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Why Volatility Is Expected Into the Future


The layers of derivatives are confusing, but examining them can give investors some perspective on where the market is heading.

Editor's Note: The following was posted in real time on our premium Buzz & Banter (click for a free trial).

To borrow from Winnie the Pooh: "I'm a bear of very little brain and third derivatives confuse me." That why I pretty much stay away from trying to trade the plethora of the volatility measures and trading vehicles out there. What started as the basic Volatility S&P 500 (VIX), which measures 30-day implied volatility on S&P 500 Index options, has grown into VIX futures tied to S&P futures, to all the ETFs with various term structures and now recently leveraged and inverse VIX products. And all of these have options layered on top, meaning you would be trading, in some cases, a third derivative. But I still find it, if not profitable then useful, to look at some measures to get a sense of market perception.

Right now the horizontal, or skew across time, is essentially flat. For example, the implied volatility of October SPX options is around 37% and the implied volatility for SPX options that expire in January and Mach are at 36% and 35% respectively. The mean for the VIX over the past two years has been 22%. The mean over the past 10 years has been 15%. Given that the VIX is a "reversion to the mean" statistic -- and even though it has been promoted as an asset class, it is actually a statistic as there is no underlying security -- the expectation that volatility will remain at elevated levels for the next five months seems pretty extreme.

The VIX has already held above 30 for the past three months, its longest period above that level since the five-month period of October 2008 to March 2009. And during that period when the cash or front month VIX screamed above the 80%, the 5-6-month VIX futures remained near the 35%-40% level as many people were short longer-dated VIX-related products in anticipation of a reversion to the mean. When that didn't come for several months in a row, and instead as futures rolled forward and those VIX contracts rose higher, large losses were suffered. I think that memory is what is creating this flat skew now.

I don't think we will experience another such extended stretch in terms of both time and levels. For those brave enough, and with bigger brains than I, there is probably a good trade to be made shorting the longer term option. Maybe use the ProShares VIX Medium Term (VIXM) which is a measure of the 5-month implied volatility. You probably want to hedge it with something, and that's where it gets tricky. I don't think I'd want to buy short-term volatility, but maybe buying some March puts on the Spyder (SPY) would work in case volatility continues to roll higher (and S&P lower) in coming months.

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No positions in stocks mentioned.

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