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Summary

  • Volatility is at historically low levels- the VIX is sitting at the lowest levels since 2007.
  • Examining historical prices of the VIX indicates that there is seasonality to the levels of VIX and index is generally lower during summer than non-summer months.
  • There are several possible investment options for going long on volatility including buying options in the VIX or equities in VXX.
  • Based on the data examined, there is a very strong probability that volatility will rise out of the currently abnormally low levels in the Aug-Oct time-frame.

Remember what happened on September 14, 2008? If you are an investment banker, then chances are that you remember very well; for the rest of us, that was when Lehman Brothers declared bankruptcy. This single incident sent ripples throughout the global financial infrastructure and in part, affected many subsequent fiscal decisions. This event and others happening in that time led to the volatility index (VIX) to rise 320% from August levels of 18.8 to October levels of 79.1, as shown below. This was the highest recorded level of the VIX since its measurement began in 1990 and it has not yet been surpassed again.

(click to enlarge)

Source: Historical price data from Yahoo Finance.

Understanding the VIX

The VIX was conceived of by Dr. Robert Whaley and introduced to the public by the Chicago Board Options Exchange in 1993 (but was back-calculated to as far back as 1986). It measures volatility that investors expect to see in the future and not volatility that has already occurred. It takes into account the prices of many out-of-the-money calls and puts for the front and second month expirations. The VIX is quoted as a percentage such that current levels of 10.7 represents an expected annualized change of 10.7% in the S&P 500 over the next 30 days; this amounts to 10.7%/(12^0.5)= 3.1% over the next 30 days. This is just a short primer on the VIX and more detailed information can be found here.

What is Normal for the VIX?

Clearly the VIX at 79.1, the level it hit in October 2008, was abnormally high. Fast forward to today and the VIX is currently at 10.7; is this normal? To get a better sense of normalcy, we can examine the descriptive statistics of the VIX over its history. The median closing level of the VIX is 18.9. The VIX's range 50% of time is between 14.6 and 23.7, the range 75% of time is between 12.0 and 29.1, and the range 95% of the time is between 11.3 and 37.2. In context of these ranges, the current level of 10.7 seems unusually low.

There are many other articles that talk about the current complacency in the market as a reason for why the VIX is at such low levels. The markets are at all-time highs and continue to rise in value. However, trading volumes are very thin, but not unusually so for this time of the year. Fear and anxiety that prevailed in the financial marketplace between 2008 and 2011 have now disappeared. Veritably, the banking sector is in much better shape now, the housing industry is showing signs of recovery, and the unemployment rate is decreasing. Still, is the current market valuation justified? The argument that current market performance is related to the Fed's policy of quantitative easing is a reasonable one, and indicates that market performance will suffer once quantitative easing is reined in.

Also, quantitative easing for such an extended period of time (~$2 trillion over the last 6 years) has greatly increased monetary supply, which can be an underlying cause of inflation, as I point out here. Historical trends also indicate that inflation occurs in a cyclical fashion and it is due to reach another peak from its current trough over the next few years. A rise in inflation will result in increasing interest rates, which is also likely to negatively influence market performance. With growing uncertainties in the near future about life after quantitative easing and rising inflation, one wonders why the volatility index is currently at abnormally low levels.

Seasonality: A Reason for the VIX's Abnormal Behavior?

Why is the VIX at such low levels? One plausible reason may be seasonality. Trading volumes are currently at the lowest levels since 2007, and are generally lower in the summer than at other times of the year.

An examination of historical prices of the VIX (obtained from Yahoo Finance) between 1990 and 2014 plotted by month also points to seasonality as an important factor in volatility levels as shown below. When historical prices are averaged over the 25 years, data points to a dip in the VIX between April and July and then a buildup in volatility that peaks in October. Indeed, statistical analysis shows that there is a significant difference (p = 0.037) between summer (April to July) and non-summer (January to May and August to December) months.

(click to enlarge)

Source: Historical price data from Yahoo Finance.

How to Profit from Volatility

1. Options give investors the right to buy or sell stocks at predetermined strike prices and are priced in part based on expected volatility in the future. If implied volatility is low, then options are less expensive, all other things being equal. This is useful to keep in mind as you are developing your long and short positions to also take a look at options as they may present better opportunities right now. Options can also be purchased for the VIX. The seasonality data above is a useful guide for what type of options are most attractive. A conservative (but certainly not risk-free) investment would be to sell naked puts expiring in Aug-Sept such as those shown below.

Strike

Expiration Date

Ask Price

Downside

Upside

Breakeven Price

Annualized Return @ Max Upside

13

Aug 20th

0.7

1120

70

12.3

37.50%

13

Sept 17th

0.5

1120

50

12.5

17.86%

13

Oct 22nd

0.45

1120

45

12.55

12.05%

As you can see, the further the expiration date, the lower the return but the more likely that the VIX will have risen to match or exceed the strike price.

2. Going long on volatility indexes is another viable strategy in the current market environment. It is not possible to purchase equities in the VIX, but options like the ones listed above are a possibility. Another possibility is to buy equities in exchange traded notes (ETNs) that follow the VIX such as the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX). As shown below, there is a strong positive correlation between the VIX and VXX over the last 10 years.

(click to enlarge)

Source: Google Finance.

Conclusions

Betting one way or the other on volatility seems like a bad idea at face value. However, this is a rare opportunity to invest in volatility levels that are abnormally low - the lowest levels since 2007. One reason for why volatility is so low may be seasonality; over the last 25 years, volatility has been lower during summer (April to July) than non-summer (August to December and January to March) months 80% of the time or in 20 out of 25 years. There are several strategies that can be pursued when investing in volatility, including selling put options in the VIX, which tend to be cheaper when implied volatility is low, and buying ETNs that track the VIX, such as VXX.

Few investments warrant backing up the truck and betting the farm on, but in my opinion, this is one of them. When looking at the historical performance of the VIX, volatility always increases from historically low levels, so with a long-term perspective in mind and several uncertainties on the horizon, there is a very high chance that going long on volatility will pay off over the next few months.

Source: A Safe Bet On Volatility