While the media sensationalized Dow 20,000, equity markets finished lower Wednesday: the S&500 index (SPX) closed lower -0.25% to 2,265.18, the Dow Jones Industrial (INDU) closed -0.16% to 19,941.96, and the Russell 2000 (RUT) closed -0.63% to 1,375.19. Volatility, as measured by the VIX , is at historic lows, considering the average for the index is around 20.00; however, there is nothing to indicate that volatility can’t remain below that level. It remains to be seen if hedgers will be sizable buyers of current lower priced volatility, and create a typical reversion to its mean.
As the markets hover near all-time highs during the last weeks of the year, the CBOE S&P500 volatility index (VIX) traded at an intraday low of 10.93 and closed at 11.27. The CFE had 263,112 VIX futures trade yesterday and VIX options volume in the CBOE was 745,881 as VIX settled at 11.15. The VIX futures forward curve has remained steep (contango) where wider spreads between the front month volatility and back month volatility will cause spot VIX to typically track lower. Because of this curve structure, time decays have made it difficult to be on the long side of volatility during a relatively quiet part of the year.
In typical fashion, as markets become concerned about rising risks in financial markets, risk assets are sold and safe assets are bought. For example higher beta names -those companies that are riskier compared to the market- tend to be bought during market rallies and sold during market sell-offs. If one tends to believe that risk in smaller capitalization names is rising relative to large cap ones then one can surmise the volatility is rising in general.
Measuring the relative performance of the Russell 2000 volatility index (RVX) versus the S&P500 volatility index (VIX) can help determine the general direction of volatility. Typically, as risk sentiment improves, the RVX/VIX ratio increases as higher beta names are bought, and as risk sentiment falls, higher beta names are sold.
Over the past year, volatility has tracked pretty closely to the price action in gold and treasuries. It should be noted that correlation is not causation, but rising risk sentiment tends to favor equities and falling risk sentiment tends to favor bonds and gold. Since the presidential election, bonds, precious metals and volatility have sold off as money flowed into equities. There persists a general feeling of euphoria and exuberance in the markets as we close out the year.
Forecasting volatility is just as difficult as forecasting markets and the general picture in terms of risks remains unclear in 2017. As we close the year, it is likely volatility is underpriced. For one thing, uncertainty is on the rise as it pertains to political risk with a number of upcoming elections in Europe. Although there is optimism in the new administration, there is less clarity on the direction their fiscal policy will take. In other words, rising tail risks are what presently concerns many market participants. To take advantage of any spikes in the VIX large position traders and money managers could pair volatility strategies and other assets classes within their current portfolios. Playing volatility doesn’t necessarily mean trading only VIX options and VIX futures. Financial futures and index option strategies can serve as hedges as well.