Stocks Are Quiet. Too Quiet.

Stocks Are Quiet. Too Quiet.
Milou Beunk

almost 3 years ago4 mins

Mentioned in story

What’s going on here?

Sure, a key measure of US stock market volatility just hit its lowest level in a year. But growing investor concerns about everything from the pace of the economic recovery to looming company tax hikes and higher inflation could well make this current calm short-lived. With that in mind, here are a few ideas on how you can set yourself up to benefit when volatility inevitably picks back up again.

What does this mean?

Volatility is a way of tracking how quickly investment prices are moving up and down. And the influential Volatility Index – commonly referred to by its ticker symbol, “VIX” – is an estimate of the expected volatility of the US stock market in particular, based on the price of associated options.

The VIX is an important touchstone for investors because it provides a measure of how concerned other investors are: a low reading signals calm, while a high one indicates panic. Over the last three decades, the average value of this “fear gauge” has been 20 – although it hit 83 during the mid-pandemic market crash last March, its highest level since 2008. This year, however, the VIX has been trending down – and at 17, the index currently sits around 15% below its long-term average.

The VIX’s movements over the past 14 months
The VIX’s movements over the past 14 months (Source: Bloomberg)

But this may be misleadingly low. Economic recovery in the US, as elsewhere around the world, still looks fragile, and the path out of the current health crisis is unlikely to be completely free from further setbacks. My view is that stock market volatility will soon pick up again, and I’m not alone: last week an anonymous institutional investor made a major bet on just that eventuality.

Why should I care?

There are several short-term trading opportunities you should think about exploiting if you agree that volatility looks like it’s going to rise. First, you should buy the VIX – but because volatility isn’t exactly a tangible asset, you can’t invest in it directly. You’ll have to deal in derivatives instead.

Professional money managers regularly use futures and options to bet on the VIX’s direction. These derivative investments both involve agreements to buy or sell an asset at a defined future date and price. The main difference between them is that options, unlike futures, don’t oblige you to conduct that transaction if it no longer makes financial sense.

Retail investors aren’t always able to access such products: trading platforms can be reluctant to let you trade these often leveraged investments, where losses can quickly pile up. If you are to trade options, however, you may also want to consider buying US S&P 500 options.

With volatility as low as it is, options are cheap: the slower pace of stock market price swings means investors are less willing to pay for the chance to profit from future changes. If you trade options on the VIX, you’re betting purely on the volatility of the US stock market – but if you’re buying options on the stock market itself, then you’re betting on both their volatility and their direction of travel, and therefore stand to benefit from either.

If futures and options aren’t for you, you can simply “buy into” the VIX via an exchange-traded note (ETN) – a close cousin of exchange-traded funds (ETFs). One of the biggest out there is the iPath Series B S&P 500 VIX Short-Term Futures ETN (ticker: VXX).

But there’s a drawback you need to be aware of: ETNs invest in the kind of (typically short-term) VIX futures contracts described above, and futures contracts have expiry dates. ETNs therefore need to constantly reinvest in new futures contracts, and new VIX futures are often more expensive than previous ones. This constant “rolling” of futures contracts is costly – and if the VIX stays flat, then the ETN will lose you money.

All this explains why the price movements of VIX-based ETNs frequently deviate from the index they’re trying to track. As shown in the graph below, the VXX ETN trended downward during relatively unruffled periods for the VIX in 2018-2019. But while such ETNs are a poor long-term investment, they could be useful for a short-term opportunistic trade: after all, if the VIX jumps, then so should the VXX.

The price of the VXX ETN compared to the VIX’s value over the last four years
The price of the VXX ETN compared to the VIX’s value over the last four years (Source: Bloomberg)

Trading volatility may seem a tad complicated. But even if you aren’t interested in exploring related opportunities, you might want to keep an eye on the VIX anyway – just like the pros do. Keeping tabs on the level of US stock volatility, and by extension the general fear factor in financial markets, is likely to help you form a view on whether the value of your other investments is set to go up or down and enable you to act accordingly.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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