Historically, the Chicago Board Options Exchange Volatility Index — or VIX for short — has been a bellwether benchmark for measuring the volatility of the U.S. financial markets.
Its formula is fairly simple: Take a mathematical estimate of how investors believe the S&P 100 Index option (OEX) will move in the next year using a calculation based on the disparity between current OEX put and call option prices.
In that equation, the VIX rises when put option purchases move upward and declines when call option activity is robust.
In general, a “read” on the VIX is the result of that formula over a 30-day trading period. A high VIX figure means traders fear a volatile market environment.
A low number signifies lower volatility — an environment most non-contrarian investors want to see.
In a research paper titled “Stock Market Volatility during the 2008 Financial Crisis” by Kiran Manda at the Stern School of Business, New York University, the takeaway is this: Market volatility has not gone away despite continued low volatility levels in the VIX in recent years...
From 2004 to early 2007, the financial markets had been very calm. The market volatility, as measured by the S&P 500 volatility and the VIX index, have been below long-term averages. However, the financial crisis of 2008 changed this: most asset classes experienced significant pullbacks, the correlation between asset classes increased significantly and the markets have become extremely volatile. During this time, the S&P 500 lost about 56% of its value from the October 2007 peak to the March 2009 trough and the VIX Index more than tripled.
Now, almost seven years after the onset of the Great Recession and the subsequent loss of an estimated 28.5% in asset wealth, according to The Urban Institute, the VIX has declined by 43%, while the S&P 500 Index has climbed 70.52%, significantly reducing long-term financial market activity.
Playing the VIX
But the fact that long-term volatility has declined does not mean that short-term volatility has declined or will decline in the future.
In 2014, the VIX popped up 15% nine different times.
In 2015, the gauge skyrocketed to unprecedented highs — doubling in August with the largest monthly gain since 1990.
Throughout 2015, the VIX climbed 4% for every 1% fall in the S&P.
Ultimately, that’s how you capitalize on rising volatility — by taking a long position in the VIX prior to an upward spike in the index.
Two historically useful indicators of imminent market volatility are energy prices and commodities. When both crude oil and gold prices tank, another upward spike in volatility is likely (but not guaranteed).
Michael Purves, head of equity derivatives research at Weeden & Co., said:
Crude oil volatility has made a series of steadily higher lows since the extreme lows in early July, and has recently spiked to three year highs. These dramatically lower crude prices magnify the divergence in macro economic conditions across several countries which in turn should enhance FX volatility. All of which should help nudging the VIX to a higher floor. Realized volatility too is starting to pick up.
We urge caution here and think the VIX may well edge into a higher range in the coming weeks.
Purves is hardly alone in that consensus. In a recent research report entitled, “Higher Volatility On the Horizon,” Jim Strugger, director of derivative strategies at MKM Partners, says it’s time to get “defensive.”
“Elevated volatility across other asset classes, particularly the spike in commodities, suggest it’s time to shift moderately down the risk curve,” he writes, meaning that “with investors under-protected, we like adding [defensive options] positions in January expiry to cover the period of vulnerability ahead.”
Higher Volatility Options
If you’re looking for VIX-linked funds that do well in times of stronger market volatility, consider these:
iPath S&P VIX Short-Term Futures ETN (NYSE: VXX) — With over $1 billion in assets, the iPath S&P 500 VIX Short-Term Futures ETN is designed to provide investors with exposure to the S&P 500 VIX Short-Term Futures Index Total Return. The S&P 500 VIX Short-Term Futures Index Total Return is designed to provide access to equity market volatility through CBOE Volatility Index futures.
ProShares Ultra VIX Short-Term Futures ETF (NYSE: UVXY) — With $456 million in assets, this fund seeks to replicate, net of expenses, twice the return of the S&P 500 VIX Short-Term Futures index for a single day. The index measures the movements of a combination of VIX futures and is designed to track changes in the expectation for one month in the future. Note that performance on both a three-year and five-year basis has been in significant decline, based on lower market volatility levels over the same time periods.
VelocityShares Daily 2x VIX Short Term ETN (NYSE: TVIX) — With $317 million in assets, this fund seeks to replicate, net of expenses, the returns of twice the daily performance of the S&P 500 VIX Short-Term Futures index. The index was designed to provide investors with exposure to one or more maturities of futures contracts on the VIX, which reflects implied volatility of the S&P 500 Index at various points along the volatility forward curve. The ETNs are linked to a multiple of the daily return of the index and do not represent an investment in the VIX. Like UVXY, performance has fallen precipitously within the past three years, again primarily due to stronger market stability.
To leverage funds geared toward lower volatility periods, consider ProShares Short VIX Short-Term Futures ETF (NYSE: SVXY) and the VelocityShares Daily Inverse VIX Short-Term Fund (NYSE: XIV). With most analysts calling for higher volatility in 2015, however, these funds should be vetted thoroughly, and investors should proceed with extreme caution.
With oil prices and commodity prices in free-fall, expect more financial market volatility in 2016, not less. That’s where a closer look at the VIX bears watching.
At their most recent meeting, St. Louis Fed President James Bullard admitted that the central bank may "move back to an era of uncertain rate hikes based on meeting-by-meeting basis after the first rate hike."
When markets grow more risky, the VIX may be your best bet in leveraging chaos in the global financial markets.
Although most analysts might call this a neutral market, do not ignore the short-term volatile activity.
Until next time,
The Wealth Daily Research Team