Framing Up Volatility

Position: Closed our long position in the VIX on yesterday

 

We had a very astute subscriber ask about volatility and our view of risk / reward on being long volatility, specifically the VIX.  This subscriber’s point of view was that if the future of volatility was similar to the 2003 – 2007 time frame, there is potentially limited upside to being long the VIX.  In that period, broadly speaking, the VIX ranged from 10 – 20, so his point is a fair one to consider.

 

For starters, in our view, there are two key reasons to potentially be long volatility. 

 

First, volatility is potentially a hedge against the world unraveling with exponential risk / reward if the world does unravel. 

  • As a frame of reference, during the financial crisis of 2008, the VIX peaked at 79.2, which is ~360% upside from the current level of 17.3. In terms of downside, the lowest level the VIX has ever hit is 10.2, which~ 40% below current levels.  In aggregate, this is a risk / reward ratio of 9:1. In a scenario where the financial markets theoretically become unwound, like say in a spiraling sovereign debt crisis, being long volatility is very good protection.
Second, if we are expecting a market correction in the short term, which is our call, and believe that investors are getting complacently bullish, being long volatility as a way to play the correction is an effective instrument. 

  • From our perspective the Bullish / Bearish survey from the American Association of Individual Investors is a good indicator of emerging complacency, the bullish indicator hit 48.5% this week, which is the highest level since December and nine points above its historical average.  The Institutional Investor Survey that came out last week was even more extreme, with institutional bulls at 51% and institutional bears at 18.9%, which is the one of the widest divergences we’ve seen in the last decade.  In the first chart below, we’ve outlined our current trading levels on the VIX.

Longer term, the question remains whether the period from 2003 – 2007 is an accurate assessment of normalized volatility.  In fact, history actually suggests that that period may have been abnormally low versus history.  In the second chart below we’ve charted the VXO, which is the VIX normalized for a 2003 change in calculation, going back its inception in 1986, which emphasizes that there are periods of both low volatility and high volatility, with 2003 – 2007 being a low period.

 

At this point, we are not making a call on whether the upcoming period of volatility will be low or high, but I think we do need to keep in mind the context that the 2003 – 2007 was an abnormally low period of volatility when considering a position in volatility.

 

Daryl G. Jones

Managing Director

 

Framing Up Volatility - VIX

 

Framing Up Volatility - VXO


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