Tuesday, April 6, 2010

Is Volatility Getting Cheap Again?

One of the indicators that I like to watch, if for nothing else than for entertainment value, is Barron's Investor Sentiment readings. Last week, depending on which indicator you look at, Bullish consensus ranged from 41.3% to 70%.

One of the questions I constantly want to be asking myself is whether the market is getting complacent, which I would argue is the primary cause of bubbles. I would posit that if the market starts to get too single minded, market efficiency starts to weaken and you start seeing opportunities to take advantage of the follies of other market participants.

Just looking at the way the Dow Industrial Average has been moving (i.e. in terms of scale of the movements), things seem to be quieting down in the market. The standard deviation of daily returns for the Dow Industrial Average has dropped from 2.38 percentage points (from the beginning of 2008 to the end of 2009) to 0.82 percentage points (YTD).

Even when you look at the Dow during a more "pleasant" period of time (mid 2003 to end of 2007), standard deviation of daily returns is 0.74 percentage points, not that much lower than where we are now.

But the key test for whether the market is getting complacent or not is to look at implied volatility. The most common metric for this, the VIX, does so by backing out volatility expectations from S&P 500 put and call options expiring in 30 days (CBOE methodology). When you look at historical VIX levels, the answer to this question is debatable.

Will the Future Be More like 2004 to July 2007 or 1992 to 1999?

These are the two times periods for which there is VIX data that I would call "good" for shareholders. What I was curious about was what the VIX level looked like during these periods.

For 1992 to 1999, you have a geometric mean of 17.03, arithmetic mean of 17.90, and standard deviation of 6.02. For 2004 to July 2007, you have geometric mean of 13.52, arithmetic mean of 13.71 and standard deviation of 2.35 for the VIX.

These are obviously very dramatically different numbers, and the most reasonable explanation for the higher values for the 1992 to 1999 period was the tech boom, and the volatility that that presented. That was a bull market the likes of which was unseen previously, so perhaps an expectation that that will happen again in the near future is foolish. So if you're looking at 2004 to July 2007 as the most likely market climate for the upcoming future, the VIX, which closed at 16.23 today, is still a little bit high.

That being said, 16.23 is the lowest level the VIX has closed at since December 10th, 2007. Depending on how you're feeling about the economy, now might be an interesting time to try and profit off of volatility underpricing.

Trading Strategies

The simplest option would be to buy futures on the VIX, or check out the VXX or VXZ, two ETNs managed by iPath (Barclays).

Another option would be to literally buy options on the S&P 500 to perform a straddle. This would be done by buying a put and call at the same strike price, presumably with the strike price at the current market price. Your hope would be (presuming strike price is market value on day of purchase) that the closing price on the day your option expires would be the strike price plus or minus the sum of the premiums paid for the put and call options.

I've also written another article on volatility: Getting Exposure to the VIX as a Hedge: Is it Conditionally Correlated to S&P 500 Returns? if you're interested in reading it.

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