When Genius Failed (Roger Lowenstein) #5

Early in 1998, Long-Term began to short large amounts of equity volatility. But more than any other, “equity vol” was Long-Term’s signature trade. Equity vol comes straight from the Black-Scholes model. It is based on the assumption that the volatility of stocks is, over time, consistent. The stock market, for instance, typically varies by about 15 percent to 20 percent a year. Now and then, the market might be more volatile, but it will always revert to form. It was guided by the unseen law of large numbers, which assured the world of a normal distribution of brown cows and spotted cows and quiet trading days and market crashes. For Long-Term’s professors, with their supreme faith in markets, this was written in stone. It flowed from their Mertonian view of markets as efficient machines that spit out new prices with all the random logic of heat molecules dispersing through a cloud. And when the models told them that the markets were mispricing equity vol, they were willing to bet the firm on it.

There is no stock or security known as “equity vol,” no direct way of making a wager on it. But there is an indirect way. Remember that, according to the Black-Scholes formula, the key element in pricing an option is the expected volatility of the underlying asset. As the asset gets jumpier, the price of the option rises. Therefore, if you knew the price of an option, you could infer the level of volatility the market was expecting.

An analogy may be helpful. There is no direct way to bet on the weather in Florida—but in certain seasons, the price of orange juice futures fluctuates according to the likelihood of a frost. Indeed, an experienced trader could infer, if the price of juice was unusually high, that the market was expecting a chilly winter and thus a scarcity of oranges. And if the trader believed that the market’s weather forecast was wrong, he could try to profit on his opinion by shorting orange juice.

In a similar manner, Long-Term deduced that the options market was anticipating volatility in the stock market of roughly 20 percent. Long-Term viewed this as incorrect, because actual volatility was only about 15 percent. Thus, it figured that option prices would sooner or later fall. So Long-Term began to short options—specifically, options on the Standard & Poor’s 500 stock index and on the equivalent indices on the major exchanges in Europe. In their own argot, the professors were “selling volatility”.


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