Recession Prediction: Is Volatility A Problem?

| March 30, 2018 | 0 Comments

Stock market volatilityStock market volatility has increased substantially over the past two months. While large declines during the first week of February and over the past few days have garnered most of the attention, it should be noted that the S&P 500 has spent over 30 of past 40 trading days within 3% of all time highs. At the moment, the market data hardly supports a recession prediction in this area.

Despite that, the main measure of market volatility, the CBOE Market Volatility Index or VIX, has more than doubled from 2017 levels and remains stubbornly near 4-year highs.

The VIX is often referred to as ‘the fear index’ because it has a tendency to rise, often quite dramatically, when stocks sell-off.

The basic reason for this inverse relationship is that the stock market declines investors begin purchasing put options on the S&P 500 as a means of establishing downside portfolio protection. The faster and larger the decline the greater the demand and the more people are willing to pay for the puts. This leads to pump in premiums which is translated into a higher implied volatility or high VIX reading.

But one thing to keep in mind is that implied volatility is not indicative or predictive of whether prices are rising or declining; it only tries to account for the expected magnitude and speed of a change in price, not the direction.

Too many market participants believe rising stock market volatility can only occur in down markets. It might be true that rising volatility is considerably more likely to occur in times of market stress, but the correlation is nowhere near as certain as most pundits believe.

Perhaps the most notable period in which we saw a bull market accompanied by an increase in volatility or the VIX was during the late 1990’s dot.com days.

bull market accompanied by an increase in volatility

During this time the S&P 500 more than doubled, but so did the realized volatility90-day historical volatility went from 8% to spiking above 25%, with the average firmly pushing 20%.

Please don’t misconstrue this as some sort of proclamation that VIX is heading higher.

If you pay careful attention to my language, you might note that I referenced realized historical volatility. VIX is not the same thing. One is the actual amount of variability in the prices of the underlying security, and the other is an index that is based on the implied volatility the market place is willing to pay for options that settle at some point in the future. As we saw during the recent VIX-pocalypse, the price of that index doesn’t necessarily reflect underlying conditions and might have more to do with specific supply demand forces.

All I know is that there have been periods where both stocks and their realized volatility have risen together. Don’t assume that by shorting VIX or executing some other short volatility strategy, that you are inherently betting on a higher stock market.

No doubt, that on average, that conclusion is correct, but how many times have we seen stable relationships completely thrown out the window? It would be just like the Market Gods to punish the vol sellers by having both volatility and stock prices shoot higher in the coming quarters. 

Those vol sellers would lose on both sides. The short volatility strategy will end up being a loser, while the synthetic short of not being long equities would also be a drain on the portfolio. Not a prediction, but it might be just the kind of out-of-the-blue outcome that hurts the most market players. 

And if there is one thing that I have learned over the years, it’s that markets often end up going to the point of maximum pain for the greatest number of players. Higher volatility and higher stocks might end up being that sort of unexpected outcome.

 

Note: This article originally appeared at Option Sensei.

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Category: Options Volatility Watch

About the Author (Author Profile)

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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