When Will Volatility Return?

by Jay Pestrichelli on November 14th, 2013

Our answer is, barring some unforeseen market event, it’s right around the corner in the next few weeks.
 
We understand that watching volatility seems to many to be a theoretical exercise reserved only for those who speak the Greeks. However, if you’re someone who participates in the High Probability Option strategy we’ve discussed on this blog before, then volatility is very important to you as that is the basis on how the methodology earns its gains. Either way, if you’ve watched the market at all in the last month, you’ll know that there has been very low volatility or price action.
 
Volatility elicits emotional responses from investors and can exist for both good and bad reasons. As fear and greed govern the mental state of traders, the more volatility the markets have the more interesting those markets become. It is usually a cycle where it builds upon itself as volatility begets more volatility.
 
Let’s start out by defining volatility. Statistically speaking it is metric that measures standard deviation or variance of the day to day price action of an index. In investing terms, this is known as Historical Volatility (HV). It is a 100% look at what the stock has done in the past and the more volatility in a stock or index, the more risk it is considered to have.
 
Then there is Implied Volatility (IV). This is a calculation that measures the amount of volatility expected by a certain date in the future. It is determined by the price of options and is one of the 3 main components that make option premiums (time and strike vs. underlying price are the other 2). IV can be considered a reflection of the emotional state of the markets as it indicates how much an investor is willing to speculate that the purchase of the option will pay off. The higher the IV, the more traders and investors are willing to pay for an option and is illustrated by a higher price.  The more they are willing to pay, the more confidence they have in their speculation.
 
Implied Volatility is what makes up the VIX (aka the Volatility Index). This is an index that you may hear about from time-to-time on CNBC or read about on a financial site. The VIX tells us how expensive or cheap options are and hence how speculative option traders are about market movement. The VIX is supposed to give an indication of the volatility of the stock market over the next 30 days. That is why the VIX is considered a forward indicator and at times called the “Fear Index”.
 
Our tools now include Historical Volatility that looks back on an index or stock performance and we’ve got Implied Volatility that tells us how much volatility we should expect over the next 30 days. But there is one more (and you’ll think I’m crazy when I say it), it is the volatility of volatility. Yes, the volatility of the VIX can also be measured.  Since there is a track-able index, calculating the historical volatility is the same as any other index. And since there are options on the VIX, we can look at the implied volatility of that as well.  But what do these really measure?
 
The IV of the VIX tells us the appetite the options market has for speculating on the performance of the index. This means a trader can take a bet that the VIX will rise or fall by use of the options on the VIX.  A higher premium in those options indicates that more volatility is likely to come into the market. Remember, the VIX as an index represents how much speculation investors and traders are willing to take. As it turns out, that state of mind can be traded with the options (or futures) through the VIX.
 
Back to the question at hand: When will Volatility return? To know where it is going, let’s look at where it has been.  The VIX (and the other volatility indexes such as the NASDAQ 100’s VXN or the Russell 2000’s RVX) is trading at relatively low levels.  As of the close on November 13th, the VIX at 12.5 is only 1 of 17 times this year that it has touched this level. As a reference the average for the past year is closer to 14.5 and the average for the previous year was 18.5. Below is a chart of the VIX for the past 12 months.

VIX Index
 
Just looking at the price of the VIX, it is easy to see how the VIX is at the lower end of its range.  However, more importantly, is that there seem to be a lack of spikes since mid-October. One can say the VIX has been in a tight trading range between 12 and 14. That leads us to view the Historical Volatility of the VIX as seen below:
 
Historical Volatility

I have two observations about the VIS’s HV. First is that we are approaching a low level in the fluctuation of the VIX prices, but we’re not in uncharted territory. We have seen the HV on the VIX at this level 5 times before in the past 12 months. Actually it has been lower than where we are at each the valley’s above with the exception of the one in late September. 
 
Second, is the time frame the HV cycles lasts. Based on the distance between valleys in the chart above, it looks like the HC follows a 2 month cycle. If that patter is to be repeated, we would expect this low HV to remain until the last week of November.
 
Now that we’ve discussed the past, what are the speculators telling us about the price of the volatility? Using Implied Volatility (IV) we can see that option traders have brought the premium down to levels not seen at all this year. In other words, they aren’t willing to bet that volatility will return anytime in the next 30 days. Actually, they are probably so confident in that posture, they are selling premiums to generate income while waiting for the volatility to return.  Below is a chart of the VIX’s IV
 
Implied Volatility
As seen above, the forward looking volatility of the VIX remains low. After breaking through the 0.70 level of IV, we’re in uncharted territory not seen for at least 5 years.  In the past year, anytime the IV of the VIX reached 0.70 it bounced higher within a day. That action usually was the result of options traders being opportunistic and betting on a pop in volatility to come. However this time around that has not happened. Even in last week’s single day 1.5% selloff, the VIX never really jumped. This leads us to believe that this pattern is breaking down and the speculators don’t expect any sizable volatility to come back into the market. This lack of appetite for guessing on a VIX move tells us they are not primed and ready to pounce on the smallest hint of an opportunity. It is going to take some convincing for them to bet on a VIX move.
 
One footnote, options traders can be wrong just as they are right. The IV portion of option premiums is speculative and can be absolutely wrong. That is why it is called speculating. So keep that in mind when looking at a chart of any Implied Volatility and realize it can change direction on a dime.
 
At Buy and Hedge, we are expecting for this current state of low volatility to eventually reverse (as these charts show it always does).  If there is one thing we can count on, it is that emotions of fear and greed that drive markets are unpredictable. All it usually needs is a little jolt and the volatility returns.  It seems the difference this time around, is that it’s looking for more of a kick, shock and a bucket of water to wake from this lull of complacency. 


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