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Volatility is a way to measure uncertainty of returns; uncertainty has two dimensions, range and direction. Volatility is a term easy to use and measure looking backwards but difficult when you have to take investment decisions looking forward.

Although there is a general understanding that high volatility is associated with falling markets and low volatility associated to upward markets, something important to consider is that trading itself generate volatility, new information arriving to the market causes volatility, market expectation creates volatility, selling pressure into the stocks produce volatility, portfolio insurance potentially increase volatility, geopolitical events have a direct effect over the market volatility, and liquidity risk, credit risk and interest rate risk are variables that determine the volatility behavior.

But volatility also offers a great opportunity to generate alpha and is the key concept used by hedge fund managers and active traders too.

In this post you can see a report to have a global view of the volatility frequency distribution year by year from June 1998 to December 2014.

DJ EuroStoxx 50 Volatility frequency distribution data from June 30^th 1998 to Dec. 31^st 2014. (Year by year)

 

 

 

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An alternative way to driving a systematic methodology of hedging is to analyze the correlation pattern between market prices and implied volatility.

The initial hypothesis analyzes volatility conditions in which the market performance reaches extremes values. The objective is to evaluate and to measure the applicability of the results obtained as a tool to improve a systematic hedging model with derivatives. The model originally doesn’t consider the grade of correlation between the market prices and implied volatility, but analyze scenarios in which ones the correlation reaches extremes values.

As a result of this analysis I have open a new window of investigation on a model designed for systematic hedging risk.

The conclusion of the research shows the actual existence of a high degree of uncertainty, but it has opened new possibilities to the methodology applied in the tactical risk management of a systematic hedging model with index options.

This research in the DJ EuroStoxx 50 has been done based on an analytical data review from June 1998 to October 2014.

 

Correlation and Volatility DJ EuroStoxx 50 Oct. 2014

 

 

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There has been many things that have affected me through my years working in the investment banking industry, and I would like to mention something that happened on October 19th 1987, when terms like portfolio insurance, arbitrage, program trading, liquidity and some others took part of conversations and discussions, terms that in most of the cases we were able to understand but not to explain why and how such factors could create a so dark day of October.

In 1987, we were living in an unbelievable bullish and ultra-leverage market! Not because credit was cheap, not only for the speculation into the market, but probably just because a black swan appeared and a chaotic environment turned up when everybody took the same decisions at the same time. The concurrence of all that factors put together moved the market toward an instability impossible to assimilate! The instability was exacerbated by the computers due to the difficulty of the system’s ability to process so many transaction at the same time.

The people were crazy to get liquidity to buy stocks. I knew a few that used to get leverage by getting a mortgage over their own houses, and this it was much more common than should have been desirable, but they were doing with the hope to became rich, and that does really happen, believe me, in the stock exchange! Greed is one of the most common emotions, but also one of the most difficult feeling to manage.

But my personal story is an important part of something else, although until that October 19th all my friends and colleagues were making a killing and I was doing nice amount of money. That black Monday the wheel of fortune made that something changes. I lost a huge amount of money but also opened my mind to a new universe, the derivatives.

I couldn’t understand the reasons behind why it happened – I could see in the front line what is a real tail risk, but I also learned that behind a threat, a new opportunity can appear, and the market showed me the clear concept of volatility and the magnetic meaning of implied volatility.

This black Monday was my first approach to derivatives, without much personal knowledge or experience indeed, but this is probably the reason why years later I experienced them, I found them fascinating! So much so, that now I can understand why asset management, derivatives and risk management are so important in my professional life.

How am I to use the emotions and the analytical part of my brain transcends the role of my personality to make an original contribution to my profession. If one reasons that your lifestyle and your work define who you are, it is therefore quite probable that what I do is because it is a part of me and the reason why I do what I do, and the fascination that I feel for my work and my passion for the things that I do.

JCarlos Lopez Moraleja

• For information on the Crash of 1987, read the following paper writing in 2006; “A Brief history of the 1987 Stock Market crash with a Discussion of the Federal Reserve Response”, by Marc Carlson, Senior Economist of the Federal Reserve.

http://www.federalreserve.gov/pubs/feds/2007/200713/200713pap.pdf