The new norm is going to be increased volatility

There are a lot of gyrations going on right now with central banks jockeying for position and a certain amount of dysfunctionality out there. The new normal is increased volatility than the relatively calm times in the middle of 2014:

vix

Other than the direct purchase of VIX futures (or the VIX ETF, the most liquid of which is VXX), one must think about companies out there that can take advantage of volatility.

Highest volitility of the year

The VIX index (S&P 500 options implied volatility) has officially reached the highest of the year, at 40.96%:

This is still lower than the 48.2% seen during the depths of the early 2010 crisis involving Greek soverign debt. If this issue is worse than the one last year then my 40-45 VIX prediction should be elevated.

(Subsequent Update: 46.80… this can only be described as a slow-velocity market crash.)

Back to normal volatility

Curiously, the VIX, after spiking in the aftermath of the Japanese earthquake, and the onset of the military action in Libya, went to a peak of about 30, has slid back down to about 20:

Most people make the mistake of thinking that the VIX is predictive – it is not. It does anti-correlate with the S&P 500, however.

The real question that investors should be asking themselves is that was this just a single ripple in the market pond, or is this a good time to be loading up on index put options while the volatility is still cheap?

Notably, the April VIX futures closed at 21.50 today; going further out, July closed at 23.10. These products are not easy to trade profitably unless if you have a sharp computer model working in your favour.

The trend is clearly broken

The uptrend in the major indicies over the past six or seven months has clearly been broken. Here is a chart of the S&P 500 with my retrospective scribble on the chart, indicating the prevailing trend:

Note that volatility has increased considerably:

VIX is not predictive; however, it does say that market participants have been spooked to pricing in more volatility in the future. The question is whether they are spooked enough – my gut instinct says we may get a sucker rally here or there, but it is more likely than not that the prevailing trend will either be choppy or down – not exactly the type of environment for a buy and hold investor.

Playing conservatively is likely the better option at this point, just as it has been for the past few months.

Sucked in by volatility

It looks like the volatility trading crowd (at least if you were long) took a hit over the past week – things had looked like they were stirring up with the Irish debt issue, but it had abated over the week.

First, a chart of the S&P 500 volatility index (VIX):

Secondly, a chart of a high-volume Volatility ETF (NYSE: VXX):

Traders that were long for the week have taken over a 10% haircut. In fact, the ETF closed at a record low from its inception back in early 2009. The “spot” volatility index was down about 22% from the beginning of the week. How much lower can volatility go?

I have no positions in any of this, but do watch carefully – for example, when index implied volatility is low, it is usually a horrible time to engage in strategies like selling puts or calls. Conversely if you have any bullish projections to the future of the market, it is usually a good time to purchase calls since their pricing will be lessened by the overall volatility projection. What causes this is that there is some mean-regression baked into the quantitative models that option traders use.

Watch, but not trade volatility

I have discussed this before, but it bears watching. Volatility is at a relative low point in relation to the past thee years:

The events in late 2008 strictly related to the financial crisis (the downfall of Bear Stearns, Lehman), and volatility remained relatively high through the first half of 2009 before calming down.

The markets reached some sort of complacency in the first quarter of this year, before volatility rose again with the advent of the European (Greek) sovereign debt crisis. This resolved, and volatility is dipping again.

It may lower even further, but traditionally volatility is anti-correlated to index performance – the higher volatility goes, the lower the underlying index. Some people have the misconception that the VIX is predictive; it is not, but it can be used as a barometer of market’s future expectations of volatility.

One might be lead into believing that buying and selling volatility itself, compared to the underlying index, may be the financially wise way of playing this. Unfortunately, it is not so easy – the above chart is equivalent to a “spot rate” on volatility – mainly the volatility over the next 30-day period. There are products that are designed to trade volatility directly (VIX futures), but in order to sustain a position, you must take rollover risk.

For example, if you think volatility is going to rise in December, you can buy the December future. But if the volatility does nothing between now and the December expiry (third Friday in December), you must sell your December position (or settle it with cash) and then purchase the January future, which may have a significantly different price than December.

There is an exchange-traded fund, (NYSE: VXX) which performs the same function (for a 0.85% management expense ratio):

As you can compare with the first chart in this post, there is correlation, but during “dull” moments, the ETF is absolutely destroyed by the rollover process. This is similar to most natural resource ETFs (e.g. UNG) which are also destroyed by traders picking away at the automatic rollover.

Rollover risk is somewhat mitigated by the (NYSE: VXZ) ETF, which uses futures that are dated roughly 6 months in advance, but this has tracking error with existing volatility – current volatility may spike, but the future 6 months out might not track the current action.

There is clearly no free lunch in trading volatility – it is not as easy as looking at the VIX chart and thinking you can “buy” it, thinking you are buying low and preparing to sell high. Almost like options, not only must you get the direction correct, but you must get the timing correct, which is not easy.

Traders might be allured by past price action (e.g. this year, doubling your money buying in April, and selling in May), but your timing must be absolutely sharp. There is no way to determine that buying at 75 and selling at 150 was the proper decision except purely in hindsight.

You can even buy options on VXX, but note that the traditional implied volatility calculation (based on the Black-Scholes model) has little to do with properly valuing options on volatility futures – more so with this option than traditional equity options!