Treating “Financial PTSD”

We’re always interested in reading and sharing interesting articles regarding managed futures. We happened to come across Advocate Asset Management’s article on how investors’ reaction from the 1987 Black Monday is still visible after the 2008 Financial Crisis (hence the PTSD title.) In the most recent situation, they focus on the VIX Futures average pre and post the 2008 crisis. Take a look.

The following content was not created by Attain, and is presented for educational purposes only. It does not represent a trade recommendation.

Post Traumatic Stress Disorder (PTSD) is a severe anxiety brought on by exposure to a trauma involving loss, causing symptoms such as flashbacks, difficulty sleeping and an avoidance of situations reminiscent of the trauma. While most commonly associated with life-threatening experiences, the anxiety and pain of loss in a financial trauma is often enough to trigger PTSD-like symptoms that affect behavior and often bring about new opportunities. For savvy investors, each episode of “financial PTSD” creates its own remedy.

Prices in any market serve to match demand with supply. As demand affects prices and creates new opportunities, a response is induced from the supply side. This process is commonly a gradual evolution, but can be turbocharged by traumatic events. In financial markets, it is difficult to remember an event more traumatic than “Black Monday”, when the Dow Jones Industrial Average dropped nearly 23% on October 19, 1987. Indeed, the financial PTSD from a single day 26 years ago continues to affect markets today.

In the pre-crisis environment of the late 70’s and early 80’s, market makers in S&P 500 options matched investor demand by offering upside participation and downside protection in the S&P 500 at roughly equal prices, as represented by the implied volatility “smile” in S&P 500 options (Dashed Line, Chart 1).

Chart Courtesy: CBOE

(Disclaimer: Past performance is not necessarily indicative to future results.)

The entire structure of this market was changed in a single day, as a new anxiety caused a rush for downside protection in the form of S&P 500 puts. In response to these signals, market makers began to offer puts at significantly higher prices than equivalent calls, changing the “smile” to the “skew” in S&P 500 implied volatilities that exists to this day (Solid Line, Chart 1). For the PTSD-afflicted investor, this was rationalized as the price of avoiding a repeat of the trauma. For others, it was a more effective remedy – a new profit opportunity. In 70% of the 26 years since Black Monday, selling downside protection (puts) has been significantly more profitable than selling upside participation (calls), with the CBOE’s S&P 500 Put Write Index returning a total of 1330% versus the Buy Write Index’s 970%.

Mark Twain once said “history doesn’t repeat itself, but it does rhyme.” For as long as markets have existed, financial shocks have been changing investor behavior and creating new opportunities. The Financial Crisis of 2008 had its own unique features, but its impact on financial markets certainly “rhymes” with the 1987 experience. Similar to the introduction of options as a new risk control tool in the years prior to Black Monday, VIX futures were introduced in 2004 to offer the hedging efficiency of direct volatility exposure without the use of options. Importantly, VIX futures also provided real-time data on forward volatility expectations in the form of the VIX futures term structure (Chart 2).

Chart Courtesy: Advocate Asset

(Disclaimer: Past performance is not necessarily indicative to future results.)

Since they exhibit time decay like options, the term structure of VIX futures is analogous to options premium. At any moment, the steepness between two points on the curve represents the expense of maintaining a long volatility position for that period, or conversely, the premium paid to provide it. Uniquely, as VIX futures settle at a non-investable index (the VIX index) this premium or “basis” cannot be arbitraged as in other futures markets and is sustained as long as investor sentiment supports it.

Similar to the prevailing investor sentiment before Black Monday, a relatively flat VIX futures curve (Blue Line, Chart 2) reflected lackluster demand for long volatility exposure in the years preceding the Financial Crisis of 2008. In an echo of 1987, the widespread PTSD from the events that followed changed behavior and markets substantially. In a mass “avoidance” reaction, investors still stinging from the trauma of 2008 were drawn by the effectiveness of direct volatility exposure as an equity hedge. This new demand increased VIX futures basis substantially, lifting the average in the post-crisis period over 7% per month to maintain a constant 30 day long exposure in VIX futures. History is rhyming once again as post-crisis PTSD supports this cost, leaving the door open to a new opportunity for savvy investors.

Successfully implemented, we believe the strategy exhibits nearly zero correlation with other approaches and can act as an excellent growth generator and diversifying exposure for any portfolio.

Here are Advocate’s three programs, which are not yet ranked on our site due to not enough history.

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