Whither Volatility

More surprising than the powerful rally stocks have enjoyed since Trump was elected has been the incredible contraction in volatility. While the broad market as measured by the S&P 500 Index (SPX) has climbed some 11.2% since November 8th, the VIX, which measures volatility, has declined by 42% and now sits at decade lows.

Remember, Trump was supposed to bring chaos, controversy and uncertainty (all synonyms for volatility) and those are indeed all occurring in the public and political arena. So why is the stock market ignoring or not registering such concerns?

Correlation Collapse: The first explanation: following the election there was massive rotation among sectors and stocks as money was reallocated. So, while underlying components have moved, the overall index has remained relatively calm as winners offset losers. This is known as dispersion and comes when there is a lack of correlation among the individual issues.

As you can see, correlation has collapsed since the election.

No Puts Needed: Secondly, given the overly optimism and bullishness, investors have not felt an urgency to buy up portfolio protection in the form of put options. This is typically a large driver of implied volatility levels.

ETFs and Machines: The rise of passive investing and use of exchange traded funds combined with machine driven trading means there is less active decision making done on a day to day basis. People tend to make their allocations and walk away. Most algo based machines respond to the same news, meaning there is a uniformity action.

The result is not only do we have had less day-to-day volatility – remember implied volatility and the VIX tend to measure changes in price from one to the next – as of March 17 the S&P 500 has not had a 1% or more change in over 107 days. That’s the longest period. Ever.

But also there is less intraday swings as the market tends to open, find a price early and then sit. This is reflected in the narrowing of the Average True Range which has also sunk to historically baseline lows.

What now? It seems pretty safe to say volatility has nowhere to go but up. The question is when? And how would you position for such an inevitability?

One thing you don’t want to do is buy the iPath Short Term S&P 500 Volatility (VXX); due to the drag of cantango it has an inexorable path downwards. This volatility based ETF has declined some whopping 99% since its inception and had basically been in a straight line down since the election, losing some 37% on the year to date.

So while you’re waiting for things to pick up this product’s value is just wasting away.

Instead I’d look at establishing some type of backspread in the SPY going out at least three months in time. This give enough time for this low volatility environment to last much longer than anyone expected.

— Steve Smith

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About the Author: Steve Smith