Volatility rules!

VOLATILITY is a bit of a speciality of mine.  When natural gas was first traded, that was in the teeth of assertions from certain no-nothing economists, purely on fallacious a priori grounds, that gas was a “paradigm case” of a commodity that could not be traded.  The market price routinely exhibited vol that was unparalleled for a liquid traded asset (barring the odd rogue stock), and the economists crowed: there you go, this is set for crash-and-burn.  But as the market matured, and was self-evidently not crashing / burning, and the vol persisted … it became apparent that it was a feature, not a bug, for which reasons can be adduced.  The maths of gas market price-formation and vol were quickly established, and everyone with a stomach for roller-coasters settled down to enjoy the ride.

When electricity was first traded, well, that was considered  even more deeply impossible by the aforesaid eejits.  And electricity prices manifest vol that was completely off the scale – some three orders of magnitude higher than previously encountered anywhere (except nat gas – just one to two orders higher).  And the maths of elec price formation proved much more difficult to establish.  But established it was, and off we went.

It is first-hand experience of all this that informs what follows.

1.  Volatility is like heartbeat, or (switching idioms) friction.  No heartbeat = no life.  No friction = no traction.  But too high a heartbeat, and you’re also looking at death.  Too much friction, and you are looking at everything grinding to a halt.

2.  Some folks benefit from vol:

(a) those who’ve placed market bets on vol, which is fairly easy to do if you understand financial derivatives.  Easiest of all, for stocks & shares there is the “fear index”, a.k.a the CBOE Volatility Index (VIX).  Needless to say, this is riding high right now.

More generally, for those to whom these terms are familiar, you can put on long calls and an equal number of long puts, with the strike-price either at, or either side of, the current price (depending on your precise strategy and how much premium you are willing to pay).

(b) those who’ve invested in ‘flexibility’ assets, a.k.a optionality in the financial jargon; e.g. (in my neck of the woods) a flexible oil refinery (which can benefit from volatility in the prices of crude oil and finished products); a flexible gas-fired power station (prices of gas, power and carbon); a flexible gas storage facility or electricity battery (prices of gas / elec now, and forward prices of gas / elec for forward time periods; a flexible power interconnector (prices of elec here, and over there) etc etc etc.  As vol goes up, the value of your option-asset goes up.  As Black & Scholes proved, in their Nobel-prize-winning work, vol is a primary component of option value.

 3.  For everyone else, high vol, like high friction, is unequivocally a cost.  And eventually, when we reach the upper end of the heartbeat / friction spectrum it weighs on everyone.  The cry of “risk off” goes up, and big players withdraw from the market, at which point another critical variable – liquidity - starts to loom very large.  There are b-a-d things down that path, too.  Don’t let the know-nothing optimists tell you this is all for the best in a funny sort of way.  It ain’t.  It’s unequivocally bad.

Much more of Trump’s casual lunacy and I think that end is in sight.

ND