May

7

Since according to the regulators nothing adverse happened from a systems perspective [on May 6, 2010], are we to bake into our models the potential for a 50+ point swoon at any time and in vastly more compressed windows than ever seen before? The risk/return scenarios turn completely lopsided.

Riz Din asks:

I'm not familiar with the details of trading systems that may have been behind the move, but if they are just as happy buying as selling, can we then assume that there is an equal chance of a similarly mammoth sized swing to the upside? 

William Weaver writes:

I doubt we could ever see the same type of vol to the upside simply because we're dealing with much more than computers, we're dealing with humans. Prospect Theory states that an investor who realizes a gain and a loss of equal magnitude will value the loss as much as twice that of the equivalent gain. This can be graphed by plotting the one day changes in the SPX on the x-axis (gains function) and the inverted one day changes of the VIX on the y-axis (value function). After calculating a least squares regression on both the positive days and the negative days (individually; two regressions) it is apparent that the slope of the losses is steeper than that of the gains.

We would need the entire world to be stuck short to see that kind of vol. But it would be fun to trade– of course I say that with a caveat; yesterday was a hell of a lot of fun to trade… after the fact. During it was survival even if you were raking it in!


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