Derivatives and Low Volatility

The financial markets have become, to use David Stockman`s phrase, one huge gambling casino. 

Dr. Walter Snyder –

Wally`s Newsletter No. 164

The size of the derivative market, which is now an impressive $639 trillion, dwarfs the trivial Forex daily turnover of only $5 trillion. What is disturbing is that volatility has recently hovered at 10 or even below except for a slight blip a few weeks ago.

Low volatility is an indication of investor complacency and results in option prices being lower as volatility is a key element in the determination of how much an option should cost. There are also other factors at work, namely, the speed at which orders can be filled thanks to electronic trading as well as automated trading. When the crash comes, it will come fast. At the first sign of a crisis, the markets will be closed automatically for a certain period before being reopened, but that will not necessarily stop the fall in prices.

This Newsletter has advised investors to avoid over-priced equities, and there is one Australian asset manager who sold all the equities in his fund and went on vacation. That stocks are overpriced has become clear to most commentators, but investors continue to buy despite low earnings. The most glaring example is Amazon that had 2016 earnings of $2.3 billion and a market capitalization of $483 billion which yields a P/E ratio of 210. The stock price was nearing $1,000.00 and recently settled at $978.00. Speculation is the reason for the high price, but what is going to happen when investors realize that the stock is not going to go to $2,000.00.

The madness of the Tesla capital valuation of $59 billion, more than Ford at $42 billion and GM at $56 billion, is apparent. The company has never shown a profit but is proficient at cash burning with a loss of $330 million in Q1. What is going to happen when GM and Ford announce production of their electrical vehicles at prices far below those of Tesla? Ford and GM have a dealer network and can service their cars. They will not wait to be forced out of business.

Investors can try to hedge with derivatives and buy puts. Of course the market makers selling puts assume that the market will at worst maintain its present level. But with stock prices for FANGs so high and the rest of the market marking time, the smart boys will have already taken defensive measures because, as noted above, when the market swings, it will be fast as it has been in the past. So get ready now before it is too late. Goldbugs can eat gold, and certain commodities can also be eaten, and they are ripe for the picking. Enjoy a cup of coffee before the crash.