Mainstream media has been bashing on about the FEAR in markets over past days. What most people, that have never traded volatility as an asset, fail to understand is that high volatility itself is not a great predictor of markets crashing.
We are not going into a detailed discussion about volatility and how it is priced/traded in this article, but there are a few relevant charts to consider below.
Most investors use options to hedge their exposure. The most widely used hedge is buying puts to protect the downside, basically buying insurance on your portfolio. People buy insurance to protect their houses, so why not buy protection on the equity portfolio. This is the most basic use of options (Volatility trading as such, is a strategy deployed by banks and hedge funds mainly. Volatility traders trade volatility, and are therefore not thinking options premium as the “normal” investor does).
There is no real difference between buying insurance on your home and your equity portfolio except for the fact people tend to buy the insurance policy when they buy the house, and renew it yearly. Most people are bullish on stocks by nature and hence focus on the upside and not the downside. Equity portfolio insurance is often something people tend to buy when stocks have sold off. Investors often end up buying equity protection “after the house has burnt down”.
Another classical fallacy most investors tend to engage in is the fact they confuse direction with pace, often leading people to pay way too expensive insurance (buy options when volatility is high).
Below is a chart showing SPX (orange) versus the VIX index (white). Note how every market local low has been occurring with a spike in VIX. High VIX itself does NOT mean markets must crash further.
CBOE put call ratio measures the number of puts bought relative to calls (white line). Note how the put call ratio versus the SPX (orange) has spiked on every occasion as the SPX has been marking a local low. Investors ironically often buy the greatest number of puts relative to calls at market lows.
High fear does NOT mean the markets must crash further. The below chart shows the SPX term structure. Orange is the current curve and green how the curve looked 1 month ago, when SPX traded 150 handles higher. The below chart is showing clearly how short-term maturities have gained much more relative to longer dated maturities, but this is not to be confused that markets must crash further. It does tell us that investors have been chasing short term protection.
The below chart shows the 1 vs 6 months VIX futures curve. In calm markets the curve trades in negative territory (People are not overly concerned by buying short term options to hedge and the curve trades negative due to faster theta decay in short term options).
The curve spiked into positive territory as the sell off accelerated in October. The entire curve has been elevated since then, but note that all spikes in the VIX curve since the sell off started have been marking local lows in SPX, and a violent bounce has followed.
Source: charts by Bloomberg
Understanding volatility, the VIX and fear is a great input for successful trading. Listening to media pundits bashing on about VIX this and that, has no value, and risks blurring your view on the markets. It reminds us of the Fear logic we concluded yesterday: Why not a fearful bounce, just to frustrate the crowds again?
We have said it before and will say it once again:
Don’t buy volatility when you must, buy it when you can