Volatility Looks Cheap In A Number Of Ways

Includes: SPY, TVIX, VXX
by: Tom Guttenberger

Volatility can be a portfolio manager's best friend when understood and used correctly. A grasp of historical and implied volatility enables traders and portfolio managers to take calculated risks on their underlying investments. Based on a number of observations, I think being long volatility would be wise at the moment. Additionally the second derivative of volatility also looks inexpensive, and could serve as perhaps the cheapest broad-market hedge today.

First a brief background on historic vs. implied volatility. Historic volatility is a path-dependent measure of a stock's daily variance. The more returns deviate from 0 on a daily basis, the higher your measure of historic volatility will be. Typically volatility will be calculated based on these daily returns and then scaled by the square root number of days for the X-day volatility (shown to be somewhat inefficient, but I digress).

Implied volatility is based on prices in the options market. Using Black and Sholes equation, volatility is assigned a 'cost' to fit prices in the market with their theoretical values. The CBOE Volatility Index (VIX) is calculated using bid-ask midpoints on the two nearest expiry months of SPX options.

The first observation I want to draw attention to is that we are back in a state of cheap implied volatility compared to the 30-day scaled daily measurement. While implied volatility became mildly elevated in May's sell-off, it is back to approaching its yearly low levels. Considering IV is at a 15% discount to a positively trending historic series, it appears cheap on this view.

A second observation is that the volatility of volatility measure also appears inexpensive. I personally don't trade volatility ETFs, but rather trade options on the VIX itself. (If some volatility is good more is better!) The series of volatility of volatility shows that VIX options are a nice theoretical discount as well.

Examining this chart, you can see volatility of volatility is right at yearly lows, so short-dated - in this case VIX July and August options - are at their biggest discount relative to 30-day historic since December of 2011.

What is most interesting is that the stage seems perfectly set for potentially volatile movements in the market too. Without going off topic, the macro economic risks in the market loom large while there are other indicators that suggest very cheap equity prices. The ingredients for unpredictable asset prices seem present. Further, the charts confirm that the market is at a sort of tipping point. The SPY ~135 level is a remarkable convergence of the simple 10-day moving average, exponential 30-day moving average, and long and short term support/resistance.

Traders follow these technical patterns very closely, and inevitably it will impact psychology. These critical technical junctures are scrutinized and price action at these levels will almost certainly be given too much attention. That first sharp move, a bad news item, a Ben Bernake sneeze, or any number of things seem capable of triggering an exaggerated reaction in the market one way or the other. The risk/reward dynamics of purchasing volatility here seem attractive, and even if stocks move higher and the position becomes a loser, it seems very plausible that realized volatility outpaces its current implied cost, thus serving as a worthwhile hedge.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: May initiate Long VIX calls in next 72 hours.

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