The equity markets have mostly been trending higher so far in 2021, and the market’s “fear gauge” – the CBOE Volatility Index or VIX, for short – has been declining. The VIX last peaked near 40% during the height of the February selloff.
In general, the VIX increases quickly when equity prices decline and ebbs when prices are rising. Its current equilibrium level seems to be much closer to long term historical averages than it has been over the last several years.
With the exception of a few spikes during brief periods of market uncertainty, the VIX has been trending steadily lower in 2021.
For many years between the great recession and the start of the pandemic in 2020, trading in VIX derivatives held the index artificially low. A wide range of traders from small retail investors to relatively sophisticated professional shops found the apparent easy money in the VIX irresistible. They shorted the VIX every time it rose using futures, options and inverse ETFs/ETNs and profited handsomely…for a while.
Huge spikes in volatility during a brief selloff in the spring of 2018 wiped out most of these traders. We documented that effect when VIX trading profits started showing up on big banks’ quarterly reports.
Many traders suffered losses in excess of the value of their accounts, especially those who were using leveraged ETNs, leaving their brokerage and clearing firms with significant debts.
Ultimately, there’s not much difference between being short the VIX and being short equity index options. Both involve significant risk.
Big trading desks that had the patience and foresight to stay long volatility - knowing that it would spike sooner or later - cleaned up.
When stocks fall and demand for protective options rises, the VIX sees upward pressure from all sides. The rush for the exit creates a vicious circle in which every uptick creates more fear and greater demand.
Short volatility strategies tend to blow up eventually. Though they appear to work for a while, but practitioners are really borrowing the money from the markets rather than actually earning it. When it comes time to pay the debt back, it’s usually very painful.
Here’s the story of another one…
While that trade was working in 2013-2018, the effect of all that money available to sell volatility had a depressive effect on the VIX. Other than a few short-lived increases, the index stayed in the low double digits (near 12%) for long stretches.
Over the long term, the observed volatility of the S&P 500 is between 14-16% - depending on the length of the period used for the calculation - and the implied volatility of options tends to be 1-2% higher than observed actual volatility.
That would mean the equilibrium level for the VIX is 15-18%, which is almost exactly where the VIX index closed on Wednesday - 16.5%.
Now that those chasing easy profits have been flushed from the markets, the VIX seems to be floating back to more normal levels.
If the markets are lulled into complacency during this rally, it’s possible that the VIX may once again trend lower, but beware of strategies that seek to profit from those declines. They tend to be fool’s gold.
Low VIX levels should be a signal to ordinary investors that it’s relatively inexpensive to buy options to speculate and/or protect the value of your holdings.
-Dave
David Borun runs the Zacks Marijuana Innovators Portfolio as well as the Black Box Trading Service and the Short Sell List Trading Service. Want to see more articles from this author? Scroll up to the top of this article and click the “+Follow” button to get an email each time a new article is published.
Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.
Image: Bigstock
Buying the Dip in the VIX Makes More Sense Than Selling the Rips.
The equity markets have mostly been trending higher so far in 2021, and the market’s “fear gauge” – the CBOE Volatility Index or VIX, for short – has been declining. The VIX last peaked near 40% during the height of the February selloff.
In general, the VIX increases quickly when equity prices decline and ebbs when prices are rising. Its current equilibrium level seems to be much closer to long term historical averages than it has been over the last several years.
With the exception of a few spikes during brief periods of market uncertainty, the VIX has been trending steadily lower in 2021.
For many years between the great recession and the start of the pandemic in 2020, trading in VIX derivatives held the index artificially low. A wide range of traders from small retail investors to relatively sophisticated professional shops found the apparent easy money in the VIX irresistible. They shorted the VIX every time it rose using futures, options and inverse ETFs/ETNs and profited handsomely…for a while.
Huge spikes in volatility during a brief selloff in the spring of 2018 wiped out most of these traders. We documented that effect when VIX trading profits started showing up on big banks’ quarterly reports.
Many traders suffered losses in excess of the value of their accounts, especially those who were using leveraged ETNs, leaving their brokerage and clearing firms with significant debts.
Ultimately, there’s not much difference between being short the VIX and being short equity index options. Both involve significant risk.
Big trading desks that had the patience and foresight to stay long volatility - knowing that it would spike sooner or later - cleaned up.
When stocks fall and demand for protective options rises, the VIX sees upward pressure from all sides. The rush for the exit creates a vicious circle in which every uptick creates more fear and greater demand.
Short volatility strategies tend to blow up eventually. Though they appear to work for a while, but practitioners are really borrowing the money from the markets rather than actually earning it. When it comes time to pay the debt back, it’s usually very painful.
Here’s the story of another one…
While that trade was working in 2013-2018, the effect of all that money available to sell volatility had a depressive effect on the VIX. Other than a few short-lived increases, the index stayed in the low double digits (near 12%) for long stretches.
Over the long term, the observed volatility of the S&P 500 is between 14-16% - depending on the length of the period used for the calculation - and the implied volatility of options tends to be 1-2% higher than observed actual volatility.
That would mean the equilibrium level for the VIX is 15-18%, which is almost exactly where the VIX index closed on Wednesday - 16.5%.
Now that those chasing easy profits have been flushed from the markets, the VIX seems to be floating back to more normal levels.
If the markets are lulled into complacency during this rally, it’s possible that the VIX may once again trend lower, but beware of strategies that seek to profit from those declines. They tend to be fool’s gold.
Low VIX levels should be a signal to ordinary investors that it’s relatively inexpensive to buy options to speculate and/or protect the value of your holdings.
-Dave
David Borun runs the Zacks Marijuana Innovators Portfolio as well as the Black Box Trading Service and the Short Sell List Trading Service. Want to see more articles from this author? Scroll up to the top of this article and click the “+Follow” button to get an email each time a new article is published.
Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.