On a cold winter night, in January 2018, a group of fellow hedge fund managers and your humble servant were sitting around a dinner table and discussing volatility. The VIX index had just fallen below 10, marking one of the lowest VIX levels in years. The market, meanwhile, was hitting new highs almost every other day, riding the wave of euphoria over recently passed tax cuts. Some of us thought that this euphoria will continue throughout the rest of 2018, following the year 2017, which was one of the least volatile years on record. Others were less optimistic, viewing the recent run as a melt-up.
In the end, the latter group was proved right - and quite quickly. On February 5th, the S&P index abruptly fell several percentage points, with the VIX skyrocketing meaningfully above 20 within hours, even hitting the rarely seen 40-50 range at one point. A melt-up ended, as they frequently do, with a meltdown. That January-February story is instructive because it demonstrates two extreme tails of volatility within a short period of time. Further, it sent a chilling reminder that the average historical VIX index is around 20, making it difficult to get too cozy in the 11-14 range we witnessed during 2017.
In fact, after the February 5th crash, the VIX world was never the same: no low VIX period lasted for too long, with significant swings in both directions (3-4 points, or even higher) becoming commonplace. Some people view this trend as an aberration and wistfully remember the quiet era of 2017. However, we have to remember that back then the forward-looking market was feverishly anticipating a 40% (!) cut to the corporate taxation rate, a legislation that happens once in a generation, if at all. Once the law was passed, only then did the market start anticipating other negative externalities associated with it, such as higher inflation and ensuing Fed rate hikes.
The VIX trend we’ve seen since February 2018 is actually the norm, rather than an aberration. Even the disastrous fourth quarter of 2018, when VIX regularly spiked above 20, was entirely indicative of a correction that is due to happen once every ten months, on average. Rather, every time the VIX index falls to the 11-14 range, it should serve as an indicator to traders that a spike in volatility is just around the corner. If VIX proceeds to fall below 10, then a meltdown is likely coming. Such is the nature of our brave post-2017 world.
When it comes to specific instruments, as an example, VXX short-term futures ETN affords the best liquidity. At the same time, we have to be cognizant of contango: when the futures price of a commodity is higher than the spot price. Further, futures markets are highly speculative. The further out the contract expiration, the more speculation there is: this is an important risk that has to be kept in mind.
As we look toward the end of the year, we believe that a replay of last year's fourth quarter volatility could definitely be in store, given 1) uncertainty of US-Chine negotiations; 2) continued macro pressures in Europe and a threat of spillover effects into the United States; 3) Brexit-related fears (though Brexit's impact on the US economy should be limited). Given this outlook, we view the VIX range of 11-14 as a meaningful entry opportunity for those who are looking to benefit from sudden spikes in volatility.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.