The equity markets have been trending steadily in a positive direction with no significant interruptions since the steep selloff in December of 2018. The market’s “fear gauge” – the CBOE Volatility Index or VIX – has been staying mostly near all-time lows in the 12% range for most of that rally.
In general, the VIX increases quickly when equity prices decline and ebbs when prices are rising, though its current equilibrium level seems to be higher than it has been over the previous several years and much closer to long term historical averages.
For a long time, trading in VIX derivatives seems to have held the index artificially low. A wide range of traders from small retail investors to relatively sophisticated professional shops found the apparent easy money in the VIX irresistible. They shorted the VIX every time it rose using futures, options and inverse ETFs/ETNs and profited handsomely…for a while.
Huge spikes in volatility during a brief selloff in the spring of 2018 wiped out most of these traders. We documented that effect when VIX trading profits started showing up on big banks’ quarterly reports. (The banks had taken the other side of the VIX trade, knowing it would blow up sooner or later.)
Many traders suffered losses in excess of the value of their accounts, especially those who were using leveraged ETNs, leaving their brokerage and clearing firms with significant debts.
Ultimately, there’s not much difference between being short the VIX and being short equity index options. Both involve significant risk.
Big trading desks that had the patience and foresight to stay long volatility - knowing that it would spike eventually - cleaned up.
Anyone employing the VIX-selling strategy that survived that explosion was almost certainly finished off when the VIX spiked again at the end of 2018.
Since then, however, a new crop of VIX sellers has appeared to take their place. The lure of easy money is often irrestible.
Short volatility strategies tend to blow up eventually. Though they appear to work for a while, practitioners are really borrowing the money from the markets rather than actually earning it.
When it comes time to pay the debt back, it’s usually very painful.
While that trade was working in 2013-2018, the effect of all that money available to sell volatility had a depressive effect on the VIX. Other than a few short-lived increases, the index stayed in the low double digits for long stretches.
Over the long term, the observed volatility of the S&P 500 is between 14-16% - depending on the length of the period used for the calculation - and the implied volatility of options tends to be 1-2% higher than observed actual volatility.
That would mean the equilibrium level for the VIX is 15-18%, which is just below where the VIX index closed on Wednesday.
If the markets are lulled into complacency during this rally, it’s possible that the VIX may once again trend lower, but beware of strategies that seek to profit from those declines. They tend to be fool’s gold.
Notable trader and author of “The Black Swan: The Impact of the Highly Improbable” Nassim Nicholas Taleb often argues that it’s totally unpredictable events that shape history - and the financial markets. He also contends that “Black Swan” events are not uniformly surprising for all participants.
As an example, Taleb offers the parable of a turkey who has been fed every day of his life by a butcher and grows increasingly confident that he has a nice cushy living situation - until the fateful day comes when the butcher decides to kill him. That event comes as much more of surprise to the turkey than the butcher…
Not surprisingly, the notoriously private Taleb is reported to have made the majority of his considerable fortune during the 1987 crash, the 2000 bursting of the tech bubble and the 2007-2008 financial crisis.
The takeaway for traders and investors is that most options are extraordinarily cheap right now, but option sellers and short-VIX traders have still become accustomed to a consistent and apparently low-risk source of income and trading profit.
When the next event comes that shakes up the markets and sends the VIX to 30, 50 or even 80%, make sure you’re the butcher, not the turkey.
Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.
Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report
Cboe Global Markets, Inc. (CBOE) : Free Stock Analysis Report
To read this article on Zacks.com click here.
Zacks Investment Research