Japan and the Euphoric Volatility Trap

When equity markets are buoyant and optimism abounds, fears of volatility tend to subside. But recent events in Japan remind us that euphoria itself can generate turbulence.

Most people associate rising volatility with bearish market environments. In down markets, mounting fears of further declines often prompt demand for put options, which protect against price declines. This demand causes the price of puts to rise and implied volatilities to increase. Here, the increase in volatility is due to fears of the downside, known in industry jargon as left-tail risk. Think of it as pessimistic volatility.

But volatility can also jump during good times. It may be less common—but it does happen. As momentum picks up and more people believe that big gains are imminent, investors buy more call options, giving them levered positions that benefit from an asset’s upside. This, too, results in higher implied volatility. However, in this case, it’s caused by large anticipated gains, known as right-tail risk. We call this euphoric volatility.

Nikkei Boom Sparks Volatility

Since the beginning of the year, the Japanese equity market has boomed on hopes that Bank of Japan Governor Haruhiko Kuroda and Prime Minister Shinzo Abe were committed to pursuing aggressive quantitative easing to pull the country out of its perennial deflation. While the Nikkei 225 Index rose sharply, its implied volatility also spiked relative to the S&P 500 Index (display).

Why did volatility jump in such an upbeat atmosphere? We think the Nikkei’s implied volatility rose because investors priced in very large gains, resulting in an increase in right-tail risk. You can see this in the rising price of Japanese call options relative to puts. The differential between the two, known as the skew, decreased and even turned negative (display). This rarely happens with index options because risk-averse investors are usually inclined to pay more for downside protection, resulting in an options skew that is typically positive.

From Enthusiasm to Disappointment

Rising volatility resulting from optimism can be dangerous. When markets ride on unbridled enthusiasm, the slightest disappointment can cause volatility to spike further. That’s what happened when investors started to question whether Japan’s economic leadership was really up to the task, which sent the Nikkei plunging by 7.3% on May 23.

Something similar happened during the tech bubble. Back in the mid-1990s, the volatility of the S&P 500 generally increased. With growing hope that the Internet revolution would create a new economic paradigm, investors flocked to call options on the S&P 500 to get in on the action. When the bubble burst and stocks collapsed, market volatility leapt higher from levels that were already elevated.

Both of these cases illustrate that the only transition away from euphoria is toward less euphoria, which breeds uncertainty and often translates to higher volatility. In contrast, the transition away from pessimism is toward less pessimism, which typically generates calmness and, in turn, often translates to lower volatility.

There are lessons here for investors. For derivatives traders, we think that shorting elevated pessimistic volatility may in fact be less dangerous than shorting elevated euphoric volatility. In addition, in common volatility spread trades, we would be wary of selling euphoric volatility against pessimistic volatility because the two are not comparable.

For investors in general, we think it’s wise to consider protecting portfolios from downside risk—even when markets are galloping ahead with confidence. Usually, when the market pricing of right tails looks excessive, the cost of protecting portfolios from a sudden downturn is relatively inexpensive. And when volatility spikes, the cost of insurance is likely to rise—as we saw in Japan when the skew jumped as the market tumbled.

Proactive risk management is often cheaper and less taxing than reactive risk management. Although such protection might mitigate potential gains if markets continue to surge, it will also help reduce the pain if a spike in volatility were to burst the prevailing euphoria.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Arnab Nilim

Portfolio Manager
Arnab Nilim is a Portfolio Manager on the Currency Strategies team in the Global Fixed Income Group. He is responsible for portfolio management, quantitative research and strategies for developed and emerging-market currencies. Nilim joined AB in 2012 as a vice president and quantitative analyst in the Fixed Income Group. Prior to joining the firm, he worked in the Emerging Markets Trading Group at Citigroup, where he traded, managed risk and developed quantitative trading models for nonlinear portfolios composed of credit, rates, foreign exchange and derivatives. Nilim holds a BSc in engineering from the Bangladesh University of Engineering and Technology, and an MS and PhD in stochastic controls/optimization from the University of California, Berkeley, where he received the prestigious Leon O. Chua Award in 2004 for outstanding achievement in an area of nonlinear science. Location: New York

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