to continuously rolling "naked" put options on the global economy, backed bymargin provided by the US taxpayer, generating short-term growth at the expense of long-term systematic risk. Thereinvestment of the vol premium into risk assets by the investor class ensures the Fed's naked put is not exercised. Althoughpolicy makers have been rolling the great vega short for the past 30 years it has never been more levered than today. Atpresent bullishness is pervasive as the government has succeeded in artificially suppressing asset volatility with the newstimulus. To be fair the economy is improving with corporate profits increasing for seven consecutive quarters and creditspreads narrowing. Many economists are revising their 2011 GDP projections upward. Nobody should be afraid to attendthis stimulus party or the fledging recovery but before agreeing to ride home on the risk bandwagon I'd prefer to make surethere is a designated driver. In the future we may look back at this period of unanimous euphoria as the best opportunitysince mid-2007 to purchase 'tail risk' insurance in the form of long-dated volatility.In Q4 2010 thevolatility markets werefully sedated by amassive dose of fiscaland monetary methadone.In the wake of weakeningeconomic data thissummer and near 10%unemployment the USgovernment wasted notime in applying newrounds of stimulus.Immediately prior to thestart of the quarter theFederal Reserve signaledits intention to renew itsTreasury bond purchaseprogram (QuantitativeEasing 2) andsubsequently purchased$168 billion of debt onroute to a planned $600billion total by the end of June 2011. In Novemberthe Fed passed China asthe #1 largest holder of US Treasury Bonds andnow has $1.2 trillion of holdings as of December
S&P 500 Index
VIX Index1m SV2m SV3m SV4m SV5m SV6m SV7m SV
Volatility (%)
May 6, 2010 Flash CrashEU bailout / EFSF createdGreece Downgraded to JunkDodd-Frank Bill PassedBP Oil Spill in the gulf of mexicoRiots in Athens / GS Fraud ChargesObama introduces VolknerRuleIMF proposes bank taxUS Gov sells CitistockFed increase discount rateUS announces $11.7bn IPO of GMIreland announces austerityEU/
IMF bails out IrelandFed hints at QE223 states halt foreclosures due to RoboSigner crisisUS Homeprice
unemployment@9.4%Fed officially announces QE2 bond buyingRepublicans win CongressBush Tax Cuts Extended Cross-asset Correlations at Multi-year highs
VIX Index & S&P 500 Realized Volatility (months 1-7) (Top Chart)S&P 500 Index (Bottom Chart)Year In Review -January 1, 2010 to December 31, 2010
7 of 25 Euro banks fail stress testsHome sales fall at record lowCisco misses earnings
Artemis Capital Management, LLC |
The Great Vega Short - volatility, tail risk, and sleeping elephants Page 3
(310) 496-4526 
2010. Not to be outdone Congress piled on its own supply side stimulus in a bi-partisan "compromise of excess" byextending the Bush era tax cuts for all classes, providing a payroll tax cut, and extending unemployment benefits. Thisshould increase the deficit by approximately $900 billion over the next two years. Government liabilities have expandedover $4 trillion in nine quarters.The double-dose in monetary and fiscal stimulus resulted in a "melt-up" in the equity markets contributing to the bestDecember performance for the S&P 500 index since 1991 on the heels of the best September since 1939. The S&P 500index has remained above its 50 day moving average for 4 straight months, the longest streak in 7 years. As the equitymarkets have surged higher volatility has barely registered a pulse. The statistical volatility of the S&P 500 index hasdropped 112% since early September to its lowest level since early 2007. The VIX index has dropped 38% and moreimportantly the volatility of volatility is in the bottom quintile of observations since 1990 (ominously at the lowest levelsince before the May flash crash). Implied correlation is above historical averages at 65+ albeit lower than the peak of 80reached in September. As realized volatility creeps lower the volatility market's expectation for future vol remainshistorically steep with the high skew predicting a long-overdue correction. More telling is the fact that while the market forequity volatility has fallen into deep slumber volatility in US Treasury yields is increasing at a rapid pace. While recentsigns of economic recovery are encouraging there are many "unnatural" technical signs in equity and interest rate volatility.These volatility aberrations observed during the fourth quarter may be bad omens that asset prices are overly dependent ongovernment stimulus. Below is a list of volatility anomalies recorded since the introduction of the second round of fiscaland monetary stimulus:
The market registered some of the largest drawdowns in the history of S&P 500 realized vol dating back to 1950
The spread between the VIX index and 21 day realized volatility (and respective volatility of volatility) is at the widestlevels in history
The differential between S&P 500 realized volatility and 10-year US treasury % yield volatility is at the lowest level inhistory
An incredible 7 of the largest 50 drawups in 10-year UST yields (as a percentage) since 1962 occurred in Q4 2010
Tranquilizing the Economy - Lessons from the Zoo
 A good friend of mine from college is now is a wildlifeveterinarian at a major metropolitan zoo. One of her firstassignments during her residency was to dart a sick elephant with a tranquilizer gun so she could safelyprovide medical treatment to the animal. This is every bitas difficult as it sounds. Each load of tranquilizer for afull size elephant costs $20k+ so it is very expensive tomiss your target. If you hit the elephant but don't use thecorrect dosage you could have either an overly violent orcomatose giant mammal on your hands. It is important forthe vet to understand when the elephant is properlysedated and how long the before the effects of the drugwears off or she puts herself at risk. My friend is a verycompetent wildlife veterinarian and I guarantee shewould never be stupid enough to mistake a tranquilizedelephant for one exhibiting normal behavior.Oddly when it comes to the economy many talking headsare not smart enough to differentiate between a healthyfinancial system and one sedated by unprecedentedamounts of stimulus. This is not to say that a certainamount of cautious optimism isn't warranted. As they sayyou don't fight the Fed. In a November 4 op-ed piece inthe Washington Post Fed Chairman Ben Bernankeexplicitly stated that higher equity prices were at theforefront of the quantitative easing program adding that,
5791113151719September-10 October-10 November-10 December-10 January-11
21 day Realized S&P 500 Volatility (%)
SPX Realized Volatility (21day) since Fed's QE2 Annoucnement
Lowest reading since January 2007!

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