Gedanken Experiment

The volatility sellers are working hard this morning to keep the market levitated.When volatility declines, the risk parity funds, descendants of the portfolio insurers that caused the 1987 crash, buy stocks – usually the FANG team (Facebook, Amazon, Netflix, Google, the current four horsemen).

As a thought experiment, could they get volatility to zero? That is the S&P, for example, never changes? I don’t see why not, even the fast-reacting algos would have a limit cycle, of course, like any other control system, but in principle should be able to hold price pretty steady.

The question is who is taking the other side of this trade – and why. Option sellers, of course, want to buy volatility to hedge their risk. Using dynamic hedging, as volatility rises they will need to buy more (and vice-versa). So in the limiting case, when volatility is zero, will the volatility sellers become impotent as there is no demand for their product? So then zero is unstable because there is no control force?

The risk parity funds move both ways, you know.

I wonder if anyone has a Bode plot for this system.

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