Wednesday, November 20, 2013

What the Low Stock Market Volatility is Indicating

Why is Market Volatility So Low? By Dr. Van Tharp Trading Education Institute

“Complacency is a state of mind that exists only in retrospective: it has to be shattered before being ascertained.” — Vladamir Nabokov, Russia-born U.S. novelist

Volatility Measures at the “Bottom of the Page”

Complacency in the markets is most often measured using the CBOE’s Volatility Index, or VIX. To simplify the concept, VIX really measures how much option premium is being paid for S&P 500 options. If options buyers and sellers think the market will be jumpy (volatile), then they bid up the price of options — market pundits call this a fear premium. On the other hand, if options buyers and sellers foresee smooth markets, then the price paid for options drops and complacency rules.

Over time, markets cycle from higher to lower volatility and back again. But over the past two years, the range of those swings (the amplitude of the cycles) has been severely reduced. In fact, since December of 2011, the VIX has never been above 30 — the traditional “line in the sand” that classically defined an oversold or “volatile” market. Let’s look at a long term chart:



As you can see, we’re in our 23rd month of volatility contraction. Now for all those perma-bears who are screaming that this is a long time and we should expect a massive correction soon — I direct your attention to the period on the chart from April 2003 through July 2007 (a massive 52 month stretch!) when there wasn’t a single VIX reading anywhere close to 30.

Here’s another graph from Lance Roberts of STA Wealth Management that tells the volatility story in a slightly differ manner:



ere we see that Roberts breaks the VIX readings into three categories: Capitulation, Complacency and a Greenspan-esque “Irrational Exuberance”. Again, notice that from 2003 to 2007 the market stayed “irrational”, calling to mind the quote from John Maynard Keynes that most everyone has heard, “The market can remain irrational longer than you can remain solvent”.

So volatility is really low already and then, early this week, it approached its lowest point of the last few months. In fact, VXX and similar volatility exchange traded funds/notes did reach their all-time lows due to contango issues with the instruments they hold.. Note: an all-time volatility low does not point to an immanent market top because this low VIX environment (what I’ve called a grinding bull market) can last for very long periods as recent history shows. There are some trading implications, of course, which we’ll discuss below. But for now, let’s discuss why this period of low volatility persists.

What’s Keeping VIX Depressed?

As we discussed above, low VIX shows a high level of complacency in the market. A simple explanation might be the so called Bernanke Put. The Fed chairman has essentially given investors a put option (the right to buy the market at a particular price at some time in the future), thus backstopping the market. Indeed, after markets had stabilized following the Great Recession of 2007-2009, Operation Twist plus QE’s 3 & 4 seemed to convince market participants that the Fed in particular and central banks in general would keep the liquidity train chugging at full speed. This has led to ongoing and ever-increasing complacency in the markets.

As traders and investors, what are the effects of this low volatility environment? Most obviously, anyone who has a strategy that includes selling options has issues to deal with right now. Covered calls, credit spreads, iron condors and the like are producing much smaller returns for those writing them. Players in this end of the trading world that I know are either using extreme caution or standing aside completely.

For those with a shorter-term time horizon and a small grasp of recent history, you’ll recall that, for the last three years we have had market drops either in the week before or the week of the U.S. Thanksgiving holiday. With VIX at a very low point relative to even the past 22 month’s depressed rates, one might look for a low-risk way to play a potential short term expansion in volatility.

Next week we’ll dig back into our series on monetary policy.

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