A few weeks back I wrote on the Buzz & Banter
(subscription required) about how the VIX
(^VIX), the de facto gauge of perceived market volatility and risk, was actually relatively high and expensive despite the seemingly low absolute value near 15.5 which was near a five-year low. But now, for the first time in over four months, I believe options or implied volatility is inexpensive and represents a buying opportunity.
But we do not want to use the VIX, or its related products such as ETFs or ETNs like iPath S&P 500 VIX Futures
(NYSEARCA:VXX) or leveraged products like Velocity Shares 2x VIX
(NYSEARCA:TVIX) as the vehicle. Instead we will go right to the source: the SPDR Trust
I’ll get to the strategy in a bit, but first I want to define volatility and the VIX and give some reasons why I think it is “cheap” right now.
The first and foremost thing to keep in mind when looking at the VIX is that it is a statistic, and as such it tends to revert to the mean. While demand can drive values higher, keep in mind there is unlimited supply of the options contracts upon which the VIX is based. This pricing, or short-term implied volatility levels, is based mostly on short term perception of risk rather than on some long term fundamentals.
The biggest misconception and misuse of the VIX is that implied volatility is a distinct asset class that can be traded or used to hedge a portfolio. It is not predictive, only reflective of current conditions. Let’s take a look at exactly how the VIX is calculated. The VIX is calculated based on a weighted blend of options, both puts and calls, on the S&P 500
(INDEXSP:.INX) with an average 30-day duration. While the VIX is often referred to as the “fear index” (because investors are typically more concerned with downside risk and therefore lean towards buying puts to protect their portfolios), it should be noted that implied volatility is directionally agnostic.
Implied volatility merely expresses the magnitude, not the direction, of the expected move in a given time frame. So while over the past few years the VIX has confirmed its status as a fear gauge, you should note that back during the dot-com bubble, it was actually the reaching for call options to gain upside exposure that kept the VIX above 30% for most of 1999-2000.
A Recent Reversion
During the month of August, actual or realized volatility dropped precipitously as the market went into a narrow trading range, but implied volatility remained elevated as anxiety regarding a series of events loomed: Jackson Hole, the monthly jobs report, the German vote to decide on approving the ECB’s ability to buy sovereign debt, and FOMC meeting options kept traders on edge and bracing for potential large price moves that might be coming.
So even as the 30-day historical volatility (or HV) sank below 10%, the VIX was running around the 16% level That was a six-point, or nearly 60%, premium. This “fear” extended out in time as the term structure of VIX futures had a steep contango. The November contracts were trading at 23 and in December, at 27. These were very large premiums not only to the cash VIX, but also between the monthly futures contracts.
Given that the futures settle into the cash contract, prices necessarily need to converge as expiration approaches, meaning this extreme skew would need to be resolved. Now that we have passed through these events, IV and HV are reverting to their mean. Implied volatility, or the cash VIX, is down to 14 and the 30-day HV is up to 12.5. Note that the HV, or actually realized volatility, rose even though the market rallied following Ben Bernanke’s pledge of QE infinity. Again, volatility is not based on direction, just the magnitude of the move, and the surge following the Fed announcement was the last move in several months.
The VIX futures and its term structure also flattened out with front October now trading 15 or just 7% premium, and the November futures are now trading 17.50 or 25% premium to the front month. December futures are down to 22 or a 28% premium to October, which is down from the 60% premium. This convergence of prices and squeezing of some of the excessive premiums suggests options are now relatively inexpensive.
Problems Still Loom
While we have passed through several key events, many of the larger macro issues that inflated IV during August remain in place and could potentially come back to haunt the market in coming weeks and months. We are facing the fiscal cliff, the uncertainty of the US election, the lack of any real resolution or solution for the eurozone, geo-political unrest on the rise, and the beginning of earning seasons, which ticks up volatility even in the best of circumstances.
And as long as we are talking about reversion to the means statistics, note that neither the Dow Jones Industrial Average
(INDEXDJX:.DJI) nor the S&P 500 had suffered a decline of 1% or more in over 63 trading sessions. This is the longest period in over six years. On Tuesday we finally got that 1% decline in the S&P and the VIX popped 11% to the 15.7% level. Implied volatility and SPY options are still inexpensive on a relative basis to the realized or historical volatility. And yes, it is also low on an absolute basis, at 13% level; meaning even if it doesn’t lift, we’ll only be jumping out the ground-floor window and end up mainly bruised by time decay.
Buying Both Puts and Calls
I realize that VIX and the products based on it have become extremely popular, but I think they are too complicated for most retail investors to use them as a hedge successfully. It starts with the fact that, as described above, these are derivatives on a derivative. This creates a certain dampening effect making pricing behavior extremely hard to predict and often ineffective or disappointing in the performance.
Even institutional investors or hedge funds that can run some complicated strategies seem to lack a full understanding of how these products work. In fact it was professional money managers loading up on VIX futures and ETFs that drove the steep premiums and term structure described above. I don’t think they realized just how much they were overpaying for that supposed “protection.”
My approach is to simply buy the options on which the VIX is based, thereby not adding an extra layer of something I need to be right about; namely, how futures will respond to current events. Buy purchasing relatively short term options, I know that if there is a spike in realized volatility there will likely be a commensurate, if not greater, spike in the implied volatility of the options.
Last week I established a position in SPY by purchasing a diagonal calendar spread on the call side and a ratio back spread on the put side. Both of these are long volatility or vega positions, meaning they will benefit from a strong directional move. But the put position has much greater exposure to a pop in implied volatility. The thinking here is that on a rally, IV will probably not increase too much. However, on a sharp decline, the fear will kick in and IV will in fact spike. Let the fireworks begin.
No positions in stocks mentioned.
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