The stock market rally has been quite resilient... virtually a one-way, low volume ticket to higher prices.
Not surprisingly, volatility has gotten absolutely smashed along the way.
As measured by the widely followed CBOE volatility index commonly known as the VIX, or the “fear gauge”, it recently put in a five year low.
(Extremely low readings in the VIX, as most Tycoon Report readers know, infer that investors have become very complacent with regard to risk. More to the point, these low readings usually coincide with short-term market tops.)
However, it's important to note that volatility can remain low for extended periods of time. So the challenge is to figure out whenmarket volatility will once again rear its ugly head.
What’s interesting about the VIX right now is that it’s currently giving us a huge clue that higher volatility may be coming back not only sooner, but with a greater magnitude than most investors think.
This can be powerful information in helping you manage your investment strategy and better protect your portfolio assets if you can identify it early.
So today, I’m going to share with you a helpful tip on how you can better interpret what the VIX is telling you.
If you really want to know the secret to having great “market feel”, I’ll be happy to share it with you. It’s simply getting a good read on market volatility.
So let’s take a look at the VIX. Like I mentioned, it just hit a multi-year low, briefly dipping below 14.00 this past Tuesday. Yesterday it closed at 15.31 -- a level that is still very indicative of overly complacent investors.
VIX (5 year daily chart)
Simply put, the VIX measures implied volatility. Specifically, how expensive option premiums are on the S&P 500 index that are roughly 30 days from expiration.
High readings (above 30) usually infer elevated fear among investors who are bidding up the price of options (protection). The markets are more active with heavier volume and wider ranges.
Low readings (below 18) usually infer subdued levels of fear, and option prices tend to recede as investors become comfortable selling premium (generate income). The markets tend to behave in a more orderly fashion with lower share volume and tighter ranges like we’re seeing right now.
Market volatility tends to mean reverting. While the historical average of the VIX is around 20, you can see from the five-year chart above that it can spike very high during times of heavy market stress, or can fall and stay subdued below its mean for months at a time.
So we know the VIX is low. In fact, it’s historically low. We also know that the markets have been behaving in lock-step fashion with a low reading in the VIX. Trading has been orderly, with lower average volume and tighter intraday ranges.
But for how long?
We know that volatility will eventually shift at some point. At the very least revert to its mean average. More realistically, move much higher and spike sometime in the future during the next market crisis, whatever that may turn out to be.
We also know that low volatility can hang around for quite some time, generally much longer than the periods of high volatility.
Still leaves a lot of question marks, doesn't it? So what else can we do to help us get a better handle on this?
Well the answer for me still lies in the VIX. But we’re going to broaden our horizon.
Let me explain...
The VIX is an index, and does not trade as a security. It’s simply a quantifiable perpetual mathematical calculation that measures implied volatility on S&P 500 index options.
So when we look at the VIX, it’s a “spot price” that we’re looking at.
And while it certainly gives us a decent amount of information about the current volatility environment, you can actually take your analysis to the next level-- into master “market feel” territory.
Several years ago, VIX futures and VIX options on futures were introduced and became tradable products. And while you may have no desire to trade these products, a wealth of free information lies at your fingertips as a result.
By following the VIX as well as VIX futures, you can refine your interpretation on not only the current volatility landscape, but perhaps where future volatility may likely be heading.
From my analysis, this extreme low volatility environment will most likely be short lived rather than extended.
And I am also expecting volatility to move up significantly higher than its mean average.
The following Table and Graph show the term structure of the VIX spot and VIX Futures
You can see that “Spot” VIX closed yesterday at 15.31, which is indicative of low investor fear and a continued sanguine outlook.
But if we look a little deeper on how the “smart money” is pricing future volatility, the picture it paints is quite different. In fact, the term structure across the delivery months is extremely steep -- steeper than I think I’ve ever seen.
The VIX April futures are not only 40% higher than Spot, but also above the long-term mean average (in a few weeks we’ll get into Q1 earnings season).
The VIX July futures are even higher (with six-party talks set to get under away and potentially a last ditch effort to find a diplomatic solution regarding Iran’s nuclear program, the summer is most likely the window of opportunity if a military strike is carried out).
And the VIX November futures are extremely elevated, nearing almost 30, which is a historical level of heightened volatility (the US will be going to the polls to determine who will control the White House for the next four years).
The bottom line is that paying close attention to volatility is very important.
Most average investors do pay some attention to the VIX, but if you want to really up your game and obtain master “market feel” status, start to look a little deeper into the future... sometimes you’ll be surprised at what you may
find.
