Diamond and Gold(man)

Boy there’s nothing to get you in the holiday spirit like an animated Neil Diamond cover of “The Chanukah Song”.

Anyway, I bet you’re wondering about Goldman’s number 1 idea for 2010. How about shorting some volatility?

At current levels, forward variance suggests that the coming years will be as volatile as 2009. But this past year was the 8th most volatile year on record (2008 ranks as number three), and our recent work on the 2004-template suggests that even in a sluggish recovery and a range-bound equity market, as macro-driven uncertaint declines, volatility can continue to moderate. Realized 1-month S&P 500 volatility is currently at 16, towards the low end of Buzz Gregory and team’s near-term macro driven forecast range of 15-19, and front-month VIX is at about 25.50. And the upward-sloping term structure has kept forward variance higher still.

We would recommend holding a short position in S&P 500 Dec10/Dec11 forward starting variance, now at 28.20 with an initial target of 21.0, to express the view that US equity volatility is likely to fall as the economic backdrop continues to improve, even if more slowly in the coming year. Our target of 21 in the Dec10/Dec11 swap would be a return to just below median levels (relative to the last 13 years), would be consistent with realized volatility at the low end of the current forecast range, and would be worth about 6.4 Dollars per unit of variance (‘vega’) invested.

Two points on the implementation. Firstly, we have deliberately chosen to hold this trade on a one-year, oneyear forward basis. This allows us to continue to have a view on forward variance even as we begin to movethrough the calendar, though the moderately upward sloping term structure suggests this trade does have some positive ‘carry’. Secondly, this structure has much lower market ‘beta’ than outright variance swaps or more near  dated implementations.

I’m not entirely sure how one would implement the “long” side of the spread. Dec. VIX expires next week and cashes out, and we can’t exactly do the sort of swaps they recommend. So let’s just consider the basic concept here, they believe longer term volatility is overpriced. And that’s tough to argue against. As we’ve noted many times, longer dated options, no matter how you look at them, trade at a large premium to closer one’s. And the closer one’s are not particularly cheap relative to realized volatility. And they’re probably right, you’d have to hold the position in order to realized any convergence. I mean Jan10 VIX trades at a $4 premium to “cash” VIX, so that’s a good portion of the spread right there.


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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