The CBOE Volatility Index is perhaps the most widely misunderstood, and misused, risk management tool we track. Think of today's installment as a tool safety course. Our macro work includes tracking the price action in a considerable array of currencies, commodities, indexes, securities, and indicators. The secret, which I am sharing with you and which is misunderstood by the majority of even institutional investors, is to understand in advance precisely why we are tracking a particular item, what constitutes a legitimate signal which in turn triggers further analysis and what it does not mean.
Most investors, including the majority of professional investors, believe VIX provides a reliable barometer of market risk.
This is not true. Think of it as GIGO or "garbage in, garbage out." A high or rising VIX usually tells you the market went down already. A low VIX tells you the market has gone up and investors are possibly underestimating risk. The current VIX has dropped (37%) in the past month to about 14, and uses the inputs of implied 30 day forward volatility to suggest that the next 30 days the market probably moves up or down by about 3% to 4%. Unless something happens. That by itself is useless. Since its inception, large spikes in VIX have come after the market tanked.
As contrarians we can profit from this insight. You know the old saw - it is easy to get a loan when you don't need the money and, as well, insurance is cheap when perceived risk is low. When insurance is cheap, considering buying. When insurance premiums are expensive, become an underwriter.
The concepts around VIX apply to options and futures on individual securities as well. Here is a current example.
One idea I've shared with my clients is an investment theme with 400% upside over the next 1-2 years. One of the plays is a stock trading in the neighborhood of $4. When we study the value of that company's assets we find, after stripping out all debt and pension obligations, that the value of this company's natural resource reserves is $44 per share! The "fear" in this sector is high and thus a current holder of that stock would have to pay a big premium to protect their position.
But because we have carefully analyzed the reality we can find multiple ways to profit. In fact, a savvy contrarian investor could, instead of or in addition to purchasing the stock would sell July 2014 PUTS with a$4 strike price and collect about $0.90 of premium (about 22% of the strike price) for only eight months of capital at risk, which is equivalent to selling insurance and earning a 33-35% annualized return. Even though the assets of that company suggest its value is $44 per share, the market is allowing you to underwrite "risk" and capture this 33-35% return, which is ultimately backed by the underlying asset value of the security.
Brian Langenberg, CFA
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.