Friday, August 17, 2007

A Perfect Storm

It is not my intention to begin beating a dead horse, but I must return to the topic of volatility one more time. In the previous post “Ticking in the Black Box” I floated the idea that the recent spike in volatility in the U.S. equity market could be due in part to the recent elimination of the Uptick Rule. Investors in the small cap world may often overlook the VIX, the Chicago Board of Trade’s volatility index. However, nearly everyone in the small cap world is aware of the lengthy debate leading into the abolishment of the Uptick Rule that prevented unfettered short-sales.

I imagine there might be more than a few skeptics of my theory and, lacking the resources to carry out a full fledged study, I have little in the way of quantifiable proof. However, a look at the VIX chart might provide some evidence that there is some relationship.

Historically, the U.S. equity markets have experienced several periods of high volatility. During the period between 1998 and 2003 there was an extended high volatility over 20 point on the VIX scale, as is illustrated in the chart to the right covering the seventeen years between 1990 and 2007.

In recent months volatility decreased except for a short period near the end of February 2007, when the U.S. market reacted with fear after the Chinese government intervened to quell speculation in the China stock market. Within a short time concerns subsided and the U.S. market quieted down. That time is noted with a small red square in the chart below.

The trading days July 3rd and July 20th in the same chart are also noted with small squares. July 3rd is the first trading date that the Uptick Rule was no longer in effect. July 20th is the first trading date after significant report on employment. It is clear that volatility had started to rise in the two weeks before the jobs report came out. While there could be other factors at play, the chart helps make a case for a link between increased volatility in this round and the demise of the Uptick Rule.

Clearly the elimination of the Uptick Rule alone is not responsible for the dramatic spike in volatility that has been observed in August 2007. However, we believe that reaction to credit market concerns has been amplified by programmed trading schemes - the so-called Black Boxes - that have not appropriately anticipated the change in trading processes. It was a perfect storm, one which may never be repeated since the hedge fund programmers and mathematicians are no doubt already busy tweaking and adjusting their models.

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