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Trading the current low-volatility regime

by 8/5/2013 7:17 AM
Stocks quoted in this article:

We often (well, sometimes) talk of volatility regimes. These refer to longer-term CBOE Volatility Index (VIX) trends, which we simplify as "up" and "down" VIX trends of a multiyear duration. There's often debate over when one regime ends and another begins, but it's a fairly accepted concept.

We're pretty clearly in the middle of a down wave now. It doesn't mean we won't have VIX pops we clearly will. It just suggests that those pops will be relatively short-lived.

Anyways, Jim Strugger delves into the regime concept a bit in this week's Striking Price, as well as a couple of ways to play it.

The "volatility is dead" mantra is growing louder as a recent series of equity-market pullbacks have failed to trigger shocks similar in magnitude to those experienced over the past several years. We at MKM Partners think volatility isn't so much dead as in the early stages of a multiyear dormancy that will drive greater dispersion of individual stocks and be a boon for equities. Investors can exploit suppressed volatility via relatively new products linked to the CBOE Volatility Index, or VIX. Returns can be supercharged by harnessing the embedded leverage of options.

So where are we in this particular down phase? Here's a very broad look at the VIX over the past 20 years -- (click to enlarge).

Monthly Chart of the VIX since August 1993
Chart courtesy of TD Ameritrade

The previous up phase essentially commenced in February 2007. It seems to have lasted about five years, so by that interpretation, we're about 1.5 years into our current down phase.

The effects of the last up phase remain, though. Everyone looks to bottom-tick volatility on the assumption that the 2007 to 2012 stretch was "normal" and this current stretch is the aberration. But that's really the wrong way to approach it. That was simply one phase, while this one is a completely different one.

When does it end?

The debate now shifts to the potential duration of this low-volatility environment. Since the mid-1980s, volatility cycles have averaged 5.5 years and correlated with underlying economic cycles. It's logical that risk and equity volatility increase late in an economic expansion and remain elevated through a recession trough before subsiding once sustained real growth is achieved. During two comparable low-volatility regimes that began in 1991 and 2003, stocks held an upward trajectory for several years punctuated by the type of short and shallow pullbacks witnessed in recent months.

So if MKM's hypothesis is correct, we could see volatility like this for another four years or so. And volatility spikes are generally for fading. How do you go about that?

While we expect the VIX to range between 10 and 25 for a similar period of time, occasional spikes to the upper end are likely in reaction to market events such as changes in interest rates or an end to the Federal Reserve's bond-buying program. But the longer-term picture is one of relatively low volatility and an upward-sloping VIX futures term structure.

There is a range of securities to exploit this benign volatility environment. The VelocityShares Daily Inverse VIX Short-Term ETN (XIV) and the ProShares Short VIX Short-Term Futures ETF (SVXY) are short VIX exchange-traded products that benefit from negative roll yield, the decay that occurs due to the daily reweighting of the underlying futures contracts.

That last sentence refers to the contango "problem" that affects our friend iPath S&P 500 VIX Short-Term Futures ETN (VXX). In order to maintain a constant 30-days duration, the VXX must roll out of nearer-term VIX futures or swaps and into longer-term VIX futures or swaps. If the VIX curve slopes up, that costs money every day. And the VIX curve virtually always slopes up, ergo costing the VXX money each and every day.

The XIV is the inverse-tracking ETN to the VXX. So as such, it benefits from the same contango that drills the VXX. It's not perfect, though. As a tracker, the XIV loses money via compounding. Any time VXX revisits a price, the XIV loses a bit of value. On the plus side, the VXX doesn't revisit that many prices -- it mostly goes lower. The XIV won't fully capture all that VXX ugliness, but it comes close enough. The SVXY, meanwhile, is the ETF version of the XIV.

But by and large, if you agree with the low-volatility regime thesis, it does make sense to incorporate these anti-volatility plays in your portfolio.

Disclaimer: The views represented on this blog are those of the individual author only, and do not necessarily represent the views of Schaeffer's Investment Research.


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