Volatility, or annualized standard deviation of price changes, of the S&P500 index in the US, as represented by the VIX index, has been declining for the past 18 months and now trades significantly below its long term average. Some market participants have pointed out that now may be a good time to go long and use this asset as insurance against events such as further deterioration of the Eurozone crisis and the potential end to US Federal Reserve’s money printing.

As shown in the chart below, past falls in the S&P500 (green line) led to spikes in the VIX (red line), whereas rising markets tend to suppress this measure. This is because stocks typically rise in small increments but fall sharply when retracing. Furthermore, major falls in share markets since 2010 have tended to follow the end of quantitative easing (QE) programmes as highlighted by the orange vertical lines which match the times when the US monetary base stopped expanding (black line). In theory, the strategy of buying volatility cheaply should work.

However, we see implementation issues with this strategy.

Firstly, one cannot buy the VIX. Unlike a stock index there is no underlying to replicate. This means any exposure to the VIX will have to come from options (which are priced based off volatility) or contractual agreements.

Secondly, the curve of the futures market for volatility means the market is effectively pricing in some 50% appreciation of the VIX in the next 9 months already. While a spike similar to that in Q2 2010 or Q3 2011, when spot volatility reached 40, would likely still lead to a handsome payoff for a long bet, the cost of carrying the trade is high. To illustrate the point, VIXY, a US listed ETF designed to replicate the returns from short term VIX futures, lost 78% in 2012 when the VIX declined 23%. The difference in returns (55%) was the cost of maintaining the position during that 12 month period.

Thirdly, there is still uncertainty regarding when QE3 will end. Per the above point, the longer one has to wait for the next volatility event, the less rewarding this strategy will be. Therefore, timing is critical.

An alternative that removes the timing element is to venture into very long dated options, which is something institutional investors can do but difficult for retail investors to replicate.






Please click to enlarge the above image.

Felix Fok

Portfolio Manager