By Thorsten Wegener
If you are active in financial markets, talking about volatility is a bit like talking about the weather. Everybody seems to have a rough idea how it should be, can look out of the window observe how it actually is, and otherwise rely on the experts telling us what we can probably expect in the near future.
Our market equivalent to the handsome weather presenter using his colourful charts divining the coming cold front on the evening news, is the VIX Index. Broadly spoken, the VIX measures the volatility of the stock market. Of course, it does much more than that, but I will come to that in a moment. So, for a while now we can observe that the VIX usually trades around 10%, until it doesn`t anymore, funds close down, traders get fired and everybody starts crying, lamenting that they knew all along that volatility was too low and it didn`t make any sense to sell volatility at these levels. These comments are usually made by the same people who didn’t have the guts to buy it at these suppressed levels, never mind selling it levels five times as high. And why should they?
The VIX is one of those indicators that tells you that you wrecked your car after you’ve driven with high speed into the only tree guarding the country road ahead of you. Why is that, you might ask? Because most people talking about the VIX or volatility in general do not really have a clue what volatility actually really means and what information it can convey. Therefore, lets fill in some details.
The VIX describes the volatility of at the money options of the S&P 500 with a maturity of one month. This means option prices of calls and puts, whose exercise price is at current market levels, getting funnelled into the famous Black-Scholes Formula and the so-called implied volatility comes out of the other side of the equation. As the implied volatility is the measure for the markets anticipation of the riskiness of the S&P 500, it gives us a fairly accurate picture of the opinion of traders and investors in which region the market should trade in a years’ time. If the S&P is trading at 2,800 points than a volatility of 10% recorded in the VIX tells us that the market participants, that means everybody who actually has skin in the game by buying and selling these options, believe that in 12 months from now the S&P 500 will trade 10% above or below the 2800 level.
Helpful to know is the fact that this estimate is, on average, only true about 68% of the time. That is what is called a standard deviation of one. Two standard deviations cover 95% of the possible range and three standard deviations cover 99% of the potential range. Everything beyond that are the real freak occurrences. So, there is a good chance, better than 50:50, that the S&P will trade between +/- 10% in a years’ time. A 95% chance that it will trade between +/- 20% and a 99% chance it will trade between +/- 30% from todays 2800 level. But what does it tell us about the next 30 days, which is after all the time horizon measured by the VIX Index? Let me here introduce some Geek Talk: The square root of time rule simply transforms the annual volatility of 10% by dividing it through the square root of the time horizon we wish to observe, in this case one month, or a twelfth of a year. Therefor an annual volatility of 10% comes down to a ca. +/- 2,9% expected price change over one month. These are the boundaries for the up/down movement we expect to see with a probability of 68% over the next month.
Now we finally have defined what we are talking about, when we speak of volatility. Unfortunately, it doesn’t tell us the really interesting bit of information. What is going to happen tomorrow? It only provides us with the rather lame insight that when we observe a spike in the VIX Index to, for example 50%, everybody is wetting their pants, because a move has already happened.
But do not despair; there is another index you have probably never heard of before, called the SKEW Index, calculated and published by the CBOE. This Index tells us how keen Traders and Investors are to buy risk insurance against market drops beyond two (-20%) and three standard deviations (-30%), will say load up on puts. Why is that valuable? Well just ask yourself how you would drive your brand-new supercar back from the showroom to your home if you had no insurance, or what you would do with it in the full knowledge that you are the ultimate well insured road warrior? The same is true for equity markets. If your portfolio is protected and you have fresh money coming in, keeping on investing feels a lot better than adding risky assets to an already exposed portfolio.
This is where the information the SKEW Index provides might give you a leg up. If you take the time to go over the history of the SKEW-Index you can make some interesting observations.
Firstly, a rising market, or at least a stable market, closely followed a high SKEW Index Value that developed over a longer time period. The market was climbing the proverbial “Wall of Fear”. Everybody was heavily soaked in crash protection, and as markets barely ever do you a favour, this was an unnecessary insurance.
When you see on the other hand that these insurance policies are not renewed or actively sold, a falling SKEW-Index, while the VIX is trading at levels below 10% usually was a good indicator to get cautions. Where are we at the moment? Over the last months the Skew Index kept reliably rising while everybody kept talking about a potential crash. We have just seen new all-time highs in the S&P500, the Russel 2000 and the Nasdaq, which used to be a strong buy signal in the past. In the olden days before every retail investor picked up on that rule, new highs meant go long, explanations would be delivered later.
There might yet be another up move in the cards, just keep vigilante and have a close eye on the SKEW-Index. If VIX volatility levels stay subdued, while the SKEW Index indicates less interest in insurance over a period of time, let’s say two to three months, this might be a good signal to do something cool with all your profits, like investing in Gold. There I said it. More about Gold in another column.