The Volatility Index Is Very Low Considering What Might Happen

by: D. H. Taylor


VIX levels are still abnormally low considering market moments that have already started to happen.

As more and more news comes out the markets will respond in kind.

Market participants are likely to start purchasing options driving up the VIX on equities and FX.

The potential for sustained moves, or at the very least, a whole lot of "mind changing", exists in the FX markets. The potential that Trump broke the law with obstruction of justice is large. Politicians are not screaming at the top of their lungs just yet, but that may be moments away. How long is a moment? No idea. And, that is what volatility is all about. One traders viewpoint could be quite different than someone sitting two feet away. Because of that, there is very likely a lot of buying and selling going to transpire. This will move the high/low range of markets, and, also the closing prices. However, as far as volatility goes, the current market landscape is likely to pull in a lot of "insurance" purchasers as options get bought up to lock in profits, protect positions or bet on potential moves. That is an opportunity as all this buying will push up option prices: Option volatility is likely to go higher.

I am constantly watching volatility, or the VIX, on multiple levels because of economic data. When economic data moves so do the opinions of market participants. Option prices move up and down from this. Lately, I changed from being moderately bullish on the United States economy to mostly bearish. I had thought the economy was going to start expanding at a more rapid pace, even if it was just a slightly greater expansion level. Instead, economic data started to slide, and retail sales started to go negative on month-over-month data. Since the United States economy is driven by consumers, I needed to quickly change my mind on what the potential of the consumer was.

At the same time, the government seemed to have lost all of its momentum after the election; the ACA repeal/replace basically fell flat on its face. Tax reform would be nearly impossible after that. Infrastructure? I can't even remember the last time that was even brought up in a laughing conversation. Also, there was the French presidential election that was getting to be very close and uncertain. All of this made me think that what we thought was going to happen had no chance of happening. I figured that financial markets would start to move quickly in one direction or the other.

Then, I happened to see the VIX print sub-11.00. The only thing I could think was "Really?". I ended up putting a long position via some options on the VIX when it was about 11.16. The VIX shot up and then came crashing right back down. The only thing I could think was "Really?" So, I doubled down, a very big no-no in the markets. However, I thought I was correct that there was going to be even more market uncertainty and that any lack of market response was nothing more than an opportunity. As it turns out, I was not alone: Ben Bernanke has been puzzled by the lack of response to political events by the markets.

This morning, I noticed that the VIX was up nicely. But, I also noticed that although there are movements in FX, volatility is very low in most currencies. Other events that seemed to be less important have moved volatility indexes a lot more over the past several months than the possibility of a president being removed from office. Here are the charts on Euro, Pound Sterling and Japanese yen volatility measures, as per CBOE, respectively:

On a historic basis, covering the past six months, volatility is low. But, you cannot look at previous volatility measures and just assume that things are going to change.... Mostly. You have to look on a relative basis. You start at the point you are right then, and ask how the market will move from that point and then base it upon the past.

If you look backwards on the charts I have above, volatility moved very high because of a large shift in the markets: The world thought Hillary was going to win the presidency. The world was wrong. Markets moved. Volatility went up.

I got a question to an article I did on the Japanese yen. The commenter wanted to know where I thought JPY would be on a specific date about a week away. I have no clue. But, I feel pretty certain the political world will not be the same as today and the financial markets will respond accordingly. I feel pretty certain the markets are going to move, however, I have no idea in which direction.

The most obvious currency that will move is the Japanese yen. As financial markets begin to move based upon the idea of a president being removed from office then investors in the interest rate differential will be heading out the door the fastest. The carry trade is based upon interest rate differentials widening. The quants get calculators out and determine that if someone can borrow money in one country they can then invest in another country and earn the difference in interest rates in between - Japanese 10-year government bonds were yielding 0.09% versus United States 10-year government bonds at 2.31% a couple of days ago.

What happens is that as the interest rate differential widens more and more, the currency moves more and more simply because more and more investors take advantage of that investment opportunity. In this case, the USDJPY rate was at 113.00 and the differential was set at 2.22%.

However, as markets got jittery, equity participants sold stock positions and then pushed money into the bond market. That rush of money into that market made yields move lower because of the inverse relationship. Translation: The differential narrowed. The quants exited their positions, reversing their positions and got out of their currency exposure selling their USDJPY positions. This pushed the interest rate differential to get even more narrow. It has a built in feedback mechanism.

I do not see the fortunes of a certain president improving from here. I see just the opposite. While this may take a moment to unravel, when it does unravel a vast amount of money that has been poured into the carry trade will be hitting the "sell" button. The markets are going to move a very large amount.

As more and more news comes out, more and more volatility will enter into the market, driving up the FX VIX indexes. with the JYVIX being as low as it is I feel very confident that there will be a large movement upward. There is already a small move to the upside. Pretty soon, it will eclipse the recent highs.

You can trade this in two ways: You can trade options on the FX VIX, themselves. You can go long the VIX volatility itself hoping for a spike in VIX. Or, you can buy options outright. Both are great strategies.

If you buy an option out-of-the-money, perhaps 6 months out, as time goes by you lose Theta (The time component in the Black-Scholes equation). But, you gain a great deal of Vega (The volatility component in the Black-Scholes equation).

My favored trade is to sell puts below the market to bring in premium while buying calls out-of-the-money. Typically, I sell a .30 Delta with the puts and buy a .25 Delta on the calls (Delta being the "distance" away in from the market, and therefore the "probability" of the option going in-the-money).

My thinking is this: is the market about to become calm and tranquil, thereby seeing volatility go lower? I think probably not. Even if it does, since my position size is manageable, if the puts go in the money, eventually the market will go favorably for me seeing how low volatility is relative to the past six months. I feel very comfortable that this position will work out, volatility is going higher.

Disclosure: I am/we are long VIX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.