Lions in the trap street

Vol #221: April 3rd, 2025

There isn’t much use for a paper map anymore.

As a child who was old enough to do arithmetic, but too young to appreciate the dimensions of a multi-hour drive, the tattered Rand McNally kept me entertained, counting the miles between exits. The little numbers between junction points detailed the miles to our destination long before Google provided color coded estimates.

Addition soon was cobbled with long division, so with enough road trips I could estimate how much time was left in the backseat. Fortunately my parents mostly drove at about 60 miles per hour. The main roads hardly changed, and if you wanted traffic updates you had to tune in after the weather every hour on the 8s.

I learned that cartographers sometimes put little signatures on their work; unique and insignificant blips that could immediately identify the work of a forger. A minor cul-de-sac in a quiet neighborhood won’t send anyone down the wrong path, and prevents the competition from simply using tracing paper. The “trap street”.

Maps much older than the 1976 New England Road Atlas had to deal with out of bounds problems, as the known and surveyed world was smaller than the sheet of paper. These lands were filled with mythical beasts - men with four foot horns and serpets who could devour an entire cow.

“Here be dragons” or “"HIC SVNT DRACONES” for the fanaticus linguarum.

While this concept has creeped into popular culture, it’s mostly an anachronism. Two very famous globes contain the inscription, but it’s not otherwise found on historical maps or records. Dragons and other fantastic wild beasts decorate maps from around the world, but the phrase medieval map makers used was actually - here be lions.

Lions, dragons, (oh my!) - we have no idea what’s past the fringe. For centuries our forecasts tended towards the fanatical, with the most savage beasts and exaggerated cryptoids dwelling in borderlands. No matter how dangerous a passage looks up close, it’s no match for the unknown.

When forecasts and predictions realize, the uncertainty factor deflates. Once the land and seas of dragons were visited and charted, the wild dreams of cartographers became history.

We were all born too late to explore the great unknowns of the far east or west, so those looking for wave crashing uncertainty must content themselves with financial market volatility.

Derivatives price our expectations about the unknown to a penny. Looking across the bow of the ship into the future, listed options tell us how much chop we should expect. Futures on volatility describe what we think the successive predictions of chop will be. And the implied volatility of volatility is a measure of the expected range of our forecasts.

This has more layers than Inception. You can point to exactly how the market is pricing the overall move, the move at a single point in time, or the move on a single point in the curve at a point in time. Zoom in or zoom out, there’s a hedge for you.

While that feels unimportant to anyone more concerned that their 401(k) just dropped 4% overnight, the intuition and value of what volatility surfaces tell us is fairly approachable.

For all the strike listings and terms in listed options, predictions on implied volatility itself only go out about 9 months. There’s an SPX contract over twice that far out. Options market structure has a voracious appetite for more granularity, so it’s meaningful that volatility predictions only go so far.

The VIX term structure has many shapes, but the above is April 3rd, 2025, just after the open. The S&P 500 closed Q1 down 4.6%, and tariff roiling is lopping off another 4% or more.

Looking right in front of us with the VIX, we see the next thirty days as being fairly choppy - a 26.32 reading being almost twice as much variance as we expected at the end of 2024. The market has hit the rapids.

That probably means a lot of downward movement, but some of the most significant day over day increases come during bull markets. The repricing of news is a violent process, as we see with earnings announcements, FDA approvals, and myopic economic policy. Because the weighing mechanism doesn’t get things right immediately, there’s some chop. That’s all we see for the near term, and VIX moves accordingly.

Eventually the weighing mechanism does grind towards efficiency. No matter how perilous this next leg of the journey is, the entire map can’t be land mines. We see this in the flattening of the back months. The difference between the last three months is negligible, and having any longer dated contracts would likely show the same pricing.

More importantly, this part of the curve moves much less. The future expectations about uncertainty are relatively static, because it takes a major, major shift to adjust that. The discovery of something worse than dragons. So for the most part we have a little bit of very scary, and mostly placid waters.

If we look at volatility on the same horizon as we’re looking at investments, volatility pricing starts to mimic the adages of advisors - “declines of 10% happen every two years”, or “every generation sees their equity cut in half at least once.”

If the magnitude and duration of price uncertainty reveals itself to us through the volatility futures term structure, the implied volatility of volatility describes how fast we think things will change.

The volatility or movement of underlyings tends to fall into regimes. That can be high volatility that lasts for a long time. Think the markets of 2022 when there was a long series of larger moves, that resulted in a persistent bid on the VIX, but no significant spike. Qualitatively the markets knew they would be choppy, but there was never the panic of a great and immediate repricing.

The spot:vol correlation is well studied - when underlying prices are going down, volatility mostly tends to increase. But the implied volatility of volatility can help give us an indication of how much change in turbulence is expected.

Looking at either the implied volatility of VIX options or an index like VVIX, we get an estimate of how robust our predictions are expected to be. That can be low in tumultuous periods as underlying chop is expected to continue, and higher as the expectations of future volatility shift lower, actually creating vol of vol.

Pulling back out several layers, think again of the map. There lay dragons, because the fringe provided known and unknown uncertainties.

When we see the texture of near term obstacles or lack there of, the risk premium usually deflates. That’s true most of the time. Wandering off the edge of the charted land will soon start to look exactly like the terrain before it, and the immediate risk of dragons goes away. The shoe isn’t going to drop in this expiration.

If the long dated future is pricing an implied volatility of 19 or 20, it’s going to deflate to something lower than that most of the time. That’s been the case over the last 6 months. But embedded in that 19 prediction, is the idea of dragons, tariffs, or some other brouhaha at some point.

The edge of an investors map should include a caveat. There will be dragons, lions, and certainly bears. But don’t be fooled by the presence of the many lush green fields (or trap streets) before the inevitable surprise.