The Striking Price
The Zig and Zag of 2016’s Volatilities
If the year taught anything, it was to expect the unexpected. That contrarian approach applied in spades to the VIX
By STEVEN SOSNICK
December 31, 2016
It is tempting to overweight recent post-election events, but a longer-term view is more informative. Considering that the year’s most significant moves contradicted conventional wisdom, an accurate tagline for the market year—some may say the key lesson of 2016—is “expect the unexpected.”
Despite well-reasoned investment theses, it appears investors largely failed to anticipate the United Kingdom’s Brexit vote and Donald J. Trump’s election. Both events were widely expected to drive stock prices sharply lower. Yet, the opposite happened, as stock prices rose and options volatility declined. This suggests investors may be better served by focusing on the use of options to navigate the stock market, rather than engaging in difficult debates about whether the CBOE Volatility Index, or VIX, is too high or too low.
Rather, consider focusing on the difference between implied and realized volatility, and how that can be used to create market advantages.
To be sure, there were long stretches when the VIX was in the low teens, and many investors suggested buying volatility in anticipation that the index would spike higher. The rationale was that since the VIX was near historical lows, volatility must be cheap. Yet not enough attention was given, at least publicly, to the counterargument that even though the implied volatility of options on the Standard & Poor’s 500 index was indeed quite low by historical standards, the realized volatility was even lower.
THE MATHEMATICAL RELATIONSHIP between past and future volatility levels remains misunderstood by too many investors. When stocks grind higher, realized volatility grinds lower, pulling implied volatility, which is VIX’s domain, down. This relationship proves treacherous for anyone who dynamically hedges options. A trader who owns options and continually hedges his exposure makes money if realized volatility— the annualized percentage of the underlying product’s moves—exceeds the implied volatility of his long options position. The reverse is true for a short options position.
Although the implied volatility of S&P 500 options was between 11 and 14 for long stretches of 2016, realized volatility was generally even lower during those periods. That low-volatility environment has returned as the post-election rally digests its gains.
YET THERE WERE FOUR PERIODS in 2016 when VIX crept above 20, some of them poorly recalled. We all remember the weeks before the Brexit referendum in June and November’s presidential election. Those events had worldwide repercussions. VIX rose prior to each event, but afterward the market quickly shrugged off previous concerns. Ultimately, the fear gauge gave false signals as anticipated higher volatility proved fleeting.
But VIX also briefly crept above 20 in September. This occurred at the end of the summer’s minor selloff. Implied—and realized—volatilities crept higher as the market sank. When VIX ticked above 20, the stock decline was over.
Before concluding that it is profitable to buy stocks when VIX crosses 20, it is important to remember January and February. The year began with the S&P 500 in a selloff, and VIX quickly jumped over 20. By late January, VIX topped 30, and never truly moved below 20 until March. Many investors have forgotten that long period of sustained volatility—implied and realized—that began the year.
The best lesson from the past year may be that a contrarian view can be quite profitable. We began the year with a volatile, gut-wrenching market decline that was almost forgotten as the year progressed. Many market participants seem to have completely misjudged the volatility and direction of two world-shaking events. Now, after reverting to a period of low volatility on the cusp of a major political transformation, we have to wonder if 2017 will make volatility great again.
Reprinted by permission of Barron's Online, © 2016 Dow Jones & Company, Inc. All Rights Reserved Worldwide.
The views expressed in the above papers and articles are solely those of the author of the article, and do not necessarily reflect the views of OIC; the information presented is not intended to constitute investment advice or recommendations to purchase or sell securities of any company; and the information presented is based upon particular events that may or may not recur in the future.
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