By: Steve Smith
In the four weeks since the S&P 500 Index burst to a new all-time highs the volatility index has simultaneously slipped to all-time lows. Until Friday’s employment number fueled a rally the S&P had experienced 15 straight sessions with intraday moves of less than 1%; the longest sub-1% streak ever. And the action was confined to a very tight range with the S&P holding within a 0.98% during that period; its narrowest two-week period ever.
This lack of movement pushed 10-day realized volatility down to 4.35% and 20-day down to 7.2%, the lowest readings ever. The VIX dropped to 11.95 – its lowest level in over a year, but given the miniscule realized volatile that actually still represents healthy premium. Which may explain why there is still no shortage of professional money managers willing to sell volatility in various forms from the VIX futures and ETFs to index based puts and calls.
As a recent article from Bloomberg states, “in a world of overpriced assets there’s one thing that keeps going on sale: volatility.” And this is great news for individual investors looking to protect gains as stocks stall at these lofty levels.
The cost of protecting against a fall in the S&P 500 has dipped to a one-year low, according to equity derivatives strategists at Credit Suisse Group AG. It couldn’t be better timing given analysts at Goldman Sachs Group Inc. are sounding the alarm bell of a drop in stocks over the next three months, laying out a laundry list of investor worries, including stretched valuations, potentially knocking the recent rally.
The seemingly contradictory combination of somnambulant markets in the face of a raft of headline-grabbing events has encouraged some investors to bet on an increase in volatility at some future point with exchange-traded products (ETPs), tied to the asset class seeing billions of dollars worth of inflows in recent months.
But going long volatility has generally proved unprofitable in recent years as the easy monetary policies of central banks have kept a lid on jittery market movements. The much-watched Chicago Board Option Exchange’s Volatility Index, better known as the VIX, is currently languishing at 12.6 — far below its five-year average of 17.30 — despite a host of risk events that ostensibly could have spooked investors. Even when the VIX has risen, investors who put money to work in ETFs tied to VIX futures have seen disappointing returns because of the crippling costs of rolling volatility futures.
Witness the decimation of the VXX, which has declined over 99% since its inception in 2010. The ETF has undergone five 4-1 reverse splits, meaning unadjusted basis shares have declined from approximately $3,600 to the current $10 level.
The relative cheapness of volatility insurance in the face of macro risks suggests sellers are in plentiful supply, despite the risks coming with such a strategy. Selling ‘vol’, usually through the use of derivatives, has often been likened to picking up pennies in front of a stream roller, as those betting against big market moves may make a small but steady stream of money before being wiped out by an unexpected event.
Still, the population of willing volatility sellers has expanded, according to market participants. Companies seeking to repurchase their shares are said to have been selling puts and calls on their own stock to facilitate buyback of their shares. Meanwhile the prospect of generating outperformance in a world of pervasively low returns and high correlations has encouraged investors to sell volatility as a way of boosting yields with a much wider range of investors now in on the act across a wider range of assets.
Systematically selling volatility on products linked to the performance of corporate debt, for instance, “can be very profitable,” Citigroup Inc. strategists wrote in research published last week. They urged their clients to “sell volatility, but in a smart way” as a way of creating outperformance known as ‘alpha.’
The preponderance of investors willing to sell volatility protection on the cheap suggests a market that could be caught off guard in the event of a major sell-off, argues Peter Tchir, head of macro strategy at Brean Capital LLC. In such a scenario, cut-price volatility protection could quickly be elevated from the bargain basement.
“Basically people who sold vol — in all its various forms — have done well and are likely getting more capital and more power. Those who didn’t embrace the central banks and selling vol — in all its various forms — are likely to have seen their capital and influence diminish,” he said. “I cannot tell when this strategy will backfire, but we seem to be closer to a tipping point when everyone ‘knows’ vol will be low given central banks’ eagerness to help.”
For individual investors, the willingness of institutions to sell portfolio insurance at discounted premium levels gives them reasonably low cost way to gain some downside protection.
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