If we’ve learned anything, it’s to be mindful that volatility often does the opposite of what‘s expected.
Courtesy of NYSEMurky economic, political, and medical crosscurrents deprive us of meaningful insights beyond a few weeks, and yet an often misunderstood barometer of investor sentiment is seemingly flashing the all-clear sign for the stock market.
The Cboe Volatility Index, or VIX, has declined some 44% since late October. With VIX around 24, just above the long-term average of 19, many investors are positioning for volatility to fall even lower—perhaps commencing a new era of low volatility.
The optimism ascribed to VIX’s level is perhaps wishful thinking that Covid-19 will soon be controlled, with drug companies racing to bring vaccines to market as the pandemic enters another dangerous phase. Few people discussing volatility seem to realize that the VIX essentially offers a 30-day window into how the options market is pricing the daily movement of the Standard & Poor’s 500 Index. Beyond 30 days, VIX is blind.
The stock market, of course, always looks to the future, which is likely why many investors are establishing positions in various VIX products, including the ProShares Ultra VIX Short-Term Futures exchange-traded fund (ticker: UVXY), in anticipation that 2020’s hardships may soon end.
The VIX trading seems largely speculative, though substantive changes might be occurring beneath the surface that aren’t yet fully developed.
Infinitesimal yields in the bond market—the 10-year Treasury yields 0.86%, effectively negative when considering inflation—are reportedly driving some investors into options in pursuit of incremental income. Investors generate income by selling puts and calls, which depresses volatility. If the income thesis proves true, equity options could become bond-yield surrogates. Such pontifications are intriguing, but probably aren’t significant enough to fully explain the volatility market’s recent gyrations.
If we’ve learned anything, it’s to be mindful that volatility often does the opposite of what is most expected when VIX attracts such widespread interest from pundits and the financial media.
Just as victorious Roman generals were reminded that all glory is fleeting, investors should remember that volatility’s graveyard has many prominent headstones—including Long-Term Capital Management, captained by Nobel laureates; hedge funds that specialized in volatility trading, such as the late Malachite Capital Management; and funds with generic names and exotic strategies that were sold by asset-management firms to clients.
Nonetheless, the belief persists that volatility can and should be traded by anyone who can buy funds that make the difficult seem easy, without any need for special training.
The volatility narratives, which usually arise after a big move in the VIX, often obscure reality. You will likely read little, and hear less, about Tuesday’s 480,000 VIX calls that traded.
Chris Jacobson, a shrewd Susquehanna Financial Group derivatives strategist, advised his clients that VIX call buyers should be positioning for a big stock selloff before the year ends. The observation meshes with our standard view on how to use VIX: When VIX is low, it’s time to go. When VIX is high, it’s time to buy.
When VIX is at 40, signaling that investors are afraid, it’s wiser to sell options and buy stock, given that most options are plump with a fear premium while stock prices tend to be emaciated, boosting odds of success. But when VIX is in the low 20s and stocks are surging, options selling is less attractive because there’s less fat in the trade.
If you cannot resist the urge to trade volatility, focus on puts and calls on stocks you want to own. The single-stock approach is a low-risk way to hit singles and doubles, which over time is likely to dwarf the wealth that can be quickly created by more seductive trading strategies.
Email: editors@barrons.com
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November 19, 2020 at 05:30PM
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Low Volatility Doesn’t Mean Smooth Sailing Ahead for Stocks - Barron's
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