Volatility
Trading has changed a great deal in 2018. Back in 2008 during the subprime mortgage crisis we saw a major dip in the markets, however, the fundamental trend still pointed upwards. It was still a classic “bull market” where investors bought stock market correct. This year it was February, when the market collapsed in a matter of days, that showed the fist ominous signs to cast a shadow over the future prospects of global economic growth. Disagreements over tariff policy, US interest rate hikes and a number of geopolitical conflicts all hurt the stock market outlook. Even so there was one asset to benefit from this rising uncertainty. The VIX index, traded as a Futures contract in Chicago since 1993, was well above 50 points earlier this year, however, as of October it’s been moving in a 15 to 30 point range. During a typical bull market period the VIX usually moves between 10 and 15 points, showcasing how calm the market is.
So what is the VIX index?
Often called the “fear index” by traders & investors, the Market Volatility Index is an indicator created by the Chicago Board Options Exchange and calculated from the 30 day premiums of S&P 500 index derivatives. When the market is willing to pay a higher premium on options expiring in 30 days, it shows that market participants see a realistic possibility of it reaching that higher price. If the options market is forecast to trade at a wider range, then the movements and range of the actual market will presumably follow suit. On the other hand when investors are nervous and uncertain, they’re more willing to pay higher premiums for closer strike rates. In reality the VIX is primarily a sentiment index, that effectively compiles the outlook of market participants not through a questionnaire, but rather looking at where they actually invest their money. Moreover they don’t do it on a monthly based, but minute to minute. The way it gives a real-time view of the current mental and emotional state of the market truly justifies the fear index nickname. The fact that it’s based on predictions means that it projects the expectations of the market, which at the same time often turns into a self-fulfilling prophecy as traders grow increasingly uncertain when they see the index rise.
It’s important to note that conventional volatility indicators are based on past data. They take a look at the difference between recently recorded minimum and maximum values, then it as a basis to project the future range of momement. This is called “historical volatility.” It’s obvious that attempting to predict future by only looking at the past is inherently a high risk endeavor. These kind of metrics can play a key role in projecting future results, however, they fail to account for the psychological factor despite the fact that investor sentiment is a much more powerful force on the market than mathematical probability. When making investment decisions one needs to price in the future, not the past.
CBOE Volatility Index (VX) Futures
As an instrument the index becomes tradeable at a one thousand dollar multiplier, meaning when it’s at 20 points one Futures contract is worth $20,000. The smallest unit of measurement is 0.05 points so one tick is worth fifty dollars. The asset is released with weekly expiries, making the front contract extremely short lived. Recently it could move as much as 1-2 full points within a day, meaning a win or loss of $1000-$2000 per contract depending on the direction.
Fitting it into a portfolio?
A better question to ask would be why it’s worth paying attention to. After all, Futures trading isn’t suitable for every investor, however, even those who don’t plan to trade it themselves can gleam useful information from it. One of the fundamental theses about the VIX index holds that there is a significant negative correlation between the market declining and volatility rising. That said, despite the numerous statistical and economic analyses that back this observation as a fact, high volatility on its own is not sufficient to make the decision to sell. Even if this correlation holds true, as anyone who’s ever traded on a predominantly bear market will tell you that it does, it still fails to answer the question of exactly how much the S&P will actually move. It would be misleading to claim high VIX levels as the ideal opportunity for and S&P short position, since this year alone has shown us that that stock indices can make sharp corrections even within a single day, which would only be reflected in the options market and the VIX, much later.
When all is said and done, the VIX is still an index intimately tied to market expectations. Although it doesn’t give you the bullseye on when to open a position, it’s still invaluable for signalling the possibility of a reversal. Declining volatility indicates a slow rise for the stock market, which could either be favorable for buying or simply the calm before the storm. A rising VIX on the other hand shows growing tensions, which could be a chance to think about where one would open a short position. One also needs to acknowledge that there is an element of seasonality to the index as flash report season can cause high volatility even during an otherwise calm market period.
It’s function as an indicator means you don’t necessarily have to trade it to make a profit off it, however, it’s still an exciting instrument all on its own. A flatlining index suggests the recent release of some alarming news and the longer the silence the closer the bang. Its small contact size also makes the VIX suitable for profiting off market uncertainty when used cautiously and deliberately. All in all, it’s an asset well worth your attention at least.